The effect of implementing an imputation tax system on corporate financial management - a cross-validation study based on Canada, Australia, and Taiwan

Taxes have an impact on both capital investment and capital-structure decisions (that is, balancing debt and equity) of firms. It has been theorised (Modigliani & Miller 1963) that when there is tax relief on debt, the cost of debt falls, which makes investment more attractive; and when corporate income is taxed less, there is more available in retained earnings which can be invested. Tax will, therefore, have an impact on the capital structure of the firm as well as on its capital expenditure. Some countries follow a classical tax system, while others follow an imputation system. The nature of the prevailing tax system in the economic jurisdiction under which a firm operates can be, intuitively, expected to have an impact on the firm's capital investment and its capital-structure decisions.<br><br>The impacts of taxes on firms' capital structure have been the focus of much theoretical and empirical research in financial economics and public finance. Even so, the empirical evidence on the effects of taxes on capital structure and capital-investment decisions - particularly following a switch from a classical to an imputation tax system - remains inconclusive. In the same vein, existing studies related to taxes and capital structure and capital investment within an imputation tax system contradict one another. The core issues are whether there are in fact any impacts at all from tax systems on capital-structure decisions, and whether a switch to an imputation tax system could induce a shift in capital structure towards equity. What is unclear is whether taxes and a tax-system shift to an imputation system have any discernible impact on a firm's capital investment decisions. <br><br>This study is designed to address these issues by examining: <br><br>(1) The impacts of taxes on capital structure and (or) capital investment in Canada (1982-2015), which is a context with a well-established imputation tax system; and<br><br>(2) The impacts of the shift from a classical tax system to an imputation tax system on capital structure and (or) capital investment in Australia (1982-1998) and Taiwan (1989-2009). <br><br>This is done in order to assess the impact of the switch on capital-structure and capital-investment decisions, particularly as extant financial theory suggests a relationship between an optimal capital structure and capital investment. The employed methodology is that of panel regression using a fixed-effects model to test the effects of taxes, as well as the effects of tax-system changes on a firm's capital structure and their capital-investment decisions.<br><br>The findings reveal that taxes and tax-system changes play a role in firms' capital-structure decisions. Specifically, taxes have significant effects on the reduction of debt levels of firms in countries with a well-established imputation-tax system and in those with a tax-system switch from a classical to an imputation system.  For capital investment decisions, it is found that while capital investment shows a significant increase in the Australian and Taiwanese cases following the introduction of an imputation-tax system, a significant decrease in capital investment is noticed for the post-2009 period in Canada, a country with a well-established imputation-tax system.<br><br>This present study is an extension of existing studies that focused only on Australian firms. Here, three countries under imputation-tax systems are examined. This provides a diversity of countries, which enables the researcher to examine not only the effects of taxes on capital structure and (or) capital investment, but also on how the introduction of an imputation-tax system affects a firm's capital structure and its capital-investment decisions. This makes the present work stand out from previous literature in terms of its contribution to the theory of capital structure and its impact on investment. Given the current global economic climate characterised by deflation and economic contraction, this study will be of importance to policymakers who are in need of policy tools other than monetary policy to stimulate economic growth.