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date: 05 March 2021

Abstract and Keywords

This article offers an overview of how different company decisions are affected by various tax policy instruments when some firms are financially constrained due to agency problems between inside and outside investors. To organize the discussion, the article presents a simple theoretical model of constrained and unconstrained firms with endogenous organizational choice. When the managerial effort of entrepreneurs is not observable, a high success probability of the firm is guaranteed only if insiders keep a large enough financial stake in the firm. Accordingly the company's income that is pledgeable as a repayment to external investors is reduced and limits the amount of external funding that the firm can obtain. This framework of financially constrained firms leads to predictions for the effects of taxes on investment and external financing that are entirely different from the traditional neoclassical model.

Keywords: business taxation, corporate finance, economic performance, outside investors, tax policy, organizational choice

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