A Tax Paradox for Investment Decisions under Uncertainty

In this paper we use a real option model for assessing uncertain investment projects and we show that—due to a flexibility premium—taxes asymmetrically affect the option value of projects that differ in their riskiness. Hence, this may generate distortions. We analytically identify a set of neutral tax rates (a tax regime) that preserve the post‐tax investment threshold if taxes change, and determine normal and paradoxical settings for investments. Unlike other tax paradoxes neither depreciation rules nor loss offset restrictions cause these paradoxical reactions. Taxes affect each project individually, depending on the project risks involved. This implies that, for a variety of uncertain projects, taxes cannot be neutral on aggregate.