How will a new tax regime affect the stock market?

THE finance minister will present a new budget in a few weeks. A major public policy concern is to define a tax policy regime which will promote private sector investment and revitalise a moribund (de facto) stock market. We propose that tax rates decrease across the board.
Firstly, a reduction in corporate tax rates will help corporate businesses generate more operating cash flows and so conserve more cash for their businesses, which essentially implies that the after-tax cash flows to investors will rise in the long-run. It happens via two channels. One is that an enhanced operating cash flow will enable corporate management to pursue positive NPV projects and thus enhance future profitability. It would imply capital gains to shareholders. The other is that companies will have more free cash flows which will lead to an increasing dividend payout to the shareholders. Personal taxation regime here becomes relevant. Modern taxation is that cash dividends are subject to personal tax rate whereas capital gains from reinvestment of profits would be subject to a lower capital gain tax rate. Following Modigliani-Miller Theory of Investment, value relevance of tax policies is apparent and outlined below.
Assume a hypothetical environment where corporate tax rate is 50%, personal tax rate is 25%, and an all equity firms with earnings before interest and taxes (EBIT) of $1.0. If the required rate of return by the shareholders is 10% and the firm adopts a 100% payout of profit after taxes, the value of the firm would be $3.75.  Now if the firm uses debt in its capital structure with no change in its business operations and so no change in the expected EBIT, the value of the firm would rise by $0.375 for each dollar of debt in the capital structure. It is assumed that both stockholders and bondholders require the same rate of return.  
Now assume that tax planner reduces corporate tax rate from 50% to 30% with everything else remaining unchanged. With a 100% payout policy, an all equity firm would now be valued at $5.25 instead of $3.75, which is equivalent to a 40% rise. In the case the firm is levered, i.e., uses debt in its capital structure, each dollar of debt would mean an additional $0.225 for the value of the firm.
A question arises that a firm hardly follows a 100% payout policy in the long-run and so the above illustration is an extreme point. Let us consider a more plausible case that the firm follows a 50% payout of its earnings after taxes and retains and reinvests the rest in the business. Given that personal income tax rate is 25% and capital gain tax rate is 10% and that corporate tax rate is 30%, an all equity firm would now be valued at $5.78. A reinvestment of profits even in zero-NPV projects further enhances the value of the firm and it arises from tax savings due to a lower capital gain tax rate. So a payout of 50% instead of 100% increases value of the firm by a further 10%. Should the firm use debt in its capital structure, additional tax advantage of debt will be $0.17 for each dollar of debt. A new tax policy with a reduced corporate tax rate will thus enhance value of the firm and the potential impact is unambiguous.  
The second implication lies with respect to financing decisions by firms. The present corporate tax system, which provides for deduction of interest, encourages excess leverages. Corporate management motivated by tax advantage of leverage tends to over-borrow and risks falling profitability and increased bankruptcy costs. This is particularly the case when business environment experiences rising interest rate amid contractionary monetary policies. In fact, when Bangladesh Bank pursued a relatively contractionary monetary policy at the end of 2010, it was the cohort of highly levered firms, including banks and NBFIs notably, that experienced drastic fall in profitability and so the decline in their stock prices. A long phase of depressed pricing in our stock market is an outcome of corporate management's choice of excessive debt financing. Had there been a lower corporate tax rate, no opportunity of low-cost borrowing and an effective regulatory environment during the pre-crisis time, the unfortunate bubble and its subsequent burst in the stock market would have been averted.
Third, the proposed tax regime would likely face criticism that it would lower government tax revenue. The argument is untenable on the ground that an increased dividend income to the shareholders and a positive wealth effect of potential capital gains would have positive impact on aggregated demand. To the extent corporate income tax collection declines, an offsetting improvement will occur in the form of other taxes due to rising aggregate demand. In the long-run, government tax revenue is unlikely to be adversely affected.
Fourth, the existing tax system underlies a classic corporate governance problem. It is that controlling shareholders and management depend more on borrowings and less on equity financing. An outcome is that shareholding concentration deepens and external shareholders become more marginalised. A lower corporate tax rate would encourage equity financing instead of debt financing and it would dilute stockholding from the controlling shareholders to the external shareholders. Corporate board will be more accountable and probability of insider trading will decrease. Capital allocation and investment decisions will become more efficient. Frequency of transactions between firm and insiders to expropriate depositors and external shareholders will likely decrease. Finally, a significant reduction in corporate tax rate would reduce hurdle interest rate for investment and lead to increased capital expenditure. The policy change will likely stimulate private sector investment. Given that investment demand in the country remained stagnant for the last few years and that the financial sector has excess liquidity, a pragmatic tax policy does have a real potential to revitalise corporate business and so the moribund stock market in Bangladesh. This proposal does not, however, negate the long demand of improving tax administration of the country and reforming the public spending system. It is another issue and not to be addressed in this note.

The writer is Associate Professor of Accounting, University of Dhaka.