Fluent Essays

5 pages hghly urgent and needed in 7 hrs Paper details ANALYZE THE MANAGEMENT ACCOUNTING AND FINANCIAL ACCOUNTING SYSTEM IN AN UNSTABLE TAX STRUCTURE This is a dissertation proposal 1- Produce a suitably focused systematic literature review which demonstrates a critical analysis of the chosen topic area. 2. Data collection and data analysis research methods along with practical illustrations, and understand what works best for different types of projects 3. Understand philosophical and ethical issues surrounding management research in general, and primary data collection and interpretation in particular. 130 Faculty of Business Economics and Entrepreneurship International Review (2020 No. 3-4) ©Filodiritto Editore SCIENTIFIC REVIEW ANALYTICAL SUPPORT OF THE MANAGEMENT ACCOUNTING SYSTEM IN AN UNSTABLE ECONOMY CONDITIONS DZOBELOVA Batrazovna Valentina1, DOVTAEV Sayd-Ali Shakhidovich2, KUZINA Anna Fedorovna3, SHADIEVA Movlatkhan Yusupovna4, ELGAITAROVA Nargiz Takhirovna5 1 North-Ossetian State University named after K.L. Khetagurova (RUSSIA) 2 Department of Enterprise Economics, Chechen State University (RUSSIA) 3 FSBEI HE “Kuban State Agrarian University named after Trubilin” (RUSSIA) 4 Ingush State University (RUSSIA) 5 North-Caucasian State Academy (RUSSIA) Abstract The globalization of the modern economic system, the scarce nature of the resources used, the depressive and stagnant nature of the current processes, the increasing complexity of the geopolitical situation and the deterioration of the environmental situation, etc. predetermine a serious transformation of the functions of accounting services and the role of accounting in the modern management system. In these conditions, the need to study the impact of environmental factors on the nature of the enterprise activity and the mechanism for the development and adoption of managerial decisions are especially relevant. It is indisputable that the accounting organization system in a crisis situation should be different from its management in a sustainable development environment; this determines the need to improve managerial accounting methodology in conditions of unpredictability and instability of the external environment. An analysis of the specialized literature suggests that there are insufficient studies of many aspects concerning the methodological content of the anti-crisis model of managerial accounting, the construction of its categorical apparatus, and the provision of a managerial accounting model in crisis processes in the economy, etc., which predetermined the choice of the topic of our study. Keywords: economic crises, business entities, anti-crisis management accounting, analysis, information support JEL: M41 UDC: 657.422 005.332:338.12 COBISS.SR-ID 28657417 Introduction A characteristic feature of the processes in reforming the accounting system in the Russian Federation is its focus on rapprochement with generally accepted international standards with the emphasis on financial, tax and management reporting. Among the most pressing problems with regard to the development of the conceptual and applied foundations of the current methodology for management accounting in Russian business structures, we want to highlight 131 Faculty of Business Economics and Entrepreneurship International Review (2020 No. 3-4) ©Filodiritto Editore the transformation of the methodology and objects for management accounting in an unstable economy. When speaking about the crisis-functional relationship between management accounting and other sciences, it should be noted the growing contrast of objects, functions, techniques and methods of management accounting with the corresponding components of control, management, planning, etc. in the context of strategic and operational elements. This situation causes interdisciplinary disunity of management accounting and management accompanied by organizational and infrastructural underdevelopment, and lack of prognostic orientation. As a rule, the subject matter of most of the works developed by Russian researchers is limited and mainly is focused on certain issues of cost accounting and calculating the actual cost of production. At the same time, many aspects of information support in innovative areas in management are at best considered but fragmentarily. In these conditions, the problem of using KPI technologies, compiling integrated reporting, developing a balanced scorecard from financial and non-financial indicators, etc., remain completely unexplored. Apparently, also for this reason Russian companies operating in world markets are very often faced with the situation when their reporting does not meet the information needs of users due to their inadequate analyticity and relevance. The high level of discussion nature of various approaches and interpretations regarding the issues under consideration, forming the conceptual design framework of the management accounting, has shaped the focus of our study. Research methodology The basic principles of the institutionalism theory, managerialsystems, including cyclical development, crisis management, managerial accounting, and economic analysis became the theoretical base for the study. The general scientific methods of cognition, such as system analysis, induction, deduction, comparison, formalization, etc., wereits methodological basis. The regulatory framework of the Russian Federation in the field of accounting, IFRS, the works of domestic and foreign scientists, etc., served as an information base. Research results Globalization processes in the world economy objectively imply the development of modern tools of scientific, methodological and practical support for the sustainable growth of economic systems, which, undoubtedly, puts them among the most significant tasks in the state power system and in the scientific community. In the today’s conditions of increasing competition, economic systems have become more nonequilibrium, which is associated with additional research in the field of monitoring and controlling the economic processes of the exogenous and endogenous environment, affecting the development sustainability of both individual enterprises and socio-ecological and economic systems in general. A feature of the modern system of accounting and analytical support is its focus on accounting and analysis of internal information. It is clear that in such conditions almost all external information (independent of the activities of enterprises) falls outside the scope of mandatory accounting, which actualizes the unpreparedness of business entities for crisis phenomena. [1, 4, 8] All this requires that the analysis of the environmentalsituation in the macroeconomic instability conditions become an everyday component of management accounting. It seems to us that this also requires the use of special principles and methods of constructing information for the development and adoption of managerial decisions, different from those that are 132 Faculty of Business Economics and Entrepreneurship International Review (2020 No. 3-4) ©Filodiritto Editore applied in conditions of sustainable development. In today's realities, it is no longer impossible not to see that constantly changing economic circumstances can directly affect accounting and the practice of preparing financial statements. It seems to us that accounting cannot be seen as a dogma, as something forever established, because it is constantly influencedby a constantly changing environment. It should also be noted that, as a rule, the effectiveness of management decisions made in practice depends on how much an accountant-analyst was able to consider the individual characteristics of the enterprise. This provision suggests that the constant use of only one unified approach in the implementation of accounting and analytical actions is not always appropriate and, moreover, can often lead to the adoption of ineffective management decisions. We proceed from the fact that an individual (creative) approach consists in the ability to the fullest extent consider the factors that shape the special aspects of activity of an enterprise. Researchers note that the management accounting methodology is more dependent on the stage of the life cycle, which involves the use of a wide range of tools to implement the enterprise’s strategic plan at the appropriate development stage [12]. Our analysis of the institutional evolutionary theory allowed us to identify environmental factors that influence the algorithm for the development and adoption of effective management decisions and to justify the mechanism for an adequate response to external market and macroeconomic triggers. In this format, the life cycle theory allows to a greater extent to consider the features of the strategic management accounting system. The life cycle of an enterprise depends on its balance with the financial cycle, on the ability to influence it, and, thereby, steadily and proportionally develop economic systems at the micro level. In these conditions, the management accounting system must be directed to leveling internal contradictions that have the nature of organizational properties, as well as emerging conflicts with external factors when an enterprise moves to the next stage. [15, 17] To solve the complex of strategic management tasks, portfolio analysis methods, including such as the Boston Consultancy Group matrix, life cycle matrix (ADL), etc. are actively used A characteristic feature and commonality of these models is the combination of some systemevolvement parameters of different levels such as a company, product, or even a particular sector of the economy. In our opinion, the strategic goal of any enterprise in the face of increasing competition is the implementation of such a business model that can enable the generation of sufficient added value with any environmental changes. This situation implies the need for structuring the properties of the accounting and analytical system with all kinds of combinations of stages of the enterprise life cycle. Being a direct factor in the macroenvironment, any stage of the life cycle itself actively forms management accounting models and affects the configuration of the methods used that are generally accepted for the accounting direction under study. In modern economic realities, stable economic growth can only be achieved through effective management of business structures at the micro level, subject to prompt and accurate management decisions. All this is associated with the need to search for effective tools to increase the relevance of the generated information base. Let us turn to the consideration of macro environment factors affecting the configuration of the used management accounting tools. In recent years, the tendency on transformation of the subject of financial accounting comes into more and more sharp focus. Moreover, if in the past it was determined by the composition of assets and liabilities in the balance sheet, at the present stage the market economy itself determines the subject of accountingunder the influence of cyclical and evolutionary processes. Globalization and structural changes at the 133 Faculty of Business Economics and Entrepreneurship International Review (2020 No. 3-4) ©Filodiritto Editore micro level are accompanied by changes in the tools of operational and strategic management at the level of individual business entities. [2, 16, 18] Traditionally, accounting and analytical work has always been aimed at reflecting only the facts of economic life. At the same time, a complex of macroeconomic factors that are exogenous with respect to a business entity, which is very important for the financial situation of the enterprise, was ignored when making management decisions. It seems to us that this fact cannot be explained by the mere conservatism of the accounting methodology, because macroeconomic processes unequally affect various sectors of the economy, which makes it extremely difficult to monitor and control the financial situation of the enterprise. All this emphasizes once again thata special consideration of the factor of the economy crisis state is relevant. The study of the essence of the economic crisis impact on the management system allows us to note a number of contradictions in the system of accounting and analytical support. First of all, it concerns the attitude to costs. Under current conditions, there is a mismatch between the policy of the need to reduce costs due to a lack of own funds and the policy of the need to increase costs to intensify the business activity of enterprises. Further, the need to establish anti-crisis funds while escalating the financing of current operations is controversial. It is also possible to note certain contradictions in the choice of priorities in the methods of generating information, in the style and priorities in management, in the stable tendency of the faster growth of financial and economic technologies over accounting and analytical technologies; those factors negatively affect the prognostic potential of the generated information base and thereby strengthen unpredictability in identifying threats and risks of manifestation of economic crises at both micro and macro levels. [3, 11, 14] To eliminate the above and other contradictions, we need in new effective methodological approaches to the development of relevant data in order to provide information-analytical support for making managerial decisions. Modern accounting methodology is characterized by increasing integration with tools for generating relevant information in systems such a s financial management, crisis management, controlling, marketing, economic and mathematical modeling, statistical and econometric analysis, etc. Undoubtedly, all this form an additional synergetic effect in the system strategic management of business structures and thereby expands the subject and functions of management accounting. In these conditions, in our opinion, the study of the anti-crisis aspect of management accounting becomes even more relevant. Indeed, in conditions of increasing uncertainty and instability of macroeconomic processes, which impedes the stable development of enterprises, it is necessary, first of all, to develop the functions of warning, which anticipate crisis phenomena in the management accounting system. Experts note that economic crises violate generally accepted and well-established approaches to making managerial decisions through a complex impact on the information support system itself. [7, 10] As an example of such a transformation, we can consider a change in attitude to assets as an economic category. So, if in modern accounting, the composition, methods of valuation and recognition of assets are almost the same as they were fifty years ago, then from the perspective of investments, a number of highly liquid assets influenced by global financial crises (2008, 2014) became less liquid (these include, including, real estate, securities, etc.) in today’s realities. It seems to us that all this should affect the system of accounting and analytical support for the activities of enterprises. So, for example, it is necessary to modify the management accounting system to achieve the proper management of assets, liabilities, income and expenses in the new economic conditions. In addition, it should be noted that in the context under review, many objects of financial accounting are moving into the sphere of 134 Faculty of Business Economics and Entrepreneurship International Review (2020 No. 3-4) ©Filodiritto Editore management accounting, direct penetration of the constituent methods of financial and management accounting is performed out. All this allows us to argue that at the present stage the accounting methodology is subject to pressure from macro environment factors, which, to a significant extent, modifies the tools of management accounting. Indeed, the development of the post-industrial economy is accompanied by evolutionary processes not only in the system of ongoing business processes, but also by the need to adapt the management accounting technologies used to the specifics and characteristics of crisis phenomena in the economy. All this suggests that the modern methodology of managerial accounting must be adapted to the functioning of enterprises in the face of increasing competition, quite often accompanied by a fall in traditional markets. The successful conduct of modern business requires learning to diagnose the environment, anticipate its depressive development, which will allow timely identification and subsequent leveling of negative trends for the efficient operation of the enterprise. An analysis of the works of Russian scientists suggests that almost the majority of the developments are devoted to diagnosing the financial situation of enterprises and, at the same time, the whole set of recommendations for the anti-crisis nature does not go beyond an enterprise. In fact, it seems to us that the deteriorating financial situation of an economic entity, in our case, is not the cause of the crisis situation, but its consequence, because crisis processes affect not only the finances of an enterprise, but also other areas of its activity, including accounting tools and the order of production and financial activities of an economic entity. In the conditions of increasing competition and the instability of economic conditions, the system of accounting and analytical support for an enterprise should have some flexibility and adaptability to ensure the use of effective management tools for implementing the strategic plan and operational tasks of the enterprise. Among these tools, there can be noted a balanced scorecard (developers – D. Norton and R. Kaplan). [6] Its use allows managers to have a balanced view of the main production and financial activity indicators, through which it is possible to reliably evaluate various aspects of the functioning of an enterprise at the same time. Indeed, a set of various financial indicators allows us to see the results of the implemented measures and managerial decisions, but financial indicators alone do not allow us to evaluate the future economic values of an enterprise. Hence, it must be assumed that the process of strategic management of an enterprise also requires the development of a certain array of non-financial indicators, which, together with financial indicators, objectively reflect the actual financial, economic, social and market situation of the enterprise and its ability to implement a given strategy. [13] Other models of management accounting and strategic management are also very popular abroad, including economic added value model, triple reporting system, strategic position matrix and action assessment, etc. Among Russian researchers in this area, we may note G. B. Kleiner; he considers the fifteen functions of an enterprise, including anti-crisis stabilizing function. [2] In general, we must admit that in times of crisis, an analyst should also pay special attention to the state of the external environment, because at the present stage, the financial situation of Russian enterprises to a large extent depends on the influence of external factors. Conclusions and proposals In the course of the study, we analyzed various approaches of the conceptual-theoretical and organizational-methodological substantiation of the management accounting system in an 135 Faculty of Business Economics and Entrepreneurship International Review (2020 No. 3-4) ©Filodiritto Editore unstable economy, which allowed us to identify a wide variety of factors which are the basis of the genesis of economic development, and at the present stage have a direct impact on the methodological content of management accounting. It is proved that the economy cyclical development factor is one of the key ones when considering approaches to the formation of the management accounting concept. This situation indicates the objective need to change user requests for relevant information concerning the development and adoption of effective management decisions in a non- deterministic environment; it is the evidence that economic crises in the economy significantly affect, among others, the improvement of the management accounting methodology. Using a systematic approach allows us to modify the anti-crisis model of managerial accounting, and also to level out the resulting disorder in the construction of elements of the managerial accounting theory, and thereby to develop effective tools for creating relevant information to work out effective management decisions in the today’sconditions of unstable economy. REFERENCES [1] Adizes I. How to overcome management crises. Diagnostics and solution of managerial problems. St. Petersburg: Stockholm School of Economics, 2007. P. 294. [2] Berdnikov V.V. Analytical tools for developing and monitoring the effectiveness of business models // Audit and financial analysis. 2013. No. 3. Pp. 283-294. [3] Bulgakova S.V. Prerequisites, conditions for the emergence and periodization of the development of management accounting // Bulletin of Voronezh State University. Series: Economics and Management. 2005. No. 2. Pp. 198-204. [4] Vakhrushina M.A. Problems and prospects of development of Russian management accounting // International Accounting. 2014. No. 33. Pp. 12-23. [5] Gerasimov V.O., Sharafutdinov R.I., Kolmakov V.V., Erzinkyan E.A., Adamenko A.A., Vasileva A.G. Control in the human capital management system in the strategy of innovative development of a region. Entrepreneurship and Sustainability lssues. 2019. Т. 7. № 2. Pp. 1074-1088. [6] Kaplan R. Balanced scorecard. From strategy to action / R. Kaplan, D. Norton. Translation from English. M.: Olympus Business. 2003. P. 320. [7] Kaspina R.G. Application of a process-oriented approach in management accounting to the formation of a business model of an organization // International Accounting. 2013. No. 39. Pp. 2-8. [8] Kogdenko V.G. Features of the financial policies of companies in a crisis // Economic analysis: theory and practice. 2015. No. 15. pp. 2-14. [9] Kolupaev A.A., Voronkova O.Yu., Vakhrushev I.B., Adamenko A.A., Solodkin V.S., Alekhina N.A. Corporate identity of lodging establishment as a factor of increasing tourism activity in the region. Proceedings of the 33rd International Business Information Management Association Conference, IBIMA, 2019: Education Excellence and Innovation Management through Vision 2020. Pp. 7948-7956. [10] Legenchuk S.F. World trends in the development of accounting in a post-industrial economy // International Accounting. 2011. No. 8. Pp. 56-62. [11] Ovsyannikov S.V. Formation of an anti-crisis strategy based on factors of the organization’s life cycle // Bulletin of the Voronezh State Agrarian University. 2012. 32. Pp. 274-279. [12] Rumyantseva E.E. New Economic Encyclopedia. 4th edition. M.: Publishing House Forum: INFRA-M, 2012. P. 256. [13] Fomchenkova L.V. Transformation of the strategic analysis tasks in the context of organizational development // International Research Journal. 2016. № 4-1. Pp. 127-129. [14] Dzobelova, V., Olisaeva, A. (2018) Analysis of innovative development of the NCFD regions in Russia. IDIMT 2018: Strategic Modeling in Management, Economy and Society – 26th Interdisciplinary Information Management Talks, pp. 473-479. [15] Misakov V.S., Misakov A.V., Tsurova L.A., AdzhievaA.Yu., Eskiev M.A. Ways of improving the economic mechanism for the social development of rural settlements of mountainous areas//International Journal of Advanced Biotechnology and Research. 2017. V. 8., № 4. Pp. 964-972. https://elibrary.ru/item.asp?id=30650150 https://elibrary.ru/item.asp?id=30650150 https://elibrary.ru/item.asp?id=30650150 https://elibrary.ru/contents.asp?id=34547055 https://elibrary.ru/contents.asp?id=34547055&selid=30650150 136 Faculty of Business Economics and Entrepreneurship International Review (2020 No. 3-4) ©Filodiritto Editore [16] Misakov V.S., Tsurova L.A., Yandarbieva L.A., ThamadokovaI.Kh., Goigova M.G. Certification of regional economic complex as a highly effective tool for analysis and diagnostics of its development // Amazonia Investiga. 2019. V. 8., № 20. Pp. 451-458. [17] MisakovV.S., KhamzatovV.A., TemrokovaA.Kh., MisakovA.V., DikarevaI.A. Strategic management of innovative agro-industrial projects // Amazonia Investiga. 2018. V. 7., № 14. Pp. 16-23. [18] Ugurchiev O.B., DovtaevS.A.Sh., Misakov V.S., Misakov A.V., Temmoeva Z.I., Gyatov A.V. 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Article history: Received 13 April 2020 Accepted 25 August 2020 https://elibrary.ru/contents.asp?id=35461233 https://elibrary.ru/contents.asp?id=35461233&selid=36478593 https://elibrary.ru/item.asp?id=36478593 https://elibrary.ru/item.asp?id=36478593 https://elibrary.ru/contents.asp?id=35461233 https://elibrary.ru/contents.asp?id=35461233&selid=36478593 Management accounting in less developed countries: what is known and needs knowing Trevor Hopper Manchester Business School, University of Manchester, Manchester, UK Mathew Tsamenyi University of Birmingham, Birmingham, UK Shahzad Uddin University of Essex, Colchester, UK, and Danture Wickramasinghe Manchester Business School, University of Manchester, Manchester, UK Abstract Purpose – The purpose of this paper is to evaluate management accounting research in developing countries and formulate suggestions for its progression. Design/methodology/approach – This is a desk based study of existing literature analysed through a framework of management control transformation in developing countries derived from the authors’ research. Findings – Research is growing, especially on accounting in state-owned and privatised enterprises but more is needed on small and micro enterprises, agriculture, non-governmental organisations, and transnational institutions. Originality/value – This is the first review of this area and thus should help intending and existing scholars. Keywords Management accounting, Developing countries, Poverty, Privatization Paper type Literature review Introduction Research on accounting in less developed countries (LDCs) has grown over the past 20 years. This is welcome for its previous neglect rendered the accounting needs of poor people who constitute most of the world’s population as marginal and esoteric despite their concerns being as pressing – if not more so – as in rich countries. Moreover, LDCs form part of the mosaic of world trade and rich countries can learn from them, e.g. on poverty reduction and reconciling ethnic tensions. The growth of LDC research may be attributable to increased globalization of capital markets and competition; structural adjustment programmes of development finance institutions; newer less Western-centric accounting journals; the diaspora of accounting scholars from LDCs to rich countries; and Western PhD programs that encourage candidates to The current issue and full text archive of this journal is available at www.emeraldinsight.com/0951-3574.htm The authors wish to thank the Research Foundation of the Chartered Institute of Management Accountants for funding that made this paper possible. Management accounting 469 Received 27 January 2008 Revised 3 July 2008 Accepted 11 September 2008 Accounting, Auditing & Accountability Journal Vol. 22 No. 3, 2009 pp. 469-514 q Emerald Group Publishing Limited 0951-3574 DOI 10.1108/09513570910945697 conduct indigenous research. However, most research is on financial accounting. This is unfortunate as management accounting systems (MAS) play an important role within development:, e.g. central planning requires iterative budgeting between state organs and enterprises, and current market-based policies are predicated upon private interests fostering more efficient controls. Moreover, MASs bear directly on development issues like governance, planning, employment and quality of life but their enactment is problematic: local politics and cultures can transform them into tools of coercion or external legitimacy rather than rational control and democratic accountability. Apart from editorial introductions summarising special editions of journals (Alawattage et al., 2007; Hopper and Hoque, 2004) no review of MAS research in LDCs exists. Previous reviews, notably Jaggi (1973), Samuels (1990), Wallace (1990), Needles (1994, 1997), and Rahaman et al. (1997) focus on financial accounting but touch on MAS issues[1]. This leaves potential MAS researchers ignorant of previous empirical conclusions, and debates over policy, practice and theory. Hence the motivation for this paper, which endeavours to voice to LDC concerns, stimulate interest in the area, and debate how MASs might better serve humanitarian development. The paper has three broad aims. First, it categorises MAS research by country, stage of development, topic, methods and theory to track its themes to date. Second, based on the authors’ work mainly in Bangladesh, Ghana and Sri Lanka, it outlines a framework of MAS transition from colonial times to today. Third, this is used to analyse discoveries to date and future research needs. The paper ends with conclusions. MAS research by country, stage of development, topic, theory and research methods Our definition of MAS embraces processes, structures and information for organisational decisions, governance, control and accountability. ;It is deliberately broad – too narrow and technical definitions deflect attention from historical, social, political and economic factors, and their unanticipated consequences. Rigid boundaries are dangerous as development issues need open, imaginative, problem-based approaches that transgress disciplines and forms of accounting. We excluded financial accounting papers on LDCs, including social and environmental accounting ones (see Gray and Kouhy, 1993) but in retrospect such demarcations may be dangerous, as will be discussed. The journals searched covered Abacus; Accounting, Auditing, and Accountability Journal; Accounting and Business Research; Accounting, Organizations, and Society; Accounting Review; Advances in International Accounting; British Accounting Review; Critical Perspectives on Accounting; Journal of Accounting Research; Journal of Business Finance and Accounting; International Journal of Accounting; Journal of International Financial Management; Journal of Accounting and Organisational Change; Journal of Management Accounting Research; Management Accounting Research; Qualitative Research in Accounting and Management; and Research in Third World Accounting (now Research in Accounting in Emerging Economies). Other known relevant papers were included. However, much MAS research lies untapped in non-Western and non-English research outlets, especially reports by national and AAAJ 22,3 470 transnational governmental bodies and aid agencies[2], and journals in development studies, public administration, and management. Defining a LDC is fraught and problematic: poverty may not universal within a country and development rates vary, can be discontinuous, and poverty is not unique to LDCs. Nevertheless, a LDC is characterised by low rates of per capita income, capital formation and value added. Development is not merely an economic phenomenon but includes environmental degradation, child welfare, quality of life, citizen empowerment, and governance. Despite debates on what constitutes development (Rao, 1991; Munck and O’Hearn, 1999), the United Nations’ and World Bank indices have particular currency. This review examines research on countries within the World Bank lower to upper middle income bands[3]. This covers a wide span of incomes but enabled us to cover a broad range of LDCs, including ones that have moved into higher income bands. World Bank indices are cruder than UN ones but our categorisation included all countries in categories (a) and (b) of the UN HPI[4]. However, ex-communist countries in transition were excluded [see special issue of Management Accounting Research (2002, Vol. 13 No. 4) and Research on Accounting in Emerging Economies (supplement 2, 2004)] as they are often relatively affluent, may lie within Western political and economic systems, and have a legacy of Western institutions under revival. Had papers from poorer, ex-communist countries like Albania or Kazakhstan been found they would have been included. However, we included China (excluding Hong Kong) as it still contains considerable poverty, has grown from a low economic base, is non-Western, and has material apposite to other LDCs. Nevertheless, MAS issues in LDCs and transitional economies bear similarities, so this review may contain insights for the latter. In total 75 empirical papers from 29 countries (11 African, eight Asian, two Pacific, six Latin American/Caribbean, and two Middle-East) fell within our remit. Appendix 1 details their extensive geographical spread across countries though only China has sustained research. Papers on countries within World Bank low and lower-middle income bands were more prevalent than on upper-middle income countries (see Table I). Appendix 2 classifies these papers by research topic. It reveals a preoccupation with control in SOEs and privatisation (full or partial). Papers were not classified between SOEs and privatised companies because often they overlapped both. This is understandable given the initial dominance of state led development based on industrialisation through SOEs, and subsequent turns to market oriented policies involving privatisations. However, the few papers on multi-national organisations (MNOs) and large indigenous companies were a surprise. Whether this was due to the journal search parameters or negligible MAS problems (unlikely given our review later) is unknown. More papers on MAS in central and local government may have WB GNI bands for all countries (234) Countries with MAS research papers (29) Papers per income band (75) Low income (53) 10 25 Lower-middle income (55) 10 36 Upper-middle income (41) 7 9 High-income (85) 0 0 Unclassified – global n/a 3 Table I. MAS papers across World Bank gross national income bands Management accounting 471 materialised had public administration and development studies journals been searched. The small number of papers on agriculture; non governmental organisations (NGOs); indigenous companies, especially small and medium sized enterprises (SMEs); and micro-organisations including households, domestic industry, sole traders, and peasant agriculture was disappointing though work is emerging. Classifying papers by research methods (see Appendix 3) revealed a strong preference for case studies (47) rather than quantitative statistical work (19). Of the latter, 8 incorporated fieldwork, normally interviews, usually to inductively derive key variables for testing rather than relying on research instruments derived from developed countries. Such studies have identified distinctive sources of uncertainty in LDCs and their effects (see Alam, 1997; Hoque (1995); Hoque and Hopper (1994); Kattan et al., 2007; O’Connor et al., 2006). The 47 case studies were not differentiated further as they frequently triangulated data and methods. Interviews and documentary analysis were the most common methods. Observational, participation observation, and action studies were scarce: only one experiential study was found – significantly from a World Bank consultant researcher. This reflects the poor dialogue between accounting researchers and development practitioners, unlike that in development studies. Case studies have been innovative, e.g. Davie’s (n.d.) ethnography of accounting in Fiji, and Kim (n.d.) on contemporary feminist and postcolonial writings criticising oral history. The desk and documentary studies category contains 10 heterogeneous papers ranging from literature reviews to studies of documentation and reports, normally from government and aid agencies (vital but neglected information sources despite their practice or policy hue). Appendix 4 shows many papers (19) had no explicit central theory, being problem-based, pragmatic or reviews. Only 3 were based in economics and 2 in development economics/studies, and then only loosely so. There was a smattering of social psychology papers with little commonality: 12 followed accounting and performance measurement (RAPM) and contingency theory research, and another 6 combined these with institutional theory. Two followed public administration traditions. Grounded/ethnographic/hermeneutic studies (26) of cultures and MASs predominated, perhaps because of desires to accord indigenous beliefs and social structures due respect in the face of the agendas and rationalities of political reformers. Some researchers treat the latter as objects of study using Bourdieu, Foucault or structuration theory to examine whether ideologies of accountability in official documents match the legitimate interests of locals. This gives an indigenous voice, challenges the hegemony of powerful external institutions, and scrutinises their policy documents. However, research exclusively based on discourse and texts can fail to connect this to practices and resistance (hence the need for grounded studies), and may downplay the effects of socio-economic structures. Hence the preference for some researchers (including the authors) for political economy approaches that combine grounded and institutional data, employ iterative theorising, and emphasise the dialectical interplay of the objective and subjective. A cultural political economy framework Like Wallace (1990) the authors’ have not found different accounting techniques in rich and poor countries, or that LDCs import grossly inappropriate practices. No MASs unique to LDCs been found, though they may exist, especially in traditional sectors. AAAJ 22,3 472 Most problems lie in the interplay of MASs and their cultural, economic and political context. Poverty brings distinctive uncertainties, e.g. exposure to the elements, undiversified economies, and a dominant (but not necessarily effective) state. Rich countries have shaped politics and policies in LDCs from colonialism, and today international aid institutions’ prescriptions often include (or presume) MASs framed in institutional contexts and rationalities not invariably found within LDCs. But many LDCs depend on external finance and cannot ignore its providers’ strictures. Thus when Western MASs are applied they often assume unanticipated roles or are ignored. Hence the framework for evaluating MAS research in Table II relates a dialectic explanation of MAS transformation to social, economic, and political factors in both ideational and institutional domains. Its breadth permits analysis of the theoretically and empirically diverse papers under scrutiny, whilst being in sympathy with dominant theoretical approaches, including our own. We do not claim it is conclusive, definitive or unique to LDCs – it is for analysis, understanding, and promoting dialogue, especially amongst targeted beneficiaries, not theoretical closure[5]. But it is difficult to avoid ethnocentricity or a normative stance for development entails changes from the status quo and humanitarian ideals that supersede cultural relativism. For exposition purposes the framework is presumed to embrace all LDCs (it was derived mainly in African and Asian ex-British colonies). It draws from the labour process approach in Uddin and Hopper (2001) and the “cultural political economy” in Wickramasinghe and Hopper (2005) and Wickramasinghe et al. (2004). It identifies five regimes: colonial despotism, state capitalism, politicised state capitalism, market capitalism, and politicised market capitalism (see Table II). Each epoch is brought about by force, manipulation, persuasion, and authority in political and economic struggles framed by interplays between key dimensions of each epoch – modes of production (MOP), culture, ethnicity and race, the state, regulation and the law, political parties, industrial relations, and international finance. These are defined below. The economic activities and social relations when people transform objects into useful things constitute a MOP. They range from feudalism to contemporary capitalism. Their effects extend beyond work relationships to cultural beliefs and politics (Taylor, 1979). However, behaviour is governed not just by economics but also a mix of knowledge, belief, art, morals, law, and custom known as culture – the “state or habit of mind” that underpins a “way of life” of a group or community, their outlook on the world, and their “general reaction to a general and major change in the conditions of our common life” (Williams, 1958). Ethnic groups often claim cultural distinctiveness due to divergent languages, religions, occupations, politics, and geographical demarcations (Haralambos, 1974). Sometimes this has overtones of race (classifying people by physical appearance, e.g. facial characteristics, skin colour). Ethnic claims may or not be empirically justifiable, whereas racial claims are not (Richardson and Lambert, 1985) but both can be sources of social identity and political mobilisation to influence the state (Efferin and Hopper, 2007). States include the armed forces, civil service, judiciary, and local and national elected bodies but boundaries are difficult to draw (e.g. they can co-opt religious organisations and trade unions). States have the authority to establish rules that govern a geographically determined population (Faulks, 1999). They control the means of violence in society. They may use force and coercion but normally seek consensus, exerting power through laws – often Management accounting 473 M o d e o f p ro d u ct io n C u lt u re E th n ic it y a n d ra ce S ta te , re g u la ti o n a n d la w P o li ti cs T U a n d la b o u r m a rk et s In te rn a ti o n a l fi n a n ce a n d ca p it a l m a rk et M A S s C o lo n ia l d es p o ti sm (A ct u a l re g im e) N o n -c a p it a li st a g ri cu lt u ra l a n d d o m es ti c p ro d u ct io n . S m a ll ca p it a li st m er ch a n t/ a n d o w n er cl a ss C o lo n ia l ca p it a li st en te rp ri se s in p ri m a ry se ct o r M a in ly tr a d it io n a l, et h n o ce n tr ic C lo se d a n d st a b le co m m u n it ie s D iv id e a n d ru le ta ct ic s b a se d o n et h n ic it y C o m p a n y st a te s M in im a l st a te re g u la ti o n Im p er ia li sm T U s il le g a l a n d w ea k W ea k la b o u r m a rk et s N a sc en t u n io n is m a n d st a te re g u la ti o n o f in d u st ri a l re la ti o n s C o lo n ia l ca p it a l. O th er w is e m in im a l ca p it a l N o ca p it a l m a rk et C o er ci v e co n tr o l b a se d o n ra ci a l a n d et h n ic d if fe re n ce s in v o lv in g p h y si ca l v io le n ce A cc o u n ti n g fo r H Q re g u la ti o n s a n d co n tr o l S ta te ca p it a li sm (I d ea l re g im e) In d u st ri a li sa ti o n C a p it a li st a cc u m u la ti o n b y S O E s F a ir d is tr ib u ti o n C o n ti n u a ti o n o f sm a ll m er ch a n ts a n d tr a d it io n a l a g ri cu lt u ra l p ro d u ct io n C lo se d ec o n o m y G ro w th o f m o d er n is ti c, u rb a n cu lt u re s in co rp o ra ti n g ra ti o n a l p ro g re ss , sc ie n ce a n d ed u ca ti o n , m er it o cr a cy , in d iv id u a li sm a n d n u cl ea r fa m il y N a ti o n a li sm em p h a si se d n o t et h n ic it y B u re a u cr a ti c st a te ce n tr a l p la n n in g L eg a l- ra ti o n a l a u th o ri ty In te rv en ti o n a n d w el fa re o ri en te d S tr o n g re g u la ti o n a n d a cc o u n t- a b il it y to P a rl ia m en t E co n o m ic d ev el o p m en t b a se d o n in d u st ri a li sa ti o n T U s re co g n is ed G ro w th o f co ll ec ti v e b a rg a in in g o n in d u st ry b a si s S ta te b a n k in g C en tr a l b a n k re g u la ti o n E m er g in g b u t w ea k ca p it a l m a rk et D efi ci t fi n a n ci n g fo r d ev el o p m en t B u re a u cr a ti c ra ti o n a l- le g a l a cc o u n ti n g E n te rp ri se b u d g et in g w it h in n a ti o n a l ce n tr a l st a te p la n n in g C re a ti o n o f fo rm a l w a g e b a rg a in in g a n d in te rn a l la b o u r m a rk et s P o li ti ci se d st a te ca p it a li sm (A ct u a l re g im e) S ta te ex tr a ct io n o f su rp lu s H eg em o n y o f p o li ti ca l cr it er ia in co m m er ci a l a n d p ro d u ct io n d ec is io n s P o w er w it h p o li ti ca l el it e li n k ed to tr a d e u n io n s D is tr ib u ti o n fo ll o w s p o w er a n d p a tr o n a g e C u lt u ra l fr a g m en ta ti o n a n d d iv er si ty M o re o p en a n d le ss st a b le su b -c u lt u re s In cr ea se d u rb a n is a ti o n a lo n g si d e st ro n g tr a d it io n a l cu lt u re s D iv is io n s h ei g h te n ed E th n ic it y p a rt ly b a si s o f p a rt y a n d p o li ti ca l o rg a n is a ti o n L eg a l- ra ti o n a l st ru ct u re s o f re g u la ti o n m a in ta in ed b u t ca p tu re d o r ig n o re d b y p o li ti ci a n s S ta te p a tr o n a g e, o ft en fo r p a rt y a d v a n ta g e W ea k en fo rc em en t F a ct io n a l a n d v o la ti le O ft en ch a ri sm a ti c/ d y n a st ic le a d er s o f p a rt ie s ra th er th a n id eo lo g ic a l S o m et im es n o n -d em o cr a ti c P ro d u ct io n a n d st a te p o li ti cs o ft en co n v er g e P o w er fu l p o li ti ca l p a rt y u n io n s M u lt i- u n io n is m T o p d o w n le a d er sh ip L ea d er s fr o m p o li ti ca l el it e T U m em b er sh ip a n d p o w er in p u b li c en te rp ri se s W ea k p o li ti ci se d , a n d p o o rl y re g u la te d ca p it a l m a rk et s B a n k fa il u re s F is ca l cr is es o f st a te le a d to a id d ep en d en cy a n d re li a n ce o n IM F /W B E x te rn a l fi n a n ci n g o ft en fo r C o ld W a r re a so n s A cc o u n ti n g fo r ex te rn a l le g it im a cy R it u a l ce re m o n ia l p ra ct ic es o n ly M A S ir re le v a n t fo r in te rn a l co n tr o ls D ec is io n s fo r d a y -t o -d a y a ct iv it ie s ca p tu re d b y p o li ti ca l p la y er s (c o n ti n u ed ) Table II. Regimes of control in ex-colonial LDCs: contextual factors and MASs AAAJ 22,3 474 M o d e o f p ro d u ct io n C u lt u re E th n ic it y a n d ra ce S ta te , re g u la ti o n a n d la w P o li ti cs T U a n d la b o u r m a rk et s In te rn a ti o n a l fi n a n ce a n d ca p it a l m a rk et M A S s M a rk et ca p it a li sm (I d ea l re g im e) M a rk et -b a se d ex ch a n g e re la ti o n s a n d d is tr ib u ti o n P ri v a te o w n er sh ip o f en te rp ri se s N ew p u b li c se ct o r m a n a g em en t G re a te r in d iv id u a li sm a n d in d iv id u a l ec o n o m ic se lf -b et te rm en t C o n su m er is m a n d m a te ri a li st ic ch o ic e C o n si d er ed ir re le v a n t. R ed u ce d st a te p o w er , su p p ly si d e ec o n o m ic ro le O ri en te d to a tt ra ct m u lt in a ti o n a l a n d in te rn a ti o n a l ca p it a l S tr o n g er ca p it a l m a rk et a n d re g u la ti o n , es p ec ia ll y o f u ti li ti es D em o cr a ti c a n d tr a n sp a re n t g o v er n m en t S tr o n g ex te rn a l la b o u r m a rk et s W ea k en ed T ra d e U n io n s D ec li n e in in d u st ry -w id e co ll ec ti v e b a rg a in in g L o w er ed em p lo y ee p ro te ct io n G lo b a li se d ca p it a l E x p o rt zo n es S tr o n g er ca p it a l m a rk et s G re a te r fi n a n ci a l re g u la ti o n a n d en fo rc em en t L es se n ed p o li ti ca l in te rv en ti o n M a rk et b a se d co n tr o ls C o n te m p o ra ry W es te rn b es t p ra ct ic e T ig h t p ro d u ct io n ta rg et s E co n o m ic p er fo rm a n ce m ea su re m en t E x te rn a l re p o rt in g fo r ca p it a l m a rk et s P o li ti ci se d m a rk et ca p it a li sm (A ct u a l re g im e) D o m in a ti o n o f ca p it a l o v er la b o u r W id er in co m e d if fe re n ti a ls F ra ct io n s o f ca p it a l, o w n er sh ip d if fu se /fi n a n ci a l in st it u ti o n s/ m u lt in a ti o n a ls /l o ca l fa m il ie s C ro n y ca p it a li sm M ed ia ti o n o f “m o d er n ” m a rk et cu lt u re s w it h tr a d it io n a l a n d p o li ti ca l O ft en th e b a si s o f p o li ti ca l a n d so ci a l d ec is io n s R eg u la to ry ca p tu re b y p o li ti ca l- ec o n o m ic el it es W ea k en fo rc em en t D ec is io n s p o li ti ci se d D em o cr a ti c p a rt ie s b a se d o n ch a ri sm a ti c le a d er s fr o m so ci o -e co n o m ic el it es F a ct io n -a li sm b a se d o n re g io n s, re li g io n a n d et h n ic it y S eg m en te d la b o u r m a rk et s b et w ee n co re a n d p er ip h er y T ra d e u n io n s co -o p te d in to p o li ti ca l p a rt ie s L o w er la b o u r p ro te ct io n a p o w er E x te rn a l fi n a n ci a l a g en ts es p ec ia ll y IM F /W B st ro n g in fl u en ce s o n p o li cy F a m il y /c ro n y ca p it a li sm a lo n g si d e m o re m u lt in a ti o n a l ca p it a l P o li ti ci se d re g u la ti o n a n d p ri v a ti sa ti o n . P ri v a te a cc o u n ts , to p -d o w n p h y si ca l b u d g et s R et u rn o f co er ci v e co n tr o l b u t n o p h y si ca l v io le n ce W ea k co m p li a n ce o f ex te rn a l re g u la ti o n s – fi n a n ci a l a n d n o n -fi n a n ci a l T o o th le ss tr a d e u n io n s w it h lo w b a rg a in in g p o w er In te rn a l su b -c o n tr a ct in g Table II. Management accounting 475 delegated to regulatory institutions. State policies vary: usually they are instruments of dominant elites but their interests and preferences may vary (Jessop, 1982). Access to government resides in politics, be it in a legal-rational democracy, kingdom, or dictatorship. In purportedly democratic systems (but not exclusively so) competing political parties pursue interests and ideologies, though often LDCs have single and/or dominant party systems that are not exclusively class-based and may represent a shifting mix of ideology, race and ethnicity, regionalism, and religion, and be vehicles for charismatic leadership. Often they are linked to trade unions – associations of workers united in a single, representative entity seeking to improve workers’ economic status and employment conditions by substituting individual bargaining within labour markets with collective bargaining and workplace relations governed by rules and regulations, i.e. an internal state. However, political and trade union action is constrained by external capital markets (domestic capital markets being weak and small). Development policies rely on finance from MNOs, international aid agencies, foreign governments, and external financial institutions like the World Bank and IMF who often influence domestic policies. Each regime is rendered unstable by contradictions and conflicts that fuel political struggles nationally and within production and lay the basis for new regimes. Pre-colonial eras had indigenous MASs but subsequent MASs stem from external interventions beginning with colonialism and, after independence, policy advice from Western institutions promulgating state and then market capitalism. However, such idealised regimes of control often presumed contextual factors at odds with actuality, and ensuing contradictions and conflicts brought politicised state and market capitalist regimes with unanticipated MASs. Thus MAS transformations are contextually encircled, evolve historically, and are socially constructed. Figure 1 summarises this dynamic but contingent evolution: each epoch is illustrated with examples from the authors’ research below. The expanded framework in Table II provides the diagnostic tool used to analyse MAS research in LDCs. MAS under colonialism Colonial legacies are crucial for understanding accounting in most LDCs. Before colonialism MOPs were largely feudal and based on the local community (village) and families: productivity and income were governed by their needs, diligence, and the elements. Lords or chieftains often held land though producers normally owned the simple technology. There was no separation between work and the family, and little production of commodities for exchange with other communities or institutions (Taylor, 1979). Traditional societies did not necessarily lack accounting: An early Qing dynasty period novel details how Chinese household MASs incorporated traditional family and cultural values – they segregated financial duties and used cash controls and budgets but power distance stifled flexibility, professionalism and effectiveness (Chan et al., 2001). Traditional systems may persist today, e.g. Asechemie (1997) claimed that African accounting systems in informal economic sectors still accommodate traditional values, which provoked a sharp rejoinder from Wallace (1997) who questioned Asechemie’s account of pre- and post-colonial MOPs in Nigeria, the existence of African maintenance accounting, his oral history evidence, and whether pre-colonial Nigerian cash accounting and master-servant relations … Imperial Journal of Interdisciplinary Research (IJIR) Vol-3, Issue-1, 2017 ISSN: 2454-1362, http://www.onlinejournal.in Imperial Journal of Interdisciplinary Research (IJIR) Page 1625 Evaluation of the Qualitative Features of Management Accounting Information in an Unstable Macroeconomic Policy Environment: A Survey of Manufacturing Firms OJUA, Olusegun Michael Department of Accounting, College of Business and Social Sciences, Covenant University, Ota Abstract: Accounting information reacts to the macroeconomic environment; there is a positive association between a stable economy and the inherent quality of accounting information. The aim of this paper was to ascertain if the quality of management accounting information will remain the same in face of unstable and frequent changes in macroeconomic policies especially among manufacturing firms. Using a sample of one hundred users and preparers of management accounting information, and adopting questionnaires to gather primary data, analysis was done through descriptive and inferential statistics using frequency tables, measures of central, and dispersion parameters, then independent-sample T test applied.. The first hypothesis showed results above P<0.001hence rejected. The second hypothesis confirmed that several challenges facing macroeconomic policies implementation create doubt in the quality of MAI, with calculated mean greater than expected mean of 3. The results indicated that MAI should be detail and current to aid decision making. The findings of the study have implications for accountants, and decision makers who rely on management accounting information to ensure that caveat are included in relying on such report. As a result of this research, it can be concluded that management accountants should endeavor to take into account the changes associated with macroeconomic policies in their reports to avoid financial losses and be able to compete well in the industry. It recommended that strategic management accounting reports be added to existing reports to mitigate the impact of macroeconomic policy changes. Keywords: macroeconomic policies, manufacturing firms, qualitative characteristics, strategic management accounting, 1. Introduction Accounting provides information that firms’ management require for decision making and performance evaluation. Such accounting information changes with variations in technology, competition and macroeconomic policies(Ojua,2016a;Habibollah, Nakhaei and Ahmadimousaabad, 2014), it is pertinent for accountants to include current changes in reports for such to be effective for decision making (Ojua,2016a).The challenge of including macroeconomic policies impact on the operations of businesses in Nigeria is enormous due to instability and inconsistencies on the part of government in the implementation (Olowe,2011). The Management Accounting Information(MAI) is the most frequent and widely used accounting information managements of firms apply in decision making process ( ), hence the quality of such is important and must be given due consideration (Briciu,Scorte and Mester,2013 ;Bahramfar & Rasoli, 1998).Qualitative features and qualities of any accounting information including MAI are relevance and reliability (primary qualities) which increases its usefulness and effectiveness (Kieso, Waygandt and Warfield, 2005; Mokarrami, 1997; Hendrickson, 1992); comparability and consistency (secondary qualities) which create avenue for peer review and evaluation (Habibollah et al, 2014). These aforementioned attributes could only be made possible if macroeconomics policies are stable over a period of time, which is not the case in developing nations like Nigeria. Macroeconomic policies are those policies of the government aimed at the aggregate economy to promote the goals of full employment, stability in prices (wages, inflation, interest rates and exchange rates), and growth. Common macroeconomic policies are fiscal and monetary. Fiscal policy involves steps taking by the government to make changes in government spending or tax to stimulate economic growth while monetary policy deals with changes in money supply in the economy. In achieving any of the aforementioned others will be sacrificed (Ullah and Rauf, 2013). For instance, in attempting to achieve full employment in the Imperial Journal of Interdisciplinary Research (IJIR) Vol-3, Issue-1, 2017 ISSN: 2454-1362, http://www.onlinejournal.in Imperial Journal of Interdisciplinary Research (IJIR) Page 1626 economy in the short-run, inflation may occur in the longer run which affects the microeconomic agents like the firm making MAI ineffective for decision making. The Nigerian government have embarked on various macroeconomic policies to address various gaps in the economy. Some of the policies applied apart from the use of monetary and fiscal policy are export promotion strategy, imports substitution strategy, NEEDS, Vision 20 20 20, the MDGs and Treasury Single Account (TSA). The fundamental objectives of these policies in Nigeria are meant to maintain price stability, maintenance of balance of payments equilibrium, and promotion of employment, output growth and sustainable development. There is a positive association between monetary policy, fiscal policy, exchange rate policy and firm performance (Ekpo, 2014; Dornbusch and Fischer, 1981). The instability in macroeconomic policy has been the hallmark of most developing economies with the government and monetary authorities making frequent adjustments to suit economic realities (Olowe, 2011; Ojo, 2008). Exchange rate variation can adversely affect the ability of a firm to import needed raw materials and therefore reduce manufacturing output making the reports of the making budgeting less important. Fluctuations in exchange rate leads to instability in purchasing power of the firm with projected financial statements unable to achieve set goals (Opaluwa, Umeh and Ameh, 2010).Virtually all researches on exchange rate argue that the type of exchange rate regimes incorporated by a country have implications on the economy through their effects on international trade, output, financial markets, inflation, employment, and investment (Olowe, 2011). Also interest rate (monetary policy) fluctuation and tax or subsidy variations (fiscal policy) have implications on the economy and business firms output making the four essential attributes of MAI unattainable. MAI is either traditional management accounting (TMA) which include techniques like standard costing, variance analysis, Just-in- Time, process costing, absorption costing, budgeting, break-even analysis and cost volume profit analysis or strategic management accounting (SMA) which include but not limited to activity based costing, attribute costing, brand value budgeting, benchmarking, competitive position monitoring, competitor cost assessment, environmental management accounting, life cycle costing, quality costing, strategic costing, target costing,kaizen costing, value chain costing, strategic pricing and customer accounting(Ojua,2016;Ojra, 2014;Cinquini and Tenucci, 2010;Ramljak and Rogosic,2012), while TMA is basically historical and rely on internal data, SMA is current and mixes internal and industrial data for report presentation though with emphasis on competitors’ strengths and weaknesses (Ojua, 2016; Rababa’h, 2014; Fagbemi et al, 2013) but virtually ignores macroeconomic indices. This paper investigates the extent to which MAI conforms to the instability associated with macroeconomic policy in Nigeria based on the four accepted qualitative features and how such affect effective decision making by managements. This study is important for several reasons. First, there is need to know the extent to which MAI include macroeconomic indices and how it affects decision making among manufacturing firms. Second, the internal users of MAI are interested in high quality reports which will encompass all acceptable current economic trends in line with the globally accepted standards (Caraiman, 2015; Bukenya, 2012).Third, academic researches on the qualitative features of management accounting information are limited compared to other forms of business information (Kieso et al, 2005; Bahramfar & Rasoli, 1998; Mokarrami, 1997). Lastly, the relationship between qualitative features of MAI and macroeconomic policy have resulted in mixed findings(Caraiman, 2015; Achim, 2009; Kieso et al, 2005; Bahramfar & Rasoli, 1998; Mokarrami, 1997) hence the need to make contribution on the subject matter. It provides evidence on the impact of macroeconomic policy instability on the quality of MAI and reports, hence it has potential implications for the preparers and users of MAIs especially as it’s relates to manufacturing firms. This study gives new insights into the association between instability in macroeconomic policy and the quality of MAI as presented by management accountant. The research questions for which this paper attempts to provide answers to are :( i) is there any positive association between macroeconomic policy stability and the qualitative features of MAI? (ii) Are there challenges facing manufacturing firms with instability in macroeconomic policies in relation to MAI presentation to management? The rest of the paper is divided into four parts. Part 2 discusses the literature part 3, the methodology. Part 4 explains the analysis and implications of findings while part 5 is the conclusion and recommendations. 2. Literature Review Manufacturing firms in Nigeria are the major sources of economic propeller (after the oil industry) producing for local consumption and exports. The manufacturing sector has been the pivot of Nigeria economy as it contributed 39.67% to the Gross Domestic Product (GDP) in 2011 (Oyerogba, 2014; Oyerogba, et al 2015). However, the performance and productivity have deteriorated, contributing far less to the GDP as Imperial Journal of Interdisciplinary Research (IJIR) Vol-3, Issue-1, 2017 ISSN: 2454-1362, http://www.onlinejournal.in Imperial Journal of Interdisciplinary Research (IJIR) Page 1627 compared to the past three decades when manufacturing played significant roles in the Nigerian economy (Sangosanya, 2011). Among the myriad of challenges facing the sector is the mono- product Nigerian economy, and fall in capacity utilization caused by unstable government policies (monetary, fiscal, exchange rate policy) and globalization (Aluko et al, 2004).The managements of these firms rely on MAI with budgeting highly applied for controlling costs and performance evaluation, it plays a pivot role in managing and directing process of the organization (Dugdale, 1994). Such reports in most cases do not align with the reality of unstable macroeconomic policies hence isolating the firms from current situation in the economy because they come too late, too distorted and unevenly aggregated hence not good enough for strategic management due to its lack of focus on strategic planning but only on inventory evaluation; it places emphasis on financial measures ignoring the non-financial ones. The application of SMATs is more of monitoring competitors’ performance (Alsoboa et al, 2015; Ojra, 2014; Ahmad and Leftesi, 2014; Ramljak and Rogosic, 2012) to the detriment of macroeconomic policies which impact on business organization (Olowe, 2011; Opaluwa et al., 2010; Ojo, 2008). Governments have four macroeconomic policy objectives: achieving potential growth; maintaining sustainable internal and external accounts; preventing a destabilizing rate of inflation; and poverty reduction (Hailu and Weeks, 2011). Macroeconomic policies are instruments which government of a country tries to regulate economic affairs; it consists of the fiscal, monetary, exchange rate regimes and trade policies that determine production outcomes in the real sectors and other sectors (Opaluwa et al., 2010). Monetary policy involves government control of the money supply in an economy using certain instruments by manipulating interest rate to achieve economic growth, stability in the rate of inflation and exchange rate as well as employment. Fiscal policy on the other hand involves the use of government expenditure, taxes and subsidies inform of reliefs to promote growth (Caraiman, 2015; Olowe, 2011; Opaluwa et al., 2010; Achim, 2009; Kieso et al, 2005; Bahramfar & Rasoli, 1998; Mokarrami, 1997). The stability in macroeconomic policies breed economic growth (Olowe, 2011; Opaluwa et al., 2010; Achim, 2009; Bamidele and Englama, 1998; Obaseki and Onwiduokit, 1998) and positive impact on microeconomic entities hence making reporting seamless with decision making qualitative and profitability enhanced. However the Nigerian governments over the years always make policy somersaults the norms (Opaluwa et al., 2010) making internal reporting (MAI) unreliable (Okafor, 2012; Bukenya, 2014; Kieso et al., 2005; Mokarrami, 1997) due to decisions based on incomplete knowledge of economic situation (Dumitru, 2009) .The outcome of policy somersault of macroeconomic policies is demonstrated in table 1 showing the impact on the economy. Table 1 Analysis of Macroeconomic policies outcome in Nigeria (2011-2015) Economic variables/ Years 2015 2014 2013 2012 2011 GDP Growth 2.65% 6.31% 5.39% 4.28% 4.89% GDP per capita $2,742.86 $3,300.03 $3,082.5 $2,835.3 $2,612.1 Investment 14.48% 15.8% 14.9% 14.91% 16.2% Inflation 9.01% 8.05% 8.5% 12.23% 10.28% Unemployment Rate 9.9% 7.8% 10% 10.6% 6% Gen govt revenue 7.82% 10.52% 11.05% 14.30% 16.37% Gen govt expenditure 11.81% 12.6% 13.37% 14.05% 17.36% GDP share of World total 0.962% 0.965% 0.938% 0.918% 0.908% Average Exchange rate to $1 N 190.5 N 180 N 155 N140 N 120 Source: Researcher computations The table above shows the unstable nature of the Nigerian economy which affects the operation of manufacturing firms, rendering the reports of management accountants ineffective for decision making. For instance the unstable exchange rate affects the importation of plant and machinery, and raw materials (Ibrahim and Muritala, 2015) in most cases budgeted sum are overshot leaving out the four attributes of MAI (Bahramfar & Rasoli, 1998). Also the continuous alteration in the interest rate has created challenges in the authenticity of cost of funds report (Habibollah et al., 2014).The frequent variations in granting of subsidies and tax waivers to firms for illogical reasons make reporting of net returns on investment incorrect in most cases. To mitigate these challenges the reporting quality of accounting information should be applied on MAI taking into account the instability in monetary policy, fiscal policy (tax and subsidy regimes) and exchange rate policy to avoid financial and non- financial losses by firms. Imperial Journal of Interdisciplinary Research (IJIR) Vol-3, Issue-1, 2017 ISSN: 2454-1362, http://www.onlinejournal.in Imperial Journal of Interdisciplinary Research (IJIR) Page 1628 There are two dimensions of any reporting quality: accrual quality and asymmetric timeliness of loss recognition (Fakile et al, 2013).Accrual quality leads to disclosure that improves transparency and reduce information paucity (Healy& Palepu, 2001).Asymmetric timeliness of loss recognition shows that if reporting is more transparent and more frequent, managers will have little chance of manipulation either voluntary or otherwise (Maines and Wahlen, 2003).According to United Kingdom’s Accounting Standards Board (ASB) the qualitative characteristics of accounting information are reliability, relevance, materiality, comparability, understandability and timeliness for it to be useful to the users. Using table 2 below, the primary qualities expected of MAI are reliability and relevance, while the secondary qualities include comparability and consistency. Table 2: Hierarchy of qualitative features of accounting information. Adapted from Nakhaei and Ahmadimousaabad, 2014 Reliability is the extent to which information is verifiable, faithful, and neutral. That is the users should know the meaning of the information and the limits to the knowledge content of the information provided (Maines and Wahlen, 2003; Glaucier, Underdown and Clark, 1980). MAI should be reliable with users able to hold some basic assumptions about the quality of accounting information produced by accountants. Decisions can be taken with ease without fear of backlash (Bukenya, 2014).Relevance is the influence MAI have on decision making (Bukenya, 2012). For accounting information to be relevant, it should provide a good and logical basis of pick a course of action. Relevant information should have predictive value, feedback value, and timeliness. Timeliness connotes that the information must be available to management before it loses its value to influence decisions. Obaidat (2007) opined that information is useful when it is available when it is required and not delayed. Comparability entails review over time. It is the ability to help users see similarities and differences between events and conditions. Accounting information especially MAI will be useful when it can be compared period by period internally and externally by industrial comparison (Noravesh & Shirzadi, 2012). Consistency means conformity with unchanging policies and procedures over period of time. Conformity is achievable by applying the same accounting treatment to similar events at all time. The users of MAI crave for understanding particularly when decisions are to be taken. For proper understanding, MAI must contain the aforementioned qualitative features. Understandability refers to users’ knowledge (Habibollah et al., 2014) which depends on the quality of the reports and prior information. Reviews of related literature indicate the impact of macroeconomic policy on firms operations and the reporting quality: Umeora (2013) in a review of the effect of Value Added Tax (VAT) and collection procedure on economy growth and impact on businesses in Nigeria and returned that VAT has positive association with government revenue and the economy but negatively affect firms’ operations because of the correctness of sum deducible. Thus affecting the MAI of most firms with the absence Imperial Journal of Interdisciplinary Research (IJIR) Vol-3, Issue-1, 2017 ISSN: 2454-1362, http://www.onlinejournal.in Imperial Journal of Interdisciplinary Research (IJIR) Page 1629 of most of the qualitative characteristics. Leahy & Whited (1996) reported that uncertainty and instability in macroeconomic policy reduce investment in their study but couldn’t prove any empirical evidence on this issue hence the outcome remains inconclusive. Symons, Howett and Alcantara (2011) in an international research work on payment of taxes using basic indices of cost of taxes, compliance burden and collection rate concluded that most firms pay companies income taxes faster that VAT due to inconsistent administrative procedures and variances in computations causing disagreement. Spyros (2001) and Floros (2004) in their studies examined the impact of inflation on the activities of business firms in Greece and concluded that returns on investment is reduced and depreciation of the capital of the sampled firms. Chawla (2011) concluded that exchange losses due to fluctuation in currency exchange rate affect the competitiveness of businesses making foreign firms have edge over local ones especially if the currency of such country is stable. Kamil (2012) also reviewed impact of exchange rate regimes of changes in exchange model on foreign currency borrowing decisions on firms operating in South America and concluded that the exposure level of these firms though reduced the value of debt contracted it has led to vulnerability of exchange rate shocks . In a Nigerian study, Umoru and Oseme (2013) discovered that fluctuation in exchange rate only impact on firms in the long run hence short run effect might not show critical effect. Usman and Adejare (2014) examined the effect of monetary policy on industrial growth in Nigeria, the study revealed that rediscount and deposit rates have significant positive effect on industrial output however instability in monetary rate makes planning difficult by most sampled firms. Sikiru and Umaru (2011) in their research reviewed the relationship between fiscal policy and economic growth concluded that productive expenditure positively impacted on economic growth when there is stability and consistency in policy implementation. In this situation the MAI relevance and reliability is assured. Tomola, Adebisi and Olawale (2012) linked bank lending to the manufacturing firms capacity utilization and concluded that interest rate have positive effect on the output of the firms. Charles (2012) opined in his study that a stable macroeconomic policy on money supply positively affect manufacturing firms performance, and company lending rate, income tax rate, inflation rate and exchange rate negatively affect their performances. Management accountants’ reports (both TMA and SMA) are expected to be current and trendy taking into account the volatility in the economy to ensure understandability (Nakhaei and Ahmadimousaabad, 2014). However sudden changes in fiscal, monetary and exchange policies might not be effected in the report making reliability doubtful. For instance a MAI report on the acquisition of a fixed asset to be imported abroad will not be reliable if the exchange rates fluctuate frequently within a fiscal year. Also the frequent increase in the Minimum Rediscount Rate (MPR) that determines interest rate on bank loans could make MAI report on expected return irrelevant as bulk of expected profits will be eroded. Comparability from period to period might be an uphill task because the effect of inflation which is not stable year in year out and diversity in exchange rate. MAI consistency is doubtful in an unstable macroeconomic environment because different reports will be required to suit different economic situations. The challenges facing manufacturing firms as a result of unstable macroeconomic policies are corruption and ineffective policies which have created a gap actualizing the purpose of macroeconomic policies especially fiscal policy (Gbosi, 2007), including such in MAI and when not achievable make sure irrelevant and decisions taking ineffective; lack of integration of macroeconomic plans according to Onoh (2007) is another challenge which makes managements of manufacturing firms ignore MAI that uses such plans as basis of reporting indicating irrelevance. Other challenges are misappropriations of special intervention funds; inconsistent subsidy regime for manufacturers and non-implementation of industrial policies that grant tax exemptions (Eze and Ogiji, 2013; Ogbole, 2010; Okemini and Uranta, 2008). Based on the foregoing, the following hypotheses are proposed: HoThere is no positive association between macroeconomic policy instability and the qualitative features of MAI Ho There are no challenges facing manufacturing firms in the presentation of MAI to management in an unstable macroeconomic policy regime. 3. Research Methods The survey research method was adopted in this study .The research paper was designed to evaluate the qualitative features of MAI in face of unstable macroeconomic policies in Nigeria. Survey research is concerned with identifying real nature of problem and formulating relevant hypothesis to be tested. Data were collected from the preparers and users of MAI. The preparers are accountant who are responsible for the preparation of the management accounting reports. The users are Imperial Journal of Interdisciplinary Research (IJIR) Vol-3, Issue-1, 2017 ISSN: 2454-1362, http://www.onlinejournal.in Imperial Journal of Interdisciplinary Research (IJIR) Page 1630 basically members of management teams of sampled firms. The participants were recognized through information gathered from the local secretariat of the Manufacturers Association of Nigeria (MAN), Ogba Industrial Estate, Lagos, Nigeria. The collected data were analyzed statistically to establish the findings. Ogba Industrial Estate was chosen because of the concentration of manufacturing firms and the need to have collection of experienced respondents on the subject matter. SAMPLING PROCEDURE The participants were selected by random sampling. Random sampling was adopted because it is the best way to obtain a representative sample from the population. In random sampling, members of the population have equal chance of selection without influence or chance that any other individual will not be chosen (Owojori, 2002) The criteria for participation are that (a) the participants must be a member of the management team (b) the participants must have been experienced in the preparation of MAI in the last 5 years, and (c) the participants must have good knowledge of macroeconomic policies of the government. Random samples of one hundred (100) participants were drawn as a subset of the total population of available manufacturing firms in the industrial area. Data for the study were obtained through the primary source. The primary data were generated through self-administered questionnaire. Questions were asked on the impact of macroeconomic policies on MAI given the qualitative features of accounting information. A pilot survey was adopted for the reliability test and it yielded correlation coefficient of 0.69.The instrument was a survey questionnaire with 5 Likert scale response options of Strongly Agreed (SA), Agreed (A), No Effect (NE) Disagree (D), and Strongly Disagreed (SD) with weights of 5,4,3,2 and 1 respectively. Pursuant to this, the population mean is set at ‘3’, to analyze the data, descriptive and inferential statistics were applied. Frequency tables, measures of central, and dispersion parameters were used in descriptive statistics. Then an independent-sample T test was used to analyze the data using SPSS Software. The questions used in the questionnaire were developed based on prior studies of Nakhaei and Ahmadimousaabad (2014) and Bukenya (2014). 4. DATA PRESENTATION, ANALYSIS AND INTERPRETATION 4.1 Hypotheses Testing Hypothesis 1: There is no significant association between macroeconomic policy instability and the qualitative features of MAI From table 4 below, and using responses from questions 1-6, the respondents show good knowledge of the attributes of macroeconomic policies in Nigeria. Over 60% of the respondents agreed that macroeconomic policies affect MAI’s quality as tabulated (questions 1-6). The mean and standard deviations refer to the absence of spacing or dispersion in responses to the questionnaire, the Z score column shows the relationship between the estimated mean of ‘3’ and the calculated mean-only the feedback response of 2.21 is less than 3, indicating that MAI has not been effective tool in decision making in an unstable macroeconomic policy regime. However the four qualitative features return above ‘3’ showing that the perceived qualities in MAI are affected by unstable macroeconomic policies. To further demonstrate the relationship a T test was carried out using the responses in table 4 (1-6). Table 3: Analysis of responses on macroeconomic policies and qualitative features of MAI Features No of sample Calculated mean Pop mean Std dev Std error Mean diff df T Sig Understandability 100 3.75 3 1.6 0.03 0.75 99 4.66 P<0.001 Relevance 100 3.55 3 1.52 0.03 0.55 99 3.02 P<0.001 Reliability 100 3.45 3 1.48 0.03 0.45 99 3.61 P<0.001 Comparability 100 3.50 3 1.50 0.03 0.5 99 5.74 P<0.001 Consistency 100 4.00 3 1.73 0.03 1 99 3.32 P<0.001 Feedback 100 3.32 3 1.45 0.03 0.32 99 2.20 P<0.001 Macro. Impact 100 3.92 3 1.69 0.03 0.92 99 5.43 P<0.001 SPSS computation The finding indicates that calculated mean is more than the fixed population mean for all independent variables, though the difference is not statistically significant. Also, the calculated T is more than (P<0.001) for all variables, it means that macroeconomic policies (monetary, fiscal and exchange regime policies have significant effect on qualitative features- understandability, relevance, Imperial Journal of Interdisciplinary Research (IJIR) Vol-3, Issue-1, 2017 ISSN: 2454-1362, http://www.onlinejournal.in Imperial Journal of Interdisciplinary Research (IJIR) Page 1631 reliability, comparability, consistency, and feedback. .From these results, we reject the first hypothesis, indicating that there is significant association between macroeconomic policy instability and the qualitative features of MAI. Hypothesis 2: There are no challenges facing manufacturing firms in the presentation of MAI to management in an unstable macroeconomic policy regime. Using questions 7-10 in table 4 below, the respondents expressed their opinions on the … The impact of tax structure on investment: an empirical assessment for OECD countries JOSÉ ALVES, Ph.D.* Article** JEL: D25, E62, H21, O47 https://doi.org/10.3326.pse.43.3.4 * The opinions expressed herein are those of the author and do not necessarily reflect those of his employers. This research paper is supported by Universidade de Lisboa and ISEG – Lisbon School of Economics and Management, through a PhD Support Scholarship. The author thanks two anonymous referees for helpful comments. Any remaining errors are the author’s sole responsibility. ** Received: July 8, 2019 Accepted: July 26, 2019 José ALVES ISEG/UL – Universidade de Lisboa, Department of Economics, Rua do Quelhas, n.º 6, 1200-781 Lisbon, Portugal REM – Research in Economics and Mathematics, UECE – Research Unit on Complexity and Economics (UECE is supported by FCT – Fundação para a Ciência e a Tecnologia, Portugal), Rua Miguel Lupi, 20, 1249-078 Lisbon, Portugal e-mail: [email protected] ORCiD: 0000-0002-9979-7544 https://doi.org.10.3326/pse.43.3.4 http://crossmark.crossref.org/dialog/?doi=10.3326/pse.43.3.4&domain=pdf&date_stamp=2019-09-14 [email protected] jo sé a lv e s: t h e im pa c t o f ta x st r u c t u r e o n in v e st m e n t: a n e m pir ic a l a sse ssm e n t fo r o e c d c o u n t r ie s pu b l ic se c t o r e c o n o m ic s 43 (3) 291-309 (2019) 292 Abstract Does taxation structure have an impact on investment dynamics? In our paper we evaluate the share of tax revenues in GDP and investment outcomes, making use of gross fixed capital formation as a proxy for investment. This empirical analysis is carried out for all OECD countries, during the period of 1980-2015, to assess the tax system composition effects in both the short- and the long-run. Resorting to panel data econometric techniques, the paper also aims to find optimal tax-invest- ment threshold values. Our results lead us to conclude that there is a maximising effect of income taxation on investment growth when revenues from this tax source are about 10.7%. Furthermore, we find that revenues from social security contribu- tions are detrimental to growth, in both the short- and the long-run, while tax rev- enues from firms and consumption are only detrimental in the short-run. Keywords: investment growth, tax systems, fiscal policy, optimal taxation 1 INTRODUCTION Since Adam Smith shared thoughts and reflections of an economic nature in The Wealth of Nations, it has become clear that investment is fundamental for eco- nomic development. Nowadays, be they academics or not, everyone recognises the validity of this hypothesis quite nonchalantly. Investment is promoted as a guarantee of long-run growth, is seen almost as an input for an economic unit to be able to function perfectly, in a sustainable way. In fact, investment enables sustainable consumption in the long-run, by applying economic productive factors in both old and new economic production processes. This allows us to create not only more products for exchange in markets, but also more opportunities to intensify the trade of previous investments. This is because investment decisions can improve the older production processes through effi- ciency gains, allowing the creation of more added value. On the other hand, the existence of the state can jeopardise investment decisions. For when a government levies taxes on the private side of the economy, in effect it reduces both private consumption and investment. Taxation can jeopardise investment decisions, particularly when the increase in revenues of both income and consumption taxes from the private-side of an economy can both lead to a reduction in the level of aggregate consumption and also decrease investment profitability rates through the reduction of the expected aggregate demand for the outcomes of these investments. It is also true that funds raised from taxes are spent through government consump- tion and investment. Furthermore, apart from the fact that the main purpose of taxes is to guarantee sufficient funds to conduct various fiscal policies, taxes are also levied on economic agents to correct for externalities that arise from the pro- duction process. In this case, taxes play a kind of a broker role for any nefarious behaviour of the productive process over the many dimensions of an economy, jo sé a lv e s: t h e im pa c t o f ta x st r u c t u r e o n in v e st m e n t: a n e m pir ic a l a sse ssm e n t fo r o e c d c o u n t r ie s pu b l ic se c t o r e c o n o m ic s 43 (3) 291-309 (2019) 293such as the environment, for example. Additionally, taxes can stimulate certain production process behaviours which present good externalities for the economy, as in the case of investment in human capital for the production process. On the other hand, from a macroeconomic perspective, the utility of taxation can be positively justified. When investment levels are beyond the optimal level, i.e. they are not in accordance with an optimal consumption balanced path, it is imper- ative to promote the reduction of investment decisions. This happens when the condition of economic dynamic efficiency is not verified, i.e. when the return rate on capital exceeds investment growth rates. Put more specifically, a non-optimal level of investment is verified when the marginal product of capital is less than the economic growth rate – as illustrated in several economic exogenous growth theo- ries, such as, for instance, in Solow (1956); Swan (1956) and Ramsey (1928); Cass (1965); Koopmans (1963). In contrast to this perspective, when investment levels are below the optimal level required to guarantee a sustainable growth path, one point of view is that government intervention is required – through public spending and an increase in investment. In fact, there is empirical evidence sus- taining the argument that an increase in public investment can lead to crowding-in effects in private investment, and, therefore, lead to increases in aggregate invest- ment levels (Afonso and St. Aubyn, 2009). Furthermore, several tax arrangements can have a decided impact on investment decisions. If governments decide to levy less tax on individual income, for exam- ple, this may lead to increase aggregate demand for both durable and non-durable goods which may not only give rise to higher profits but provide new investment opportunities. Moreover, when fiscal authorities decide to change corporate tax rates, they influence several branches of economic activity. In particular, tax ben- efits can lead to specialization in economic activities with higher added-value for the overall economy. Additionally, tax rises on consumption, on property and social security contributions lead generally to a reduction of current consumption. These tax policies may impact on movements of interest rates, depressing them and promoting investment decisions, in general. According to the analysis above, we think that it is essential to analyse the effects of taxation on investment dynamics. Is it possible empirically to find a correlation between taxation structure and investment dynamics outcomes? In particular, is there a relationship to be found between each source of tax revenue and GDP and investment performance? These questions point up the importance of studying the way in which investment is influenced by fiscal policy. We recognise that this issue has already been studied in depth; however, academic researchers have mainly studied this relationship from the angle of the spending side of fiscal pol- icy. We therefore think that it is important to revisit the investment – fiscal policy relationship looked at from the revenue side of fiscal policy. Accordingly, when taking it into consideration that tax revenues are reintroduced into the economic circuit via overall government expenditure, control variables are required to assess jo sé a lv e s: t h e im pa c t o f ta x st r u c t u r e o n in v e st m e n t: a n e m pir ic a l a sse ssm e n t fo r o e c d c o u n t r ie s pu b l ic se c t o r e c o n o m ic s 43 (3) 291-309 (2019) 294 the tax structure – investment connection. On the other hand, we are aware that the macroeconomic study of taxation has not taken into account the particularities of each tax incidence, or any other tax exemptions or tax law particularities capable of explaining the different degrees of compliance of each tax, in each country under analysis. However, having decided to develop this study from a macroeco- nomic perspective, we think that an optimal structure of taxation can result in a better design of each tax. In specific terms, we believe that our research is a good starting point for studying taxation analysis in more depth, and for being able to reach, at the same time, a higher rate of tax compliance, resulting in greater effi- ciency and reliability from the microeconomic perspective – ensuring the much- needed revenues that governments require to conduct their policies. Our results lead us to conclude that there is an investment threshold with respect to some tax revenue sources. In particular, with the exception of taxes on individual income, an increase of revenues from tax sources seems to be detrimental to invest- ment dynamics. Furthermore, even though we achieve a maximizing effect of almost 11% of revenues from individual income taxes, in GDP terms, in the short- run, we do not find evidence for optimal thresholds for income tax in the long-run. This study is organised into the following sections: section 2 provides a brief review of the existing literature on the causalities of taxation on investment; sec- tion 3 highlights the applied methodology and also the databases used in this analysis; section 4 details the obtained results, and, lastly, section 5 summarises our conclusions. 2 LITERATURE REVIEW The existing literature on taxation is vast. With respect to the impact of taxation on economic performance, it is particularly worth mentioning the studies con- ducted in Lee and Gordon (2005), where the authors evaluate the tax structures and their impact on economic growth for a set of 70 countries over the last three decades of twentieth century, concluding that while their results point out the neg- ative impact of corporate taxes on growth, labour income taxes are not significant for economic performance. This negative result regarding the impact of corporate taxes on growth is also confirmed by Arnold (2008), assessing 21 OECD coun- tries’ tax structures over a period of more than 30 years. On the opposite side, this author concludes that taxation of property and consumption enhances growth more, which is also in accordance with Xing’s (2010) results. In fact, this author also concludes that levying taxes on income, both individual and corporation, as well as on consumption is associated with lower long-term per capita GDP. Lastly, Grdinic, Drezgic and Blazic (2017) assess the correlation between economic evo- lution and tax composition in Central and Eastern European countries, concluding that taxation arrangements present different effects than those in the existing lit- erature investigating the effects of taxation in OECD countries. In specific terms, the authors claim there is a negative impact of all taxation on growth, underlining income taxes as the source of revenue most detrimental to growth. jo sé a lv e s: t h e im pa c t o f ta x st r u c t u r e o n in v e st m e n t: a n e m pir ic a l a sse ssm e n t fo r o e c d c o u n t r ie s pu b l ic se c t o r e c o n o m ic s 43 (3) 291-309 (2019) 295In respect of the relationship between taxation and investment, this subjects has also been deeply studied from different perspectives in economics. In fact, some of the literature has highlighted the impact of tax policies on investment behav- iour, especially corporate income tax and its effects on investment decision-mak- ing processes. For instance, a study conducted by Da Rin, Sembenelli and Di Giacomo (2010) makes use of panel data techniques to assess the impact of taxa- tion on firms for a set of more than 2.5 million firms in 17 European countries, during the period of 1997-2004. The authors conclude that a corporate tax reduc- tion is related with a decreasing capital-labour ratio, and, specifically, the impact of corporate taxes is stronger on capital than on labour. However, as the authors point out, a tax reduction is desirable for the promotion of the entry of firms into the market – however, this policy can also favour the entry of less-financially robust firms. The same conclusion regarding the effect of corporate taxation and market entry is reached in Braunerhjelm and Eklund (2014), where the authors verify that a 10% reduction in corporate taxation increases market entry by 3%. Complementing the previous conclusions, research conducted in Da Rin, Di Giac- omo and Sembenelli (2011) concludes that there is a non-linear relationship between tax and firm entry into the market. On the other hand, in a study of 14 developed countries during the period of 1982- 2007, Bond and Xing (2015) find a negative relationship between taxes on firms and their effects on a firm’s capital – output ratios. The authors develop an econo- metric specification derived from a constant elasticity of substitution in a neoclas- sical model of investment, finding in both short- and long-run that a 1% increase in a firm’s taxation has a negative impact on capital-output ratios of between -0.3% and -0.7%. These results are also corroborated by Djankov et al. (2010) for a sample of 85 countries in 2004. Additionally, these authors also found that, with respect to the tax effects on industries, manufacturing is more exposed than other segments to the detrimental effects of corporate taxation. These conclusions are also reached in Mukherjee, Singh and Žaldokas (2017). However, besides finding a negative correlation between taxes on corporate income and R&D activities, the authors also conclude that higher taxes result in a reduced supply of new goods and services into the market economy. Furthermore, by analysing the effects of consumption taxes on corporate investment decisions, Jacob, Michaely and Mül- ler (2017) conclude that this source of taxation is also detrimental to a firm’s investment policy. The results reached by the authors led to the conclusion that the detrimental effect of consumption taxation is stronger for firms with a higher degree of demand elasticity, besides having a higher exposure to domestic final consumers and to financial restrictions. With regards to the effect of taxation on firm size and ownership, Galindo and Pombo (2011) find that corporate taxes affect big firms more than small and medium sized firms, regarding investment decisions and productivity. In addition, Brandstetter and Jacob (2013) apply a difference-in-differences approach to assess the effect of corporate tax on investment dynamics for the German case, and find jo sé a lv e s: t h e im pa c t o f ta x st r u c t u r e o n in v e st m e n t: a n e m pir ic a l a sse ssm e n t fo r o e c d c o u n t r ie s pu b l ic se c t o r e c o n o m ic s 43 (3) 291-309 (2019) 296 heterogeneous responses – i.e. a cut in corporate tax can lead to growth in invest- ment for domestically-owned firms higher than that of foreign-owned corpora- tions. However, Baliamoune-Lutz and Garello (2014) found that tax progressivity tends to stimulate market entry more in low-to-average income than in high- income individuals. With regards to the productivity-tax linkage, empirical research carried out by Gemmell et al. (2016) for a set of 11 European countries between 1996 and 2005 concludes that while higher statutory corporate tax rates impact the productivity levels of small firms negatively, the productivity of bigger firms is only affected by effective marginal tax rates. Additionally, Langenmayr, Haufler and Bauer (2015) highlight the fact that the existence of an optimal corporation tax structure depends on the degree of competition. The authors conclude that when the degree of market competition is low, higher taxes favour firms with high productivity. Conversely, when the degree of competition is in alignment with competitive mar- ket conditions and firms’ taxes on profit are low, then low-productivity firms tend to be favoured. Another topic is tax burden and its relationship with risk-taking decisions for firms’ investment. On this subject, Ljungqvist, Zhang and Zuo (2017) conclude that the response to a tax change is not symmetric. In fact, the results suggest that a tax increase is accompanied by a reduction in R&D, among other activities. The authors also conclude that only low financial leverage firms react to tax cuts when it comes to risk-increasing investment decisions. In addition, a study carried out by Ljungqvist and Smolyansky (2016) on the effect of corporate taxation on employment and income in the United States, between 1970 and 2010, concluded that while a reduction in corporate taxes has little impact on economic growth, tax cuts during an economic contraction can bring about an increase in both levels of employment and income. From the macroeconomic perspective, several studies also assessed the effects of fiscal policies on investment dynamics. In particular, an empirical study was car- ried out by Vergara (2010) to assess the linkage between tax reforms and invest- ment dynamics for the case of Chile, between 1975 and 2003. The paper’s conclu- sion is in accordance with the theoretical predictions regarding the tax-investment relationship – namely that a reduction of corporate income tax led to a boost in investment in Chile. Furthermore, the author also discovered two channels that explain the negative correlation between taxes and investment: one is related with the positive correlation between higher tax rates and capital costs, and the other is related to higher taxes with liquidity constraints derived from a reduction of the availability of internal funds to promote investment. Additionally, Romer and Romer (2010) evaluated the dynamics of post-WWII tax changes in investment for the United States, and found that the negative sensitivity of investment to positive tax changes is quite large. In fact, on a quarterly basis, investment seems to reduce by almost 12% in response to a positive tax shock. This magnitude is jo sé a lv e s: t h e im pa c t o f ta x st r u c t u r e o n in v e st m e n t: a n e m pir ic a l a sse ssm e n t fo r o e c d c o u n t r ie s pu b l ic se c t o r e c o n o m ic s 43 (3) 291-309 (2019) 297much greater than the sensitivity of both GDP and consumption to tax increases. Furthermore, Mertens and Ravn (2012) evaluate the impact of both anticipated and unanticipated tax shocks for the U.S. economy, making use of VAR econo- metric techniques for the second-half of the 20th century. Their conclusions follow the theoretical predictions – and the authors highlight the important role of antici- pated tax shocks for the dynamics of several economic issues. On the other hand, Mountford and Uhlig (2009), resorting to the same economet- ric techniques, conclude that not only is there a negative response of investment to an increase in fiscal revenues, but also that a public budget deficit crowds out investment, which is also corroborated in Barro and Redlick (2011). Additionally, and besides coming to the same negative conclusions about the investment-taxes nexus, Alesina and Ardagna (2010) reached the conclusion that fiscal consolida- tion via taxation is more detrimental than via the spending side. In fact, raising taxes is more likely to produce economic recessions, and a more inefficient con- trol of government deficit and debt dynamics when compared with fiscal adjust- ment via cuts in government expenditures. Finally, Afonso and Jalles (2015) evaluate the impact of fiscal policy on invest- ment for a large panel of 95 countries, during 38 years. While the authors find that private investment evidences a negative correlation with social security spending for all OECD countries, they also found that interest payments and subsidies have detrimental effects on both public and private investments. It is thus clear that the study of taxation structure and investment dynamics can provide new insights leading to the promotion of the latter without hampering government in its imple- mentation of fiscal policies. 3 METHODOLOGY AND DATA In order to empirically study the impact of taxation on investment growth, we deter- mined that investment dynamics is a function of taxation composition. More specifically, the share of each tax revenue source, as a percentage of GDP, is denoted by T, of the ∆I = F(T) type, as detailed in equation (1). Furthermore, we make use of gross fixed capital formation growth rate as a proxy for investment growth. (1) where ∆Ii,t is the investment growth rate (annual or 5-years average), yi,t –1 is the one-lag real per capita GDP, τn,i,t represents the revenue of each tax item n, in GDP terms, xi,t represents the set of control variables, vi and ηt are, respectively, the country and time-specific effects, and εi,t is the error term of the white noise-type. Additionally, and in order to assess the existence of non-linear effects of taxation structure on investment decisions, we decided to introduce a squared term, as demonstrated in equation (2). jo sé a lv e s: t h e im pa c t o f ta x st r u c t u r e o n in v e st m e n t: a n e m pir ic a l a sse ssm e n t fo r o e c d c o u n t r ie s pu b l ic se c t o r e c o n o m ic s 43 (3) 291-309 (2019) 298 (2) Therefore, by deriving equation (2) in respect for each tax component, τn,i,t, as expressed in equation (3), and by then equalising the derivative function to zero, as detailed in equation (4), we can obtain each tax item threshold in respect to investment growth: (3) (4) Therefore, if we obtain a significant negative signal for β3,i,t, we thus have a con- cave relationship between a tax item and the investment dynamic, which trans- lates into an optimal value for that tax source to maximise investment. On the other hand, a convex relationship through a positive coefficient for β3,i,t translates into a value that hampers investment growth decisions. Therefore, in the empirical results section, when we obtain non-linear relations, we then highlight each coef- ficient to differentiate between maximum and minimum optimal levels. The model computed in this paper considers the period between 1980 and 2015, for all the OECD countries: Australia (AUS), Austria (AUT), Belgium (BEL), Canada (CAN), Chile (CHL), the Czech Republic (CZE), Denmark (DNK), Esto- nia (EST), Finland (FIN), France (FRA), Germany (DEU), Greece (GRC), Hun- gary (HUN), Iceland (ISL), Ireland (IRL), Israel (ISR), Italy (ITA), Japan (JPN), South Korea (KOR), Latvia (LVA), Luxembourg (LUX), Mexico (MEX), the Netherlands (NLD), New Zealand (NZL), Norway (NOR), Poland (POL), Portu- gal (PRT), the Slovak Republic (SVK), Slovenia (SVN), Spain (ESP), Sweden (SWE), Switzerland (CHE), Turkey (TUR), the United Kingdom (GBR) and the United States (USA). The database used in our analysis includes data from several sources: PPP per capita GDP (realgdppc); public debt (debt) and total government spending (tot- exp) – both as a ratio of GDP, output gap, as a percentage of potential GDP (out- putgap) are all obtained from the World Economic Outlook (IMF). On the other hand, taxes on income, profits and capital gains of individuals (taxinc), as well as taxes on income, profits and capital gains of corporates (taxfirms), social security contributions (ssc), taxes on payroll and workforce (taxpayroll), taxes on property (taxprop), taxes on goods and services (taxvat), gross fixed capital formation (gfcf) and its growth rate (gfcfgr) were all retrieved from the OECD.Stats data- base. Age dependency ratio, as a percentage of active population (ageratio), and also deposit interest rate (depositrate), net foreign direct investment-to-GDP ratio jo sé a lv e s: t h e im pa c t o f ta x st r u c t u r e o n in v e st m e n t: a n e m pir ic a l a sse ssm e n t fo r o e c d c o u n t r ie s pu b l ic se c t o r e c o n o m ic s 43 (3) 291-309 (2019) 299(foreigninvestment), and GDP percentage of household final consumption expend- iture (hconsggdp) are all collected from World Development Indicators (WDI). Population in millions (pop) and the real total factor productivity (rtfpna) were obtained from the data of Feenstra, Inklaar and Timmer (2015). Lastly, the liquid liabilities-to-GDP ratio (llgdp) is based on International Financial Statistics (IFS), from the IMF. Table 1 presents the summary statistics for each variable used in our regressions. For the estimation of the coefficients, we resort to panel data techniques, applying the OLS, OLS-Fixed Effects (FE), by resorting to the Hausman Test to evaluate if the respective specification should be run with fixed effects1, Generalized Method of Moments (GMM) and Robust Least Squares (RLS) resorting to the M-estima- tion technique. With the exception of RLS, all these estimations assume the white diagonal covar- iance matrix hypothesis. Additionally, we estimate both equations (1) and (2) for both annual and 5-year average growth rates. Lastly, we only discuss the existence of a threshold when the coefficients of each tax item present statistical signifi- cance for both linear and square term tax regressors, for a minimum of 90% con- fidence interval. Table 1 Summary statistics of the variables set for investment regressions, 1980-2015 realgdppc taxinc taxfirms ssc taxpayroll taxprop Mean 24.448 8.82 2.806 8.345 0.369 1.745 Std. dev. 14.313 4.635 1.500 4.981 0.728 1.003 Max 101.054 26.780 12.594 19.173 5.661 7.334 Min 2.184 0.873 0.261 0.000 0.000 0.074 Obs. 1,195 1,106 1,106 1,137 1,137 1,137 taxvat gfcf gfcfgr depositrate ageratio debt Mean 10.588 23.161 3.314 9.253 51.287 55.728 Std. dev. 3.046 4.091 8.917 25.364 6.931 35.901 Max 18.730 39.404 45.119 682.530 96.457 242.113 Min 2.979 11.546 -47.761 -0.180 36.323 3.664 Obs. 1,137 1,174 1,164 1,055 1,260 943 foreigninvestment rtfpna totexp pop hconsggdp outputgap Mean 3.645 0.941 42.621 33.531 56.382 -0.319 Std. dev. 10.487 0.123 9.657 52.235 7.069 2.850 Max 252.308 1.539 68.436 319.449 79.551 14.911 Min -58.323 0.472 14.244 0.228 29.918 -11.437 Obs. 1,120 1,173 977 1,173 1,174 851 1 For reasons of parsimony we do not provide the Hausman test results in the article, although they are avail- able upon request. jo sé a lv e s: t h e im pa c t o f ta x st r u c t u r e o n in v e st m e n t: a n e m pir ic a l a sse ssm e n t fo r o e c d c o u n t r ie s pu b l ic se c t o r e c o n o m ic s 43 (3) 291-309 (2019) 300 4 EMPIRICAL ANALYSIS 4.1 SHORT-RUN EFFECTS OF TAXATION ON INVESTMENT DYNAMICS The short-run analysis for equation (1), i.e. without the tax items square terms, show that tax burden has, in general, a negative impact on investment dynamics. In detail, a unit increase in the tax burden of individual income taxes is associated with a decrease of 0.14%, approximately, while an increase in the tax on firms’ revenues, as a proportion of GDP, presents a negative elasticity greater than the unity (-1.15), on average. Moreover, revenues of social security contributions also show an average reduction of -0.66% by a percentage point increase in this tax source. In fact, these obtained results are expected: taxes levied on household income and on social security contributions reduce aggregate demand and, there- fore, they reduce the demand for goods and services, which can decisively influ- ence new investment decisions. On the other hand, it is certain that a rise in the tax burden on these two sources can indicate wage rises, which cut into firm profits, decreasing the expected returns of previous investments, as well as of any new investments. Furthermore, a rise of taxes on firms, controlled by the cyclical condi- tions of the economy, also reduces the expected present value of future investment, leading investors to postpone their decisions to promote capital growth and, there- fore, the aggregate level of investment. For the same reasons, the negative coeffi- cients obtained for taxes on consumption of goods and services as well as for taxes on property are expected in line with traditional economic theory. Yet, and if we admit that the increase of revenues from taxes on consumption results from changes in tax rates, the price system will incorporate those tax policy changes, reducing investment opportunities. In fact, even if firms can accommodate a higher tax rate without changing their prices, the net profits will necessarily decrease, increasing the time required for an investment decision to result in a profit. With regards to the control variables, we also find the expected signs. Specifically, a rise in deposit … Tax Reform and Adjustment Costs: The Impact on Investment and Market Value Author(s): Alan J. Auerbach Source: International Economic Review , Nov., 1989, Vol. 30, No. 4 (Nov., 1989), pp. 939- 962 Published by: Wiley for the Economics Department of the University of Pennsylvania and Institute of Social and Economic Research, Osaka University Stable URL: https://www.jstor.org/stable/2526760 JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected] Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at https://about.jstor.org/terms and Wiley are collaborating with JSTOR to digitize, preserve and extend access to International Economic Review This content downloaded from �������������82.102.22.77 on Tue, 24 Aug 2021 20:08:12 UTC�������������� All use subject to https://about.jstor.org/terms https://www.jstor.org/stable/2526760 INTERNATIONAL ECONOMIC REVIEW Vol. 30, No. 4, November 1989 TAX REFORM AND ADJUSTMENT COSTS: THE IMPACT ON INVESTMENT AND MARKET VALUE* BY ALAN J. AUERBACH 1 This paper provides an effective tax rate measure that is valid in the presence of adjustment costs and anticipated tax changes and a measure of the impact of tax changes on market value that may be decomposed into the effects on discounted pure profits and normal returns to capital. Changes in the value of capital may, in turn, be decomposed further into changes in the marginal value of new capital and changes in the relative value of new and existing capital. These new measures are used to evaluate tax changes similar to those introduced by the recent U.S. tax reform. 1. INTRODUCTION Changes in tax policy are thought to influence investment behavior, and anticipated tax changes may do so as well. However, the impact of expected future tax changes may push current investment in a different direction than would be suggested by the long-run effects. For example, an anticipated increase in the investment tax credit would be expected to decrease current investment, as firms delay investment to take advantage of the credit. An important determinant of the impact of current and future tax changes is the firm's technology. For example, if it is very difficult for the firm to alter its investment plans, then anticipated tax changes may have little impact on behavior. Thus, the structure of the taxation and the structure of production interact in their effects on investment. A second way in which tax changes and adjustment costs interact is through changes in the value of the firm. Tax policies that encourage investment will also increase the value of newly acquired capital for the firm facing adjustment costs. The change in firm value that results depends not only on the magnitude of this increase but also on the tax policy's relative treatment of old and new assets and pure profits. Policies targeted at investment, such as investment tax credits, can have quite different effects from tax rate reductions that apply to income from all sources. This paper derives analytical measures of the combined effects of tax changes and adjustment costs on investment and market value. The measure of the impact on market value allows one to distinguish among changes associated with pure profits, after-tax returns to new capital, and the relative tax treatment of old and new capital. The measure of the impact on investment is analogous to the "effective * Manuscript received January 1988; revised July 1988. l Financial support for this research was provided by the National Science Foundation. I am grateful to Jim Hines, Jim Poterba, Larry Summers, two anonymous referees, and participants in seminars at Harvard, Johns Hopkins, London School of Economics, Princeton and Toronto for useful comments on previous drafts. 939 This content downloaded from �������������82.102.22.77 on Tue, 24 Aug 2021 20:08:12 UTC�������������� All use subject to https://about.jstor.org/terms 940 ALAN J. AUERBACH tax rate" found in various studies (e.g., Auerbach, 1983a; King and Fullerton, 1984). It is based on the same principle of estimating the impact of taxes on new investment, but unlike earlier measures it is valid in the presence of adjustment costs and anticipated tax changes. Using it, one can estimate how a complicated set of current and future tax provisions affects current incentives. The ability to measure current as well as long-run incentives is important. In the recent U.S. tax reform debate, for example, attention was continually focused on the effective tax rates that would eventually prevail under new law even though various phase-in provisions were being considered that would have substantially affected investment behavior in the short run. Since the effects of tax changes depend on the nature of production, the measures to be derived must be based on a specific model. The model chosen here, a production function with convex adjustment costs, is commonly found in the "q" theory literature and has been used to analyze the effects of tax reform in a number of recent papers. This model has become popular in part because of its tractability, but also because it embodies certain restrictions. These will be discussed below where they are relevant. 2. THE MODEL The behavior analyzed is that of a price-taking representative firm producing a single output using one factor of production, capital, subject to a concave production function F(-).2 The firm faces a corporate tax system represented by a tax rate, an investment tax credit and a schedule of depreciation allowances. It responds with perfect foresight to changes in these tax variables, subject to convex costs of adjusting its capital stock. These costs impart an incentive for the smoothing of investment. For simplicity, we ignore personal taxes, corporate interest deductibility and economic growth, and assume a uniform rate of inflation for output and capital goods. Relaxing any of these restrictions would pose few analytical difficulties, but would add additional complexity without really altering the qualitative nature of the paper's results. There is no uncertainty in the model, and the firm's planning is done under perfect foresight. Therefore, its objective is to maximize the present value of future cash flows, discounted at the nominal, after-tax cost of capital, r, which is assumed constant: (1) Vt = e-r(s-t)[psF(Ks) - psC(Is/Ks)Is - Ts] ds 2 The single-factor, decreasing-returns-to-scale production technology can, without any loss of generality, be viewed as a two-factor, constant-returns-to-scale technology with a fixed factor that earns a competitive return equal to the firm's pure profits. Similar results would be obtained by assuming the existence of a second variable factor, say labor, in fixed supply to the economy, since in equilibrium the wage would have to adjust to provide the price-taking firm with zero profits. This is the approach taken by Summers (1981), for example. The only difference is that in such a model there would be no pure profits, for the "fixed factor" would be owned by workers rather than the firm. This content downloaded from �������������82.102.22.77 on Tue, 24 Aug 2021 20:08:12 UTC�������������� All use subject to https://about.jstor.org/terms TAX REFORM, INVESTMENT AND VALUE 941 where (2) Ts = rs[psF(Ks) - p,,C(I,,lK)I,,D(s, s - u) diu] - kpC(IsIKs)Is is the tax bill at date S.3 Terms introduced in (1) are Ps, the price level, Is, gross investment, and KS. the capital stock, at date s. The investment unit cost function, CQ), has as its argument the rate of investment I/K. The tax variables at date s, introduced in (2) are rS, the corporate tax rate, ks, the investment tax credit, and D(s, s - u), the depreciation allowance per dollar of date u capital expenditure. Investment and capital are related by (3) Is = Ks + ksg where 8 is the (assumed to be geometric) rate of economic depreciation of capital.4 Because we will be linearizing the model around a long-run steady state, it may be assumed without further loss of generality that the convex cost function CQ) is quadratic. A convenient normalization to adopt is that the derivative of the total cost function C(I/K) * I with respect to I equals 1 in the steady state (k = 0). This derivative then has a direct interpretation as Tobin's q, greater than 1 when investment exceeds its steady state value and less than 1 when it falls short. Given (3), this normalization implies that: (4) C(I/K) = 1 - ?8 + - OI/K. Based on (4), the relative prices of capital goods is: pd[C(I/K)I]IdI (S) q = = I + (KIK). p With (2), (3) and (4) expression (1) may be rewritten as: (6) Vt = f e-r(s-t)PS (1 -)F(Ks) ( 2 2 + Ks) (5Ks + Ks)(1-ks -FS) ds + At, where 3 The expression for taxes in (2) treats all capital costs pC(IIK)I as part of capital expenditures for tax purposes. This is consistent with the U.S. tax treatment calling for the addition of indirect costs (such as installation) to basis. In reality, some of the indirect costs associated with adding capital such as retraining of labor, would normally not be capitalized but simply deducted as an expense. This is a minor issue in the current context. 4 The geometric decay assumption makes the model simpler to analyze, but does rule out certain interesting phenomena, such as "echo" effects, whereby investment booms lead to subsequent booms in investment simply to replace scrapped capital. A more general specification of depreciation would be unlikely to alter the qualitative nature of the results below, which do not depend in any fundamental way on the smoothness imparted by geometric decay. This content downloaded from �������������82.102.22.77 on Tue, 24 Aug 2021 20:08:12 UTC�������������� All use subject to https://about.jstor.org/terms 942 ALAN J. AUERBACH (7) At= e-r (s)-5 f P11C(II,/Ku)I1D(s s - u) du ds is predetermined at date t. At is the present value of tax savings due to depreciation of investments made before date t. The term Fs in expression (6) represents the present value of tax savings per dollar of date s investment: rx (8) vs = er(u-s) rUD(u, u - s) du. The Euler condition for the optimal capital stock path based on expression (6) may be written (letting p = r - plp be the real interest rate): (9) F'(Kt) + Xt = ct = qt P + 6 )+ ('Ir ( - k - Ft)l(I - Tt) where: (10) Xt= 2 4(It/Kt)2(1- kt- Ft)/( -t) Expression (9) differs from the standard Hall-Jorgenson cost of capital formula- tion in two respects. Because tax changes are contemplated, it accounts for changes in the relative capital goods price, q(l - k - F), caused not only by changes in q, but also by changes in k and F. In addition, the full marginal return to capital includes Xt, a reduction in current adjustment costs per unit of investment. This latter effect would be absent if adjustment costs depended only on the level of investment, rather than the ratio of investment to the capital stock. The ratio specification is typically used in the empirical literature, and is more convenient for the analysis of market value changes (e.g., Hayashi 1982). We discuss this further below. Expressions (5), (9) and (10) yield a familiar system of first-order, nonlinear differential equations in the capital stock, K, and the relative capital goods price, q, which may be written (suppressing subscripts) as: (lla) k (q- ) (I l) -F (K)I k F 2 0 5+ 0 ) +q(p +)+ q k+ F This two equation system in K and q is the one we wish to consider but its nonlinearity makes a general analytic solution unavailable. There have been three approaches taken in the literature to deal with this problem. One may examine the system graphically using phase diagrams, as in Abel (1982). While very helpful in understanding how the model works and how K and q will respond to various tax changes, there are many cases in which the direction of movement may be indeterminate, depending on the relative magnitude of This content downloaded from �������������82.102.22.77 on Tue, 24 Aug 2021 20:08:12 UTC�������������� All use subject to https://about.jstor.org/terms TAX REFORM, INVESTMENT AND VALUE 943 parameters, which makes an analytic solution desirable. Moreover, the phase diagram approach is ill-suited to studying effects on the value of the firm (i..e, "average" q). A second approach, used in Summers (1981) and Auerbach and Hines (1987), utilizes numerical simulations. While in principle capable of charac- terizing the sensitivity of the behavior of investment and market value to changes in parameter values, this approach is unlikely to uncover the exact nature of analytical relationships. The final approach is to obtain an analytic solution by considering the behavior of the system near a steady-state equilibrium, where the local behavior of K and q can be approximated by the version of (1la) and ( lib) linearized around the steady state. This last approach is common in the literature on dynamic models. It has been used in a related analysis by Judd (1985). The present specification differs from Judd's in several respects, however, including a richer characterization of the tax system and adjustment costs in production. Perhaps the most important contribu- tions here are the derivation of explicit analytical expressions that summarize the effects of very complicated tax changes on the incentive to invest, the extension of the analysis to study impacts on market value, and the integration of the effects on market value and investment. Linearizing (1la) and ( lib) around the steady state, one obtains (using the facts that q = 1 and k = r = k = 0 in the steady state): K* (12a) K- (q- 1) (12b) )F(K Ik* ( )* (K- K*) - 5(q - 1) + (p + 8)(q - 1) F'(K*) F'(K*) k + 1 k* F* (I - k* - F*)2 1- - where the "*" superscript denotes the steady-state value of a variable. In the steady state, (9) becomes: (9') F'(K*) = + - )(1 - k*- F*)/(I - T*) = (p + 3)(1 - k* - F*)/ (I - where (13) 3 = 5 I - ? Hence expression (12b) may be rewritten -F"(K*) -* (12b') FK= *) (p + 3)(K - K*) + p(q- 1) + (p + 3)( * - (P + (k +F) -(k* +* 1F + (l k-t) This content downloaded from �������������82.102.22.77 on Tue, 24 Aug 2021 20:08:12 UTC�������������� All use subject to https://about.jstor.org/terms 944 ALAN J. AUERBACH The term 3 defined in (13) is the rate of economic depreciation of the capital stock, in the presence of adjustment costs.5 Expressions (12a) and (12b') form a first-order linear system in K and q, which can be solved directly using the Laplace transform technique, as in Judd (1985). To relate this model to the previous investment literature, however, an alternative approach is more useful. One can represent (12a) and (12b') as a second-order linear equation in K by substituting q from (12a) and q from the derivative of (12a) into (12b'). Doing so yields a . (p +) a(p +) 1 (14) Kt -PK- Kt= - K*I1 --at aJ where: -F"(K*) K* (15) a F'(K*) and (k* + F*) - (kt + Ft) t 1 kt + Pt (16) at= - +p * - I1-k* -F* I1-r* p + 1, -k* -F*' The term a equals the elasticity of F' with respect to K, - d ln F'/d ln K, evaluated at K*. (It will normally be different for different values of K.) This term is important in the translation of capital cost changes into capital stock changes and vice versa. The term at represents the proportional deviation in the user cost of capital at time t from its long-run value defined in (9') due directly to taxation. (The user cost, defined in (9), also depends on q and 4, which are themselves functions of the firm's investment behavior unless 0 = 0). The characteristic roots of equation (14) are: 4a(p+ 4a(p +) p- p2+ P+ p2+ (17) 2 2 2 5 The total cost to the firm of new capital goods is (1 - j6 + 120IIK)I = (1 - 1/208)8K in the steady state. The steady-state value of the firm's capital stock is constant. Thus, depreciation, which is the reduction in capital value plus expenditure on new capital goods, is (1 - 1/208)aK = AK. Another way of viewing the same result is that an increase in capital expenditure today, holding future expenditure constant, yields an asset that depreciates at rate 8 plus additional capital at each date in the future because of the reduced unit price of capital induced by the current expenditure. The increase (in the steady state) is 1/2k82 per unit of capital, compounded at each date, yielding a net rate of depreciation of 8 - 1/2 82. As shown by Abel (1983), neutrality of the tax system in such a case would require netting these gains against primary depreciation in computing depreciation allowances. That such a correction to the measurement of economic depreciation is appropriate does not appear to be widely recognized in discussions about measuring depreciation properly. Given typical estimated magnitudes of the propor- tional adjustment cost parameter 0, the correction may be quite large. This would be especially true in the presence of growth, since the correction factor would then be 1I2>(n + 6)2, where n is the economy's steady-state growth rate. This content downloaded from �������������82.102.22.77 on Tue, 24 Aug 2021 20:08:12 UTC�������������� All use subject to https://about.jstor.org/terms TAX REFORM, INVESTMENT AND VALUE 945 Expression (9') implies that as long as the steady-state marginal product of capital is positive, so is (p + 3). Then, since a and 0 are also positive, the model has one stable root (A 1 < 0) and one unstable root (A 2 > 0). This is the normal result in such models. Given the initial value of K and the transversality condition ruling out the explosion of q, there will be a unique saddlepath equilibrium for the system. Incorporating the transversality condition into (14) yields a first-order equation in K: 00A(-)a(p +) (18) Kt = AKt + jeA2(t) K* (I - - as) ds. Expression (18) could, in turn, be solved for Kt using the initial condition with respect to the capital stock. However, it is more easily interpreted in its present form. Since A1A2 = [-a(p + 5)/0], (18) may be rewritten: (19) Kt = (-A i)(K t-Kt), where (20) Kt = K and rx (21) lt = A2 e-A2(5-t)as ds. t Thus, the firm's investment behavior at time t may be described as a partial adjustment process, at rate -A1, which closes the gap between the actual capital stock, Kt, and the "desired" capital stock Kt. This desired capital stock differs from the long-run capital stock, K*, due to the existence of temporary tax provisions during the period between date t and the steady state. This partial adjustment approach is consistent with the traditional investment literature (e.g., Hall and Jorgenson 1967), but goes further in characterizing the determinants of the speed of adjustment, (-A 1), and being based on an optimal capital stock, K, that is consistent with the partial adjustment process. Since full adjustment will not occur instantaneously, the target to which the firm adjusts today depends on where it wishes to be in the future. The term f?t is a weighted average of the current and future tax effects, as, with weights summing to one and declining at rate A2. As 0 gets smaller, A2 increases (see (17)), making future tax effects less important in determining fl because of a reduced incentive to smooth investment (as indicated by the coincident increase in -A1). From expression (20), it follows that -(flt/a) is the proportional deviation of the desired stock capital stock from K* due to short-run tax factors. Given the definition of a, it follows that fl represents the proportional increase in the short-run cost of capital per dollar due to tax changes. That is: This content downloaded from �������������82.102.22.77 on Tue, 24 Aug 2021 20:08:12 UTC�������������� All use subject to https://about.jstor.org/terms 946 ALAN J. AUERBACH AF' I dF' K-K* (22) F' = _ K _ (K-K*) =-a K*) fL The current cost of capital effect, lt, combines future tax changes and adjust- ment costs in a particularly simple way. First one estimates the date s impact of tax changes on the user cost of capital ignoring adjustment costs, as, for s > t, then weights these with the factors A 2e -A2(S-t) to account for the presence of adjustment costs. The term lt differs from at in that the former includes cost of capital effects due to changes in the rate of investment that make q # 0. This difference would vanish if 0 = 0, for then there would be no change in q due to investment. One may also express the effects of current and future tax policy on investment in terms of an effective tax rate. Suppose we wished to know what tax rate, 0, if applied to true economic income without change over time, would yield the level of investment actually observed at the current date. This amounts to identifying the steady-state tax rate on economic income that would make K the desired steady- state capital stock. Since expression (9') identifies the marginal product of the steady-state capital stock (and hence that capital stock itself) for any constant tax system, we may use it to solve implicitly for 0 by fixing the marginal product of capital at F(K), and, consistent with the assumption of a true income tax, setting the investment tax credit to zero and the present value of depreciation allowances to 3/p + 8 (see Auerbach 1983b). This yields a solution for 0 as a function of K, and an approximation of 0 near the steady state: F'(K)-(p + 5) F' (23) F'(K)- = + * + Q(1 (F' -) where 0* is the steady state effective tax rate. With a constant tax system, Ql = 0 and 0 reduces to the standard effective tax rate measure found in the literature (e.g., Auerbach, 1983a; King and Fullerton, 1984). The short run value will differ because of the anticipated tax changes accounted for by l. These results apply in general for small changes in the tax system, and Ql and 0 are quite easily calculated. In addition, one may simplify the expressions for Ql in particular important cases, making possible the further analysis of the impact of anticipated tax changes in the next section. 3. THE IMPACT OF TAX REFORM This section considers the impact, Ql, on the short-run cost of capital of anticipated temporary and permanent tax changes. It focuses on changes in the corporate tax rate r and in the investment tax credit k, although other experiments, such as changes in the schedule of depreciation allowances, could also be examined. A. Changes in the Investment Tax Credit. Suppose the investment tax credit changes from k to k* at date T > t. Then, for s > T, as = 0 (see (16)). For s < T, This content downloaded from �������������82.102.22.77 on Tue, 24 Aug 2021 20:08:12 UTC�������������� All use subject to https://about.jstor.org/terms TAX REFORM, INVESTMENT AND VALUE 947 k*-k Ak (24) as=I-k* F* I k* F` Through the effects of these terms on ft, a future increase in k leads to more investment today (i.e., reduces fl) to smooth the accumulation of the larger capital stock desired after date T. However, when k increases it decreases the value of existing capital, which does not qualify for the credit, relative to new capital, which does. This effect, which discourages current investment if k is expected to increase, is accounted for by the kt term appearing in (16). Because of the jump in k at T, kT is undefined. Its impact on flt is massed at T in a T However, its effect can be calculated as the limit of the effects of the k terms associated with a change from k to k* over an arbitrarily short interval around T. This yields: (25) A2 e-A2(T- t) Ak which has the same sign as Ak, discouraging investment if Ak > 0. Combining (24) and (25), using the definition of fl in (21) yields the total effect of the change in k: (26) 1 A 2 )A -k* -r* ( + ^ -(T t)) If A2 > (p + 3), lt exceeds the value it would have for no change in k (i.e., for T -> oc). In this case, the expectation of an increase in the investment tax credit reduces current investment. The capital loss effect in (25) outweighs the smoothing effect in (24). However, A2 may theoretically be less than (p + 8). From the definition of A2 in (17), it follows that A2 > (p + 3) if and only if a < .5 and 4 is in the interval [(1 - \/1 - 2a)/8, (1 + \/1 - 2a)/8]. As shown below, this is the same condition for the value of existing capital goods to increase with an increase in the investment tax credit. The increase indicates that marginal q increases by more than the gap between marginal and average q does. Since a capital gain occurs in such an event, the anticipation of such a gain encourages current investment.6 To extend the analysis to the case of a temporary tax credit, imagine a second shift from k* to k at some date T' < T before the shift back to k* at T. The shift at T has the effect on lt just estimated, while the effect of the earlier shift is: 6 A similar ambiguity was found in a general equilibrium model without adjustment costs by Judd (1985). In his model, the interest rate is influenced by individual savings decisions. Such general equilibrium effects, like adjustment costs, induce a smoothing of investment, although the cause, the desire by households to smooth consumption, is quite different. Given the openness of the U.S. economy and the size of the U.S. corporate sector, it is questionable whether consumption smoothing by U.S. households can influence interest rates enough to induce significant smoothing of investment. In any event, the predictions of the two models are generally consistent with each other. The choice of adjustment cost specification also matters. Under the level adjustment cost specification used in an earlier version of this paper (C(I) instead of C(IIK)), A2 must exceed p + 8 and the ambiguity disappears. Even in the present specification, however, this ambiguity turns out to be empirically irrelevant. This content downloaded from �������������82.102.22.77 on Tue, 24 Aug 2021 20:08:12 UTC�������������� All use subject to https://about.jstor.org/terms 948 ALAN J. AUERBACH (27) 1~ k*~ F*(1+e). -k* -r* p + ^ Combining (26) and (27) yields the full impact of the temporary change from T' to T: Ak A2-(P + ) A (28) fit k* F* (p + 3) (eA2(T-t)e-A2(T't)) Since T > T', this has the same sign as -Ak = k- k* if and only if A2 > (P + 8). In this case, an anticipated temporary increase in the investment tax credit from k* to k raises the current cost of capital. Once again, the desire to smooth higher investment during the interval (T', T) is outweighed by the anticipated capital losses at T' (net of the gains at T) caused by changes in the relative value of existing capital. B. Anticipated Tax Rate Change. An important issue when considering the impact of a change in - is the pattern of depreciation allowances that prevails during the tax reform. The extent to which such allowances are accelerated relative to economic depreciation is … The Effects of Taxation on the Firm's Investment and Financial Behavior Author(s): Göran Eriksson Source: The Scandinavian Journal of Economics , 1980, Vol. 82, No. 3 (1980), pp. 362-377 Published by: Wiley on behalf of The Scandinavian Journal of Economics Stable URL: https://www.jstor.org/stable/3439747 JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected] Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at https://about.jstor.org/terms Wiley and The Scandinavian Journal of Economics are collaborating with JSTOR to digitize, preserve and extend access to The Scandinavian Journal of Economics This content downloaded from �������������82.102.22.77 on Tue, 24 Aug 2021 18:05:32 UTC�������������� All use subject to https://about.jstor.org/terms https://www.jstor.org/stable/3439747 THE EFFECTS OF TAXATION ON THE FIRM'S INVESTMENT AND FINANCIAL BEHAVIOR Goran Eriksson* Industrial Institute for Economic and Social Research, Stockholm, Sweden Abstract The effects of taxation on the behavior of firms are examined in this paper. Earlier studies of this issue have concluded that, given certainty and true economic de- preciation, corporate taxes have no effect on the firm's financial policy. External, e.g. legal, restrictions on the financial options of the firm have to be introduced in order for taxes to have such an effect. Our model turns these conditions around by taking the risk of bankruptcy into account. There then exists an interior finan- cial optimum for the firm. The firm's investment decisions become inseparable from its financial decisions. Furthermore, changes in taxes on profit, personal income and capital gains induce the firm to make smooth adjustments in its optimal financial structure and optimal rate of investment. I. Introduction Although considerable attention has been paid to the question of the effects of taxation in the literature, there are very few firm models which incorporate and can deal with the effects of different taxes and simultaneously take the firm's financial decisions into account in a realistic way. Almost all of the models rest on purely neoclassical assumptions implying, among other things, certainty and perfect capital markets.' Under these assumptions the firm's behavior has no effect on the price of different forms of finance. If there are no additional external restrictions which limit the firm's financial options, this means that the firm will use only one financing source, i.e. that which has the lowest cost after taxes. However, such behavior would imply financing solely through borrowing or by retaining profits. which is inconsistent with empirical evidence. In this paper we investigate the optimal investment and financial decisions for a growing, profit-maximizing firm and take into account taxes on profits, personal income and capital gains. The basic model used is a somewhat modified * I am grateful to Charles E. McLure Jr., National Bureau of Economic Research, for valuable criticism and helpful suggestions. 1 See e.g. Stiglitz (1973) and King (1974). In Stiglitz (1972), uncertainty is allowed but in a model without taxes. Sand. J. of Economics 1980 This content downloaded from �������������82.102.22.77 on Tue, 24 Aug 2021 18:05:32 UTC�������������� All use subject to https://about.jstor.org/terms Effects of taxation on the firm's behavior 363 version of one presented in Eriksson (1978).1 This model allows us to drop the assumption of perfect certainty and introduce the following financial restraints: the firm's interest rate on borrowed capital is an increasing function of its debt to equity ratio, and the rate of return required by the stockholders is an in- creasing function of this ratio and a decreasing function of the proportion of profits paid out. Due to these financial restraints, we obtain several interesting results which contrast with earlier studies where taxes have been incorporated. The value of the firm depends on its debt and dividend policies; an interior optimum exists with positive volumes of both internal and external finance. A complete inter- relationship between the firm's borrowing, internal financing and investment decisions also emerges. Consequently, taxes always have implications for real magnitudes, i.e. they influence the firm's optimal investments and rate of growth. II. The Model 11.1. Valuation of the Firm We assume a linear homogeneous production function for the firm with respect to labor and capital inputs, fixed output and input prices, and no growth costs.2 Given these assumptions and given that the interest rate rises with increased borrowing, it can be shown that the firm's optimal input mix is determined solely by the price of labor and the marginal value product of labor.3 A profit tax, personal income tax or capital gains tax will then have no impact on the proportions in which labor and capital are demanded. This result allows us to disregard the production activity of the firm. Furthermore, we assume that depreciation for tax purposes coincides with true economic depreciation and that the depreciation rate is constant. Thus, the rate of return on total capital is assumed exogenously given. The firm acquires funds for investment only through borrowing and by retaining profits. For period t, we define the rate of return on total capital (rt) as profit net of depreciation divided by total assets and the leverage ratio (he) as debt divided by equity. The rate of return on equity (rEt) is then determined according to the well-known identity rE:= rt + ht(rt-it), (1) where it denotes the interest rate. 1 For references to other models, see Gordon (1962) and Lerner & Carleton (1966). 2 Since dynamic restraints are covered on the financial side in the form of rising costs of capital (see Section II. 2), an additional restraint on the production side by allowing growth costs in the model would only strengthen the obstacles to expansion due to financial restraints and would work in the same direction with respect to the optimal payout ratio, investment rate and growth rate; see Eriksson (1978), Chapter 5. 3 Op cit., Chap. 5. Scand. J. of Economic8 1980 This content downloaded from �������������82.102.22.77 on Tue, 24 Aug 2021 18:05:32 UTC�������������� All use subject to https://about.jstor.org/terms 364 G. Erikson Assume a proportional profit tax rate (8s) and let ut denote the payout ratio. The growth rate of equity will then be Vt = (1 -Ut) (1 -SV) rEn (2) If Et is equity, dividends paid by the firm are t(L -sv)rEEt. Letting sI represent a proportional tax rate on personal income, it follows that the dividends received by the stockholders after taxes will be Ut = ut(l - s,)(I- sv) rEt E.(3 The stockholders discount rate (k) is determined by what they can earn on alternative financial investments. A proportion (SI) of these earnings is paid as income tax. This makes the discount rate after income tax equal to (1 - 8) k. Furthermore, the increase in the value of stocks (i.e. capital gains) is assumed to be taxed on an accrual basis.' Let sR be the fraction of the capital gains each year that is taxed as personal income. As s, is the income tax rate, S1Rs is the annual rate of capital gains taxation. If dP/dt is the increase in the value of stocks, then the corresponding increase after capital gains tax amounts to (1 -SIjs)dPldt. We conceive of a market in which the firm's stocks are traded. On this market all existing and potential owners of the firm have access to equal and costless information about the actual price of its stocks and other relevant facts about the firm. The market is cleared when the stockholders' discount rate after in- come tax is equal to the dividend yield plus the rate of growth in their own price of all stocks, after taxes, in each period. This market equilibrium con- dition can be stated (I - s) kt = Ut + (1 -s 8IS) }p /Pt, (4) where Pt is the price of the stocks. We now introduce a very simple form of uncertainty. We assume that the actual rates of return on total assets at any point in time (rt) is normally distributed around the long-run expected mean value (r) with constant vari- ance. Given a time-invariant leverage ratio and payout ratio, this simple stochastic profitability function is compatible with steady-state expansion of the firm with short-run fluctuations in all its monetary variables around given trend values.2 Of course such a dynamic steady state does not exactly I Of course it would have been desirable to take into account the fact that, in reality, capital gains are taxed at the time of realization. But in order to do this satisfactorily, an analysis of the optimal length of shareholding and consequently, a much more compli- cated model than ours would be required. Therefore we dispense with these complications by assuming quite simply that accrued-and not realized-gains are taxed. Since the analysis is partial and only considers the effect of taxation on the individual firm, the discount rate may be regarded as unaffected by either profit or capital gains taxes. For a similar treatment of the incidence of these taxes, see Bergstrom & S6dersten (1976). 2 See Lintner (1964). Scand. J. of Economics 1980 This content downloaded from �������������82.102.22.77 on Tue, 24 Aug 2021 18:05:32 UTC�������������� All use subject to https://about.jstor.org/terms Effects of taxation on the firm's behavior 365 hold in reality. But this simplifying assumption is common in the literature and accepted by many authors as a description of how firms expand over long periods of time.' When the firm has decided on a certain long-run growth rate v, the growth of its expected dividends in the long run is given by Ut = UOeVt. (5) Assuming payouts in an unlimited future, solution of the differential equa- tion (4) then gives2 p=| Ut -ss (t s, -exp (- (1- 8,) k) dt (-, (1ss (6) where UO= u(I -.-s) (I -sV)rEEO (7) v = (1-U) (1 -8V)rE (8) rE= r+h(r-i). (9) The amount of internal funds expressed by Eo is predetermined by rationed earnings from earlier periods. II.2. Financial Restraints We assumed random fluctuations in the actual rates of return on total assets. If the rate of interest on debt is not subject to such variations, then according to (1), a higher leverage ratio brings about higher relative variability over time in the rate of return on equity. This increases the probability that the rate of return on equity will fall below zero, in which case the firm may not be able to meet its obligations and may be forced to go bankrupt.3 Since bankruptcy involves administrative expenses, outlays for reorganization of the firm and losses due to the adverse effects of financial difficulties on the firm's 1 E.g. Gordon (1962), Marris (1964), Lintner (1964), Solow (1971) and Jakobsson (1976). 2 Note that eq. (6) expresses the value of the firm from the stockholders' point of view as the discounted value of future expected paid out dividends, net of personal taxes on dividends and capital gains. Since this valuation formula is derived from the market equilibrium condition (4) and the discount rate (1 - s) k reflects the individual income tax rate and before-tax yield on alternative investments, the use of (4) only shows that valuation of the stocks at the margin equals the required rate of return. For similar treatment in deriving the market price of stocks, see Lintner (1964), King (1974) and S6dersten (1977). Note also that (1 -si) k must be greater than (1 -8Isp)v in order for the present value of future dividends (PO) to be finite. 3 These arguments are in line with the traditional view on this subject; see e.g. Schwartz (1959). A more detailed account of how changes in the debt to equity ratio affect the risk of bankruptcy and rate of interest is given in Eriksson (1978), Chapter 4, where cross- sectional estimations also show a significant positive relationship between the interest rate and the leverage ratio. Scand. J. of Economic8 1980 This content downloaded from �������������82.102.22.77 on Tue, 24 Aug 2021 18:05:32 UTC�������������� All use subject to https://about.jstor.org/terms 366 G. Eriksson flow of operating earnings, there are indeed real costs associated with excessive debt. This is an important reason for expecting a positive covariation between the leverage ratio and the rate of interest demanded by the firm's lenders.' We formulate the interest rate function i = i(h), (10) where Oi/Sh > 0 and aS2i/ah2 > 0. On purely theoretical grounds, however, it is more difficult to reach un- ambiguous conclusions concerning the degree to which the interest rate will rise with higher leverage. Nor have any empirical studies been published on this subject. Therefore, we accept the common view that increased reliance on debt should not exert an appreciable influence on the likelihood of bankruptcy at a low leverage ratio, whereas this influence will be much stronger at a high leverage ratio.2 Next, we turn to the question of the influence of debt financing on the stockholders' discount rate. It is clear that the increased probability of in- solvency of the firm due to a higher leverage ratio also affects stockholders. This, in turn, establishes the same kind of positive relationship between the discount rate and the leverage ratio as for the rate of interest on borrowed capital. It should be emphasized that even if markets were perfect, the opera- tion of the Modigliani-Miller arbitrage process could not make the rate of discount decline at high levels of debt. This is due to the fact that every debt- holder is in a preferred position relative to stockholders in their claims on all cash flows and assets of the firm and to the presumed risk aversion of all in- vestors.3 There is also empirical evidence which indicates that the discount rate is a monotonically increasing function of the leverage ratio.4 Uncertainty should also imply that the stockholders' rate of interest rises as they increase their borrowing on personal account. Thus dividend policy might affect the discount rate demanded by the stockholders. We now propose the hypothesis that the discount rate is a falling function of the payout ratio within the relevant interval of values for this ratio (i.e. between zero and one). One reason is that stockholders' consumption should be paid for partly by current dividends, and increased borrowing costs might prevent them from fully substituting increased personal borrowing for postponed dividends. Another reason is that investors regard dividends expected in a distant future as more risky so that such dividends are discounted at a higher rate than those expected in the near future. Assuming risk aversion on the part of the stock- holders, a lower payout ratio, which pushes dividends further into the future, 1 The firm obviously has to declare bankruptcy as soon as the negative rate of return causes the value of its total assets to fall short of the value of its debt. 2 See e.g. Baxter (1969). 3 Robicheck & Myers (1965), Chapter 3. 4 See e.g. Brigham & Gordon (1968) and Bennet, Graham & Tran Van Hoa (1969). Scand. J. of Economics 1980 This content downloaded from �������������82.102.22.77 on Tue, 24 Aug 2021 18:05:32 UTC�������������� All use subject to https://about.jstor.org/terms Effects of taxation on the firm's behavior 367 will raise the average discount rate for the entire flow of dividends.' Further- more, it seems plausible that firms which try to speed up the rate of growth by lowering the payout ratio would, at the same time, switch to more risky activities and devote relatively more resources to research and development of new products, which involve greater risk.2 Of course, we are aware that these arguments are not uncontroversial. Many authors have claimed that changes in internal equity financing do not affect, or at least have a neglible effect, on the cost of capital to the firm.3 But the Modigliani-Miller conclusion of no effect at all requires, among other things, that any change in the leverage of the firms can be completely offset by changes in homemade leverage. This hardly is a realistic assumption. Although reasons can be found for market imperfections and thus for the existence of dividend effects, it is another matter to make any precise statement about the way in which dividend policy influences the discount rate. Whether this rate is an increasing or decreasing function of the payout ratio should ultimately be an empirical question. Several authors, e.g. Brigham and Gordon (1968) and Bennet, Graham and Tran Van Hoa (1969) have verified empirically that the discount rate rises with enlarged internal equity financing. Furthermore, calculations using Swedish data (allowing for the fact that an exogenous change in the discount rate might, in turn, affect the payout ratio) show a highly significant rela- tionship between these two variables. This implies that the discount rate rises at an increasing rae when the payout ratio is decreased.4 These hypotheses can be formulated as follows: k = k(h, ),(11) where Ok/ah >0, O2k/Oh2 >0, O.ck/u < 0 and a2k/aU2 > 0. Given that every stockholder's valuation of the firm equals the price of its shares and the fact that the negative impact of uncertainty on the price is taken into account through a higher rate of discount, we can conclude our enumeration of the assumptions by stating that the stockholders' objective is maximization of the share price. 1 See e.g. Gordon (1962) and Walter (1963). 2 See Brems (1976). 3 The most prominent pure-earning theorists are Modigliani and Miller (1958). 4 Eriksson (1978), Chapter 4. Note that our dividend hypothesis is not at variance with the observations that profitable and fast-growing firms which are regarded as safe invest- ments usually retain a relatively large part of their profits, and that the raising or lowering of dividends is often seen as a signal of changes in future prospects. Instead, these implications may be derived from the model. Assume, for instance, an exogenously caused permanent increase in the rate of return on total capital. It can then be shown that according to the model, this increases the retention rate and rate of growth of the firm. If the elasticity of the payout ratio with respect to the rate of return is numerically smaller than one, the volume of dividends paid out is also increased. Scand. J. of Economics 1980 This content downloaded from �������������82.102.22.77 on Tue, 24 Aug 2021 18:05:32 UTC�������������� All use subject to https://about.jstor.org/terms 368 G. Eriksson III. The Firm's Optimal Decisions We now turn to the optium financial position of the firm. According to (6), by maximizing the price of the firm's shares (PO) with respect to the decision variables, the leverage ratio (h) and the payout ratio (u), we obtain the neces- sary first-order conditions:' _ _ _ _ _ _ _ _ t i rE a i Ah~O ,D~kP-vr-i-h ----k ih]=0 (12) Sh rE(lcI- v) [ h k Ochj apo PO au ( 8-,8r8) u(l'-_V) X [(1 -83) (E- u ak- I--(8V + 8j8.e(1-8V)} rS = ? (13) The assumption of steady-state and balanced growth implies that these optimality conditions, which hold for the initial period of time, also hold for all future periods. Condition (12) can be fulfilled only if the bracketed expres- sion equals zero.2 In other words, the firm will borrow capital to such an extent that the rate of return on total capital equals the marginal cost of debt. This marginal cost reflects the effects of an increased leverage ratio on the interest rate and the stockholders' required rate of return. Other important findings are apparent from (12). First, since the discount rate is rising, with the leverage ratio (Okiih >0), debt financing should not be pushed so far that r = i + hai/Sh, which is the condition for maximization of the rate of return on equity. Second, if not only the discount rate but also the interest rate were independent of the leverage ratio (akih = ailah = 0), we would have a situation that prevails in the certainty models, implying either zero leverage or a maximal leverage determined only by outside restraints. Third, the tax parameters do not affect the criteria for optimal debt financing. This might seem curious at first. However, since equity capital is a predetermined variable, the highest share value must be obtained with respect to the leverage ratio when the percentage increase in the rate of return on equity, followed by an extra unit of debt, equals the percentage increase in the discount rate. Clearly, this happens at the same leverage ratio regardless of whether the discount rate and rate of return are defined before or after taxes. Condition (13) can also only be fulfilled if the bracketed expression equals zero.3 This implies that the stockholders' required marginal rate of return net of personal income tax equals the rate of return after taxes on ploughed-back profits. The term sv+s1sR(I -sv) may be seen as the total tax burden on re- 1 Note that k' =(1-sI) kI(1-sI8S). 2 Because k'POIrE(k'-v) cannot be zero. 3 Because Po/u(k' - v) (1- 818R) cannot be zero. Scand. J. of Economics 1980 This content downloaded from �������������82.102.22.77 on Tue, 24 Aug 2021 18:05:32 UTC�������������� All use subject to https://about.jstor.org/terms Effect of taxation on the firm's behavior 369 tained profits.' Due to the falling discount rate with respect to the payout ratio (ak/au<o), financing by retained profits should not be increase to the point where the discount rate equals the rate of return on equity. If the discount rate were not affected by the payout ratio (ak/au=0), which would be the case if there were no uncertainty regarding the future flow of dividends from the firm, a corner solution arises where the entire profit is either retained or paid out, depending on whether the rate of return on equity is higher or lower than the discount rate net of taxes. The fact that the rate of discount is a falling function of the payout ratio also explains why firms pay dividends even when the personal tax rate is higher than the tax rate on ploughed-back profits.2 Let us now compare our results with those of Stiglitz and King, who also assume perfect competition in the output and input markets and that the firm maximizes the wealth of its stockholders. Given true economic depreciation, they found that the firm's real capital should be adjusted in each short time period so that the marginal value product of capital equals the gross rate of interest, that is: paQ/aK =pK(a + i), (14) where p and P, are the product price and price of capital goods, respectively, aQ/lK is the marginal product of capital, a is the depreciation rate and i is a constant market rate of interest. This is consistent with our model in the following respects. First, if we assume, as Stiglitz and King do, that the interest rate and the discount rate are equal to a constant market rate (i), we obtain an optimality condition with the same meaning as (14) with respect to borrowing.3 Second, the fact that there are no tax parameters in (14) also conforms to our borrowing optimality condition. However, because of the separation between investment and dividend decisions4 in the models of Stiglitz and King, taxation does not interfere with the firm's investment policy, as it does in our model. It should be pointed out that this conclusion is modified when legal con- straints prevent the firm from using only the cheapest source of finance. Such constraints, along with taxes that discriminate between different ways of obtaining funds, imply that the firm, in fact, faces a stepwise rising capital cost l S6dersten (1977), p. 5. 2 Assume that the rate of return on equity equals the discount rate at zero retention be- fore taxes. It is then obvious according to (13) that only when sk/au < 0, relatively heavier taxation on personal income need not induce the firm to give up dividend payments entirely. 3 Defining the return on equity as VE -=PQ -PLL -(a + i) (1 + h) E, where h is the leverage ratio and E is equity, it is clear from maximization of PO with respect to h, that condition (14) is obtained. Note the identity pKK = (1 + h) E and that E is assumed fixed. 4 These decisions are separated due to their conception that there is no difference between debt and equity and that the firm can always obtain the desired amount of funds at constant cost. Sand. J. of Economic8 1980 This content downloaded from �������������82.102.22.77 on Tue, 24 Aug 2021 18:05:32 UTC�������������� All use subject to https://about.jstor.org/terms 370 C. Eriksson curve. The transition from one step to the next (higher) step indicates the rise in the cost level, as the firm is forced to switch to a more expensive financing method. Here, taxation may influence the firm's behavior. But this only happens when the curve for the return on marginal investment intersects the capital cost curve in the horizontal segment. Returning to our model, we may note that it can rather easily be extended to deal with external equity finance. If funds are aquired through issues of new shares in a volume which is proportionate to profits in each period and if no transaction costs are involved, the present value of all future net dividends (the payouts minus the inflow of funds from new issues) at point in time t =0 will be [(1 - s1) U - c] (1- SV) rEEO Pno (I - sl) k-[(1 - ) (I -ss.) +c] (I - s)rE ( where c is the new issue rate. The best financial policy for the owners of the firm would then be found by setting values of u and c which maximize Pno. If the discount rate k were a function only of the net payout ratio (u - c), the fact that dividends are more heavily taxed than capital gains, s8 < 1, would imply that the firm's net worth can always be increased by reducing both u and c, leaving the net paid-out dividends unchanged. On the other hand, in the case of no tax subsidy on capital gains, 8R =1, net worth will be inde- pendent of such changes between internal and external equity financing and no interior optimal solution exists. However, a much more reasonable assump- tion seems to be that old and new stockholders have different risk and liquidity preferences, which means that k is affected differently by equal changes in u and c. This might explain why firms use both retained profits and new issues sources of finance. IV. The Effects of Taxation We now examine how the firm reacts to changes in tax parameters. When a tax parameter is changed the new value is expected to last forever and the optimal ratios of the firm's endogenous variables, determined on the basis of this value, also persist indefinitely. Since there are no growth costs in our model, the firm immediately switches from one set of optimal ratios and an optimal rate of steady-state growth to another. By means of total differentiation of the optimality conditions (12) and (13) -see Appendix-we get the following effects on the firm's optimal …