The economic effects of EU-reforms in corporate income tax systems

Appendix A Modelling firm behaviour in CORTAX
This appendix discusses in more detail how firm behaviour is modelled. CORTAX starts from a
standard dynamic optimization problem of the firm, which maximizes its value subject to
accumulation constraints and a production function. In optimizing its value, firms choose their
optimal levels of employment and investment, as well as the optimal financial structure between
debt and equity. We also discuss the two extensions of the basic framework: the introduction of
a tax haven and the modelling of location choices.
Model of the firm
Denote the value of the firm in year t by V t and its dividend payments by Div t . We ignore new
equity issues and abstract from residence taxes on capital levied at the household level. An
investor is indifferent between investing in the firm and investing elsewhere at a rate of return r
as long as:
rVt
= +1 (A.1)
Divt
+ Vt
−Vt
The right-hand side of (A.1) reflects the sum of dividends and capital gains on the investment in
the firm. The left-hand side shows the return on the asset V t if it were invested elsewhere. The
rate r denotes the discount rate used by the firm. Solving (A.1) for V t yields an expression for
the value of the firm as the discounted stream of future dividends:
∞
s−t+
1
⎡ 1 ⎤
V t = ∑ Divs
⎢
1
⎥ (A.2)
⎣ + r ⎦
s=
t
Dividends follow from the cash-flow restriction of the firm:
Div
t
= Yt
− wLt
− rb
+ cb
] dbt
K t − Π t − I t + dbt+ 1Kt+
1
[ τ − d K
(A.3)
bt
t
where Y t denotes output (price is normalised to 1) and wL t stands for labour costs. The third
term on the right-hand side of (A.3) captures the cost of debt. It equals the debt ratio (d b ) times
the capital stock (K t ) times the real interest on firm debt r b . In addition to this, the variable c b
denotes a financial distress or agency cost associated with high debt finance. It depends on the
leverage of the firm, i.e. c b = c b (d bt ). The fourth and fifth terms on the right-hand side of (A.3)
reflect corporate tax payments (τΠ t ) and investment (I t ). Finally, cash-flow is affected by a
change in debt of the firm, captured by the last two terms on the right-hand side of (A.3).
The corporate tax base, Π t , is defined as:
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