Profit Taxes and Financing Constraints

Without financing frictions, profit taxes reduce investment by their effect on the user cost of capital. With financing constraints, investment becomes sensitive to cash-flow. In this situation, even small taxes impose first order welfare losses, andACE and cash-flow tax systems are no longer neutral. When banks become active and provide monitoring services in addition to finance, an ACE tax yields larger investment and welfare than an equal yield cash-flow tax.