Strategic Responses to Taxation and Welfare Effects of Tax Policies

This dissertation focuses on firms’ strategic responses to taxation and the welfare implications of changes in tax structure. The dissertation is comprised of three essays. In the first essay, I use the Tax Reform Act of 1986 to investigate how firms adjust their tax strategies in response to the tax incentives induced by the reform. The results in essay one suggest that the 1986 reform created incentives for firms following a sustainable tax strategy to engage in more tax avoidance behavior. In essay two, I test for the presence of strategic cost shifting behavior by examining the distribution of taxable income around kinks in the corporate tax code. Specifically, the McCrary’s (2008) density test, which was developed as a validity test in regression discontinuity design (RDD) is applied to a data set of US firms for the period 1988-2010. The results show that reported taxable income has a tendency to bunch at levels just under upward kinks in the marginal tax rate. Conversely, taxable income tends to exhibit gaps in the region below a downward kink in marginal tax rates. Both findings suggest that firms manipulate taxable income in response to kinks in the corporate tax code. In essay three, I provide an explicit model that illustrates the incentives for strategic cost shifting behavior when the tax code exhibits kinks. In the presence of upward kinks in marginal tax rates, profit maximizing firms will choose a path for investment that makes pre-profits bunch just below the kink point. I then use the model to quantify the welfare cost of kinks in the marginal tax rates. Additionally, I find that replacing a kinked tax code with one in which marginal tax rates rise smoothly retains the progressivity inherent in the current tax code while largely avoiding the welfare costs associated with large jumps in marginal tax rates. Adviser: Matthew J. Cushin