ID:JJF00289

Title:

Effects of tax rate cuts on equity valuation:
Impact of firms' profitability and variability

Author:Keiichi Kubota
Hitoshi Takehara

Pages:

23-39

Is Part Of:

Japan Journal of FinanceVol. 32 / No. 1.2
Feb. 2012

Publisher

Japan Finance Association

ISSN:

2186-3792

経営財務研究第 32 巻第 1・2 合併号■論文

Effects of Tax Rate Cuts on Equity Valuation:
Impact of Firms’
Profitability and Variability ＊Keiichi Kubota（Chuo University）

Hitoshi Takehara（Waseda University）
Abstract

This paper investigates changes in firm value triggered by hypothetical corporate tax ratechanges with a simulation method and assesses the effects of a government tax rate cut on ﬁrms’
after tax income and valuation. The study is based on simulations of all firms listed in Japan
excluding ﬁnancial ﬁrms. We utilize fundamental valuation equation from the residual income
model by Ohlson (1995). To explore the effects on valuation by corporate tax rate changes we pay
particular attention to tax loss carry-forward allowances as well as net changes in deferred tax
assets and liabilities, which appear on equity or contra accounts of deferred tax assets in ﬁnancial
statements. Our data covers the period between 2000 and 2008 of ﬁrms’consolidated ﬁnancial
statements. The sample paths of taxable income are generated using Graham’s (1996) method
based on the estimated stochastic process of net income before tax. By discounting the future
residual income stream with the equity cost of capital computed with the Fama and French threefactor model, we obtain the hypothetical equity value of the ﬁrm after all corporate tax effects
were fully taken care of. Then, we measure the effects of corporate tax rate changes on ﬁrm values
under alternative hypothetical statutory tax rates. We ﬁnd that changes in corporate tax rates
can enhance the value of ﬁrms most of the time, while there are cases in which effects are neutral
or even detrimental for firm values. We demonstrate that these different results are triggeredby mixed effects of current provision that allows firms to carry their tax loss forward and thenet balance of tax deferred accounts of each ﬁrm. We claim that past and future proﬁtability andvariability of ﬁrms are crucial to reach exact threshold points at which ﬁrms experience value
appreciation or not. The implications are important for both corporate ﬁnancial managers andregulators.
Keyword：Corporate taxation, tax loss carry-forward, deferred tax assets and liabilities, residual income,fundamental value

１ Introduction
Analyses of changes in firm values triggered by tax rate changes can provide important
implications for corporate financial managers as well as regulators. In this paper we employ a
23

経営財務研究第 32 巻第 1・2 合併号

micro foundation approach using individual ﬁrm level data and a residual income valuation model
to assess effects of tax rate cuts utilizing a simulation method. In this microsimulation approach,actual past data at the micro level for each firm are used to obtain necessary parameter values(Shahnazarian, 2011) and simulations are conducted at each ﬁrm level. The effects we found are
surprisingly not uniform across ﬁrms, which have important implications to ﬁrm mangers as wellas to investors. The result also demonstrates the difﬁculty and risk of correctly assessing tax policy
effects on valuation and on financial decision making of firms, and provides us with important
policy guidance on when to execute an effective tax cut to enhance higher fundamental value ofﬁrms and growth of the domestic economy.
In this paper we focus primarily on corporate tax rate cuts. This is because it is widely known
that the corporate tax rate in Japan is substantially higher than in other developed countries. Asof 2011, for large corporations in Japan, the national tax rate is 30%, the prefecture tax rate is 5%,
and the city tax rate is 12.3%. This adds up to an effective tax rate of 40.87%, which is applicable toour sample of listed ﬁrms. The long run trend of effective corporate tax rates is depicted in Figure 1,
and one ﬁnds that the trend in Japan is decreasing overall1.
The theoretical analysis of how the corporate tax rate affects the equilibrium value of ﬁrms, andhence, Tobin’s q, was conducted in RBC (Real Business Cycle) general equilibrium framework by
Kubota, Saito, and Takehara (2012)2. In that paper the effects of the tax subsidy from the use ofinterest expenses are incorporated in their equilibrium model and empirical assessments with the
newly constructed un-levered q measure are conducted for Japanese data. Tajika and Yui (2000)
analyzed the effects of corporate taxation focusing on depreciation and ﬁrm investment behavior,and conduct a numerical assessment of Japanese ﬁrms in a neoclassical framework.

*

The authors acknowledge valuable comments and suggestions by Editor-in-Chief, Professor Linyu
Zhai and two anonymous referees of the journal. This paper was presented at 49th Southwestern
Finance Association Annual Conference, 30th Northeast Business and Economics Association
Meeting, 69th Japan Accounting Association Annual Conference, 66th Congress of International
Institute of Public Finance Annual Congress, 2010 Asian Finance Association Meeting, and 18th
Annual Meeting of Nippon Finance Association. The authors thank Kazumi Asako, Naoyuki
Kaneda, Takashi Obinata, and Hong Feng Zhang for their helpful suggestions. The authors also
thank Eiko Tsujiyama for useful discussion related to accounting standards issues. Both Keiichi
Kubota and Hitoshi Takehara acknowledge financial support from Grant-in-Aid for Scientific
Research ((A) 21243029) from the Japan Society for the Promotion of Science. Hitoshi Takehara
acknowledges financial support from the Health Labour Sciences Research Grant (Research on
Policy Planning and Evaluation). All remaining errors are our own.

1

The withheld dividend tax rate and the capital gains rate were set to be 10% as a temporary relief
measure until 2011 and the dividend tax rate was raised to 20%, while the withheld interest
income tax rate is 20%. The analysis of the effects of tax rate cut or increase of individual ﬁnancial
income is our future work.

2

24

See Cooley (1995).

経営財務研究第 32 巻第 1・2 合併号

Figure 1. Trend of Eﬀective Statutory Corporate Tax Rates in JapanThe effective statutory tax rates for large corporations in Japan, including the national tax, themunicipal tax, and the enterprise tax. The source is the National Tax Bureau and the uniform
rate is assumed for the municipal tax rate.

In this paper, we focus on micro data of ﬁrms and investigate the effects of tax rate cuts on thevalue of firms by utilizing the accounting residual income valuation model devised by Ohlson(1995), and identify conditions under which effects of tax rate changes are neutral, favorable, orrather detrimental. In order to conduct these analyses we use the simulation method proposed byGraham (1996) and compute the residual income to compute ﬁrm values3. In doing so, we take into
consideration both the tax loss carry-forward allowances and changes in net deferred tax assets andliabilities and compute after-tax based residual income.
Section 2 discusses the motivation of our study, previous studies, and our research objective.
Section 3 formulates the valuation model. Section 4 explains our data and reports the basic
observations. Section 5 explains the simulation method we employ. Section 6 reports the simulation
results and Section 7 concludes.

3

Kubota and Takehara (2007) use a similar method to compute the cost of capital for Japanese ﬁrms.

25

経営財務研究第 32 巻第 1・2 合併号

２

Taxation and Firm Value⑴

Motivation of the Study

Corporate tax-shield beneﬁts or tax burdens arise from two sources: from debt or from non-debt.
In this paper we focus on the latter. When Japanese ﬁrms incur losses, they can extend their taxloss shield against future income, like in many other countries4. Hence, allowances from non-debt
sources help ﬁrms decrease their future tax burden and possibly reduce the cost of capital.
Moreover, the firm may choose to pay a higher or lower tax today, hoping that in the future
the firm can re-collect earlier payments by charging against future income to reduce future tax
burden. These timing differences between the tax payables reported in income statements and theactual tax payable to the tax authority are charged either to deferred tax assets or to deferred tax
liabilities on balance sheets. These tax timing differences can also occur both inside the parent
company and between the parent firms and their subsidiaries. These balances are recorded bycharging the differences which are either accrued or deferred during the accounting period whoseamount is multiplied by current statutory tax rates.
Note the Japanese financial and tax reporting systems follow the so called uniform reporting
system like continental European countries5. However, from fiscal year 1999, the tax deferral
accounts in balance sheets can be recorded in consolidated ﬁnancial statements on the condition
that such an accrued amount had a high probability to be reversed in the future. In spite of thisnew tax timing difference allowance, the Japanese system can still be classified as a uniform
reporting system in the sense that depreciation methods, inventory costing, and other major
accounting choices have to follow uniform reporting both for tax and ﬁnancial accounting purposes.

⑵

Previous Studies

The effects of corporate taxation on corporate income and fundamental value of the nonﬁnancial
corporate sector were analyzed by Downs and Tehranian (1988) among others. They focus on the
Economic Recovery Act of 1981 and ﬁnd that this act favored new capital, and the fundamental
value of corporations suffered with an average 6.1 percent windfall loss. Collins and Kemsley(2000) extended Ohlson’s residual income model on an after tax basis, accounting for dividend
taxes and capital gains, and found that dividend taxes were largely capitalized into share prices,

4

In Japan, the Corporation Tax Act (Article 57 Paragraph 3) allows for ﬁrms with reported losses todeduct these against future proﬁts up to a maximum of nine years. Also, the provision for tax loss
carry-back allowances is provided, although it has not been implemented since 1992 except for thecase of ﬁrm liquidations. Note also that in the U.S. the tax loss allowances can be charged to both
future and past income.

5

26

See Cummins et al. (1994) for these classiﬁcations.

経営財務研究第 32 巻第 1・2 合併号

and investors incurred additional taxes on capital gains in addition to dividend taxes. By focusing
on accounting and capital structure decisions, Calegari (2000) investigated the effect of changes
in tax accounting provisions on ﬁrm debt policy and on the magnitude of accounting accruals, andfound that there were signiﬁcant effects on both. From the viewpoint of investors, the effects of tax
changes on investors’portfolio decisions were investigated by Poterba (2001).
As to analyses on Japanese ﬁrms and the economy, Kubota, Saito, and Takehara (2012) ﬁnd apartial equilibrium solution with corporate taxation and derive Tobin’s q on an after tax basis.
However, even though their model was multi-period, it is within a neo-classical framework, andﬁrms and capital are resolved every period. In another macroeconomic approach, Tajika and Yui(2000) analyzed the effects of corporate taxation by focusing on the optimal allocations of capitalwith tax neutrality in their inﬁnite horizon model. However, their model is a certainty model.
Our paper utilizes the ﬁrm valuation model, which can accommodate future uncertainty of after
tax income with parameter estimates from all individual ﬁrm data. The simultaneous use of both
the residual valuation model and the simulation method by Graham (1996) to analyze the effects ofcorporate taxation on ﬁrm values has never been conducted for Japanese data as far as the authors
are aware of, and this is a contribution to the literature.

⑶

Research Objectives

In this paper we try to assess the importance of the aforementioned tax provisions when thecorporate tax rate is changed, which could affect ﬁrm values. The effect of tax rate changes on ﬁrm
valuation becomes a very complex computational procedure and is rather entangled for the multiperiod case as multiple integrals. Note the tax loss carry-forward allowances are valid only up to a
maximum of ﬁve or seven years by the Corporation Tax Act in Japan during our sampling period
and the book entry of deferred tax assets is also expected to be reversed in the future in order tobe certiﬁed by CPAs. Every year the new entry of tax allowances when the ﬁrm incurs losses anddeferred tax assets or liabilities are recorded and it will generate accumulated processes with ﬁnite
lives.
With that reason we choose to use the simulation method, and in particular we focus on the tax
rate cut case. As we proceed with the analysis, we demonstrate that these effects can be neutral,favorable, or unfavorable. We ﬁnd that different results depend both on past proﬁtability of ﬁrms
and its variability, whose interactions we compute by using the simulation method of Graham (1996).
The fundamental value of firms is derived utilizing the Edwards-Bell-Ohlson residual income
valuation model (Ohlson, 1995).
Finally, we emphasize our analysis is important from the viewpoint of both corporate ﬁnancial
managers and regulators. Real investment decisions chosen by corporate managers may change
through a rational response to corporate tax rate changes (MacKie-Mason, 1990). Then regulators
would want to assess the directions of new investment behavior by ﬁrms triggered by the statutory
tax rate cut for the purpose of implementing better economic policies. Such changes in firm
behavior will change the allocation of scarce resources in both industry and in the economy. With27

経営財務研究第 32 巻第 1・2 合併号

these considerations, we try to empirically identify ﬁrms which undergo favorable changes, neutral
effects, or unfavorable changes triggered by the enactment of corporate tax rate cuts.

３Firm Stock Valuation Equation

We compute fundamental value of ﬁrms using the Edwards-Bell-Ohlson formula (Ohlson, 1995).
That is, we plug in the inputs from simulated future income series readjusted for an after tax
basis into this formula. The fundamental value is deﬁned in equation (1). In equation (1), BVt isathe owner’s equity value measured at its historical cost at the end of the previous period t-1, x t isthe“residual income”as deﬁned by Ohlson (1995), and rf is the risk free rate. The left hand side
variable, V *t , thus denotes the computed fundamental value.
Vt*

BVt

Et ( xta j )j 1(1 r f ) j⑴

Ohlson (1995) originally formulates equation (1) assuming risk-neutral valuation for simplicity.
However, by allowing for risk premium, Lehman (1993) demonstrates that the formula can beextended into the risk discounting model as follows.

Vt *

BVt

Et ( NI t j
j 1

rE BVt j 1 Ft 1 )(1 rE ) j⑵

In this equation, NIt+j is the future net income stream, rE is the discount rate which is also the costof equity, and Ft-1 is the publicly available information set at the end of time t-1. Note the cost ofequity, rE, appears both in the numerator to compute the residual income and in the denominator to
discount the residual income.
In an original formulation of the Ohlson model which satisﬁes a clean surplus relationship, it is
implicitly assumed that the future net income stream NIt+j is on an after tax basis. Because we focus
on the effects of taxation in this paper, we deﬁne NIt+j on a before tax basis. We use the following
equation (3) in which τ is the effective corporate tax rate. When uniform reporting is imposed forﬁnancial and tax purposes, it coincides with the statutory tax rate τ as long as the ﬁrm does notincur losses in the past seven years. As is discussed in Graham (1996), computations of taxable
income and thus the computation of effective corporate tax rates are much more complex. We track
this by the use of numerical simulations with the parameter values estimated from the actual dataof Japanese ﬁrms in Section 6.6 The valuation equation we use is based on effective tax rates, τ,

6Collins and Kimsley (2000) formulate the Ohlson valuation equation by incorporating dividend
taxes and capital gains taxes. The use of this form of equation and the accompanied simulation
studies are subject to our future research.

28

経営財務研究第 32 巻第 1・2 合併号

taking into consideration both the tax loss carry-forward and deferred tax assets and liabilities. It
can be written as follows.

Vt *

BVt

Et ((1) NI t jrE BVt j 1 Ft 1 )⑶(1 rE ) jj 1

In the following, we assume that the cost of equity, rE, is the rate of return before personaltax, which can vary over time, and we estimate the cost of equity based on publicly available
information with the Fama and French model.7 In order to estimate rE we use the unconditionalversion of the three-factor model (Fama and French, 1993) as in (4), and we roll forward every yearwith 60 months of the rate of return data. Fama and French’s model comprises three factors: excess
market returns, the size factor spread portfolio (often referred to as the SMB factor), and the bookto-price ratio factor spread portfolio (also known as the HML factor). The empirical version of theFama and French (1993) three-factor model can be written as follows, where rj,t is the return of the
security j in month t, rM,t is the return of the market portfolio, rf,t is the risk-free rate, and SMBt and
HMLt are the Fama-French (1993) Small-Minus-Big and High-Minus-Low factors, and εj,t is theresiduals, respectively.
r j ,trf ,tMi( rM ,t

rf ,t )

SMB
i

SMBt

HML
i

HMLt

j ,t

⑷

Every year we compute the fundamental value of firms at the end of June after all financial
statements from the fiscal year end in March become publicly available and are approved atshareholder meetings. We use only the sample of firms whose fiscal year ends in March, whichamounts to more than 90 percent of all the listed ﬁrms on the Tokyo Stock Exchange.
Note valuation equation (2) includes the summation of the inﬁnite time horizon. However, in theMonte Carlo simulation framework, we compute the intrinsic value of the ﬁrm by assuming that
residual income becomes zero after the year t=21.8 Consequently, after generating the sample pathsof residual income from taxable income, we sum up the present value of the residual income for theyears t=1, 2, …, 20.

7

We discount after tax residual income with the rate of return on stock before the corporate tax
basis. See Brennan (1970) for CAPM speciﬁcations where personal tax parameters are included. In
this paper we do not consider Miller (1977) equilibrium. Also, when the estimated equity premium
becomes negative for a particular sample, we replace the cost of equity estimate with the yield of
long-term JGB bonds.

8

In view of the product life cycle of ﬁrms in general, this assumption does not seem to be restrictive.
We also thank Kiridaran Kanagartenam for discussing this point.

29

経営財務研究第 32 巻第 1・2 合併号

４

Data and Basic Observations

Our ﬁnancial data is based on consolidated ﬁnancial statements of all Japanese ﬁrms startingfrom calendar year 2000 (fiscal year 1999) through 2009 (2008), excluding financial firms. We
exclude sample firms with negative book values in equity and also firms with less than 5%
and higher than 95 % of estimated drift parameters and variance parameters estimated by thefollowing equation (5). Thus, the numbers of ﬁrm observations are a maximum of 1,101 ﬁrms forcalendar year 2006, and a minimum of 805 firms for calendar year 2000.9 The data source forfinancial variables is the Nikkei NEEDS Database, and for stock returns, the Nikkei Portfolio
Master Database.
Table 1 shows the frequency distributions of the ratio of each year’s tax loss carry-forwardbalance (shown as LCF in the table) to the book value of equity for Japanese ﬁrms for our entire
sampling period, 2000 through 2009. These allowances can be charged against future income as up
to either ﬁve or seven years after the ﬁscal year they are reported.10 Numbers reported in the table
are in percent, which we label LCF, and we ﬁnd in the ﬁrst row from the top that more than 30.58%
of the ﬁrms did not incur past losses in taxable income between 2000 and 2009. The peak boom
year is 2000 when 44.72% of ﬁrms incurred cumulative positive income from the past ﬁve years
Table 1. Year by Year Frequency Distribution of Tax Loss Carry-Forward to Book value of Equity

LCF is defined as (Tax Loss Carry Forward subject to tax effect accounting) /(Book Value of Equity) in percent.
2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

34.75

32.06

33.44

34.77

36.60

36.07

35.53

30.58

LCF=0

44.72

42.00

0<LCF≦2

23.85

27.26

28.78

27.37

31.67

35.33

37.42

37.31

35.73

27.79

2<LCF≦4

9.81

11.14

10.55

11.45

12.05

10.03

9.72

10.11

11.88

17.56

4<LCF≦6

5.96

5.68

7.45

8.29

6.33

5.81

5.09

4.77

5.29

7.33

6<LCF≦8

4.60

3.25

5.05

5.02

4.15

3.84

2.72

3.53

3.09

4.03

8<LCF≦10

2.86

1.97

3.44

3.71

2.49

1.97

1.73

1.43

1.70

2.79

10<LCF≦12

1.99

1.74

2.52

2.62

2.49

1.97

1.45

0.95

1.30

2.69

12<LCF≦14

0.50

1.39

1.26

1.85

1.87

1.50

0.54

1.05

1.30

1.34

14<LCF≦18

1.61

1.39

1.61

2.29

0.52

1.12

0.73

0.67

0.50

0.93

16<LCF≦18

0.75

0.93

0.92

0.76

1.14

0.56

0.91

0.67

0.50

0.83

18<LCF≦20

0.75

0.46

0.80

0.98

0.83

0.56

0.54

0.19

0.40

0.52

3.01

2.53

2.54

3.24

2.79

3.62

20<LCF

9

2.61

2.78

2.87

3.60

The Japanese ﬁnancial reporting system changed from individual ﬁlings to consolidated ﬁlings inﬁscal year 1999. This is why we start the sample observations in 2000.

10

Up to ﬁscal year 2004, the maximum number that tax loss could be carried forward for ﬁve years,
and then it changed to seven years, and currently, it is nine years.

30

経営財務研究第 32 巻第 1・2 合併号

Figure 2. Expansion and Contraction Period and the Trend of
Corporate Earnings before tax in JapanThe solid line is the sum of earnings before corporate tax for the sample firms and the shaded
area is the contraction period as defined by the Cabinet Office of Japan.

before and the lowest year is 2009 when only 30.58% of ﬁrms had cumulative positive income fromthe past seven years.
When one adds the percentages within the LCF range between 0 and 2 percent, one ﬁnds that inboth 2000 and 2001 and in 2006 and 2007, these numbers are higher, which means the majority ofﬁrms had been generating proﬁts or losing very little. For example, in 2001, the number is 69.26%,
and in 2006 it is 74.02%. However, after the Lehman shock of September 2008, one ﬁnds that thisnumber drastically decreased in 2009. The comparable number is 58.09%, which was 71.26% in
previous 2008. Also, in the bottom row of the table for 2009 we ﬁnd that more than 3.62 percent ofﬁrms have a LCF percentage exceeding 20%, which is a large loss. We also ﬁnd that these numbers
are also large at 2.87% in 2002, and 3.60% in 2003. Note year 2002 corresponds to the year after
the information technology bubble crushed.
In Figure 2, for the purpose of referring to business cycles in Japan, we plot the expansion andcontraction periods as well as the time trend of the total value of net income before tax for all
sample ﬁrms.
The ﬁgures for one year after 2001 and 2008 are conspicuous in terms of the sudden drop in net
income numbers. Also, one can reconﬁrm that from 2002 through 2007, Japan experienced a slow
31

経営財務研究第 32 巻第 1・2 合併号

Table 2. Year by Year Frequency Distribution of Deferred Tax Assets to Book Value of Equity

DTA is defined as (Deferred Tax Assets −Deferred Tax Liabilities)/(Book Value of Equity) in percent.
2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

0.80

0.52

DTA≦−20

2.86

2.20

2.87

2.29

2.70

3.19

4.36

3.44

−20<DTA≦−15

0.62

0.81

1.38

0.76

1.35

1.12

2.18

2.86

0.60

0.72

−15<DTA≦−10

0.75

1.62

1.83

1.20

2.28

2.53

4.63

4.48

1.30

0.62

−10<DTA≦−5

1.74

2.78

2.87

1.74

3.84

4.69

8.90

9.16

4.29

2.69

−5<DTA<0

7.08

10.09

9.40

6.22

12.46

14.62

20.44

19.47

15.47

12.19

DTA=0

1.49

0.93

0.34

0.55

0.42

0.19

0.09

0.19

0.50

1.14

0<DTA≦5

46.58

35.73

30.85

28.79

35.31

34.58

32.24

33.87

40.82

39.05

5<DTA≦10

21.61

24.83

24.89

27.59

20.98

20.34

13.35

14.12

20.36

22.52

10<DTA≦15

8.94

9.63

11.12

13.74

8.72

8.15

7.08

6.58

7.88

10.64

15<DTA≦20

4.72

6.03

6.54

7.09

5.30

4.97

3.18

2.96

4.99

4.96

20<DTA

3.60

5.34

7.91

10.03

6.65

5.62

3.54

2.86

2.99

4.96

but sustainable expansion period.
Next, Table 2 shows the balance of net deferred tax assets, which are defined as deferred tax
assets minus deferred tax liabilities in this case, divided by the book value of equity for all years of
our sample period, from 2000 through 2009. We call this variable DTA.
The sixth row from the top shows the ratio, DTA, of the cases where there is no outstandingbalance. When the ﬁrms carry zero balance on their deferred tax account, this applies to a case inwhich the timing of the tax payment and ﬁnancial reporting coincide, if there were not any balancefrom the previous period. The percentage is a minimum with 0.091% in 2006 and a maximum of
1.491% in 2000. As one reads through these numbers for DTA from the top to the bottom row, one
ﬁnds that the majority of ﬁrms in Japan have balances on the debit side, whose balance appearson the Deferred Tax Assets account.11 Also, we ﬁnd the majority of ﬁrms belong to ranges of DTA
from zero to 10 in three consecutive rows. On the other hand, the largest number of negative DTA
cases, whose balance appears in the Deferred Tax Liabilities account, lies within the range of DTA
between -5 and 0 for all years. So, unlike ﬁnancial statements in the U.S., in which tax accounting
and ﬁnancial accounting are separated and the balance on the deferred tax liabilities side is morecommon by deferring the tax payment while expensing for ﬁnancial reporting purposes in earlier
years, financial statements in Japan seem to have more balance on the debit side. When the11

US ﬁrms have their balances more frequently in deferred tax liabilities accounts. For example,
when a ﬁrm chooses the Modiﬁed Accelerated Cost Recovery System of the Tax Reform Act of 1986
for depreciation, and this firm can still use the straight-line depreciation method for financial
reporting.

32

経営財務研究第 32 巻第 1・2 合併号

corporate tax rate is reduced according to Japanese Accounting Standards, this deferred tax asset
balance has to be downwardly readjusted for the balance amount of assets to account for the lower
tax rate. Also, in the case of ﬁrms with a debit (credit) balance, future income after tax payments
may increase (decrease), and thus the value of these ﬁrms may appreciate (depreciate). We further
investigate this effect in Section 6 with the simulation method.

５

Simulating the Future Net Income Path

We compute the present value of the future net income stream after tax, using a simulation
method proposed by Graham (1996). First, we estimate a simple time series model of taxable
income for each firm. The definition of income before tax for our study is the sum of earnings
before tax plus the net deferred tax balance, divided by statutory tax rates. Japanese accounting
standards require ﬁrms to report the deferred tax balance on an after tax basis.12
The change in taxable income is deﬁned as the change in earnings plus tax deferrals, and weassume it follows a stochastic process (5), in which ΔTIit is the ﬁrst difference of taxable income forﬁrm i between time period t and t+1, μi the mean drift parameter for ﬁrm i, and ηit an identically andindependent normal random variable for all t for each i with ﬁnite and constant variance σt which
are also estimated and used for generating simulation paths.

TI it

i

it

⑸

The parameters for the stochastic process of taxable income are estimated using the past ﬁve
years of data for the mean trend and the volatility of the error term for each ﬁrm. Based on theseparameter values, we compute the expected present value of future tax payable, and consequently,
future residual income on an after tax basis, deﬁned in previous equation (3). In this computation,
we take into account both outstanding tax carry-forward balances and future tax loss possible
allowances in cases where a ﬁrm happens to incur losses on any one of the 10000 simulation paths
in future 20 years.13 We use the new statutory tax rate to readjust the future tax deferral balance byusing Japanese accounting standards.14 In the simulation, we assume that the remaining balanceon deferred tax assets is resolved in the ﬁrst next period when ﬁrms incur enough proﬁt, and if
not, in consequent next periods, irrespective of possible decision by tax authority. Furthermore, we

12

We use the earnings data from consolidated ﬁnancial statement.

13

For ﬁrms which have experienced losses less than 7 years ago, the tax loss carry-forward beneﬁts
will accrue. We conducted our simulations for the period of 20 consecutive years to fully accountfor future cumulative effects.

14

The recommendation to include tax deferral accounts in Japanese accounting standards,
Accounting Standards for Tax Effect Accounting, was released on October 30, 1998 and wasenacted in April 1999. Some ﬁrms began their voluntary disclosure in April 1998.

33

経営財務研究第 32 巻第 1・2 合併号

assume that the ﬁrms keep their average payout ratio in the past ﬁve years, and that the ﬁrms
which incur negative earnings do not pay dividends.

6 Simulated Results from Hypothetical Corporate Tax Cuts
In Table 3 we report the year-by-year results of our simulations. We compare V0, the valuation
based on the current effective tax rate of 40.87%, to V1, the hypothetical valuation under theeffective tax rate of 35%, which is equivalent to an approximately 5 percent cut in corporate tax
rate computed from equation (3). We report the ratio V1 / V0, called VR in the table, which is ahypothetical value under the tax rate cut to the value when the current tax rate is continued. All
our calibrated valuations are computed each year for June 30th. For example, for calendar year
2000, balance sheet data from March 2000 is used, which is from ﬁnancial statements of ﬁrms forﬁscal year 1999. With this ratio we can contrast ﬁrms which are expected to increase equity values
by a tax cut (lower half of table) with ﬁrms which are expected to decrease values (upper half oftable).
In Table 3 we ﬁnd that for a majority of ﬁrms, the ranges of VR values are within 1.00 to 1.15 inthree rows from the top. The mode values lie between 1.05 and 1.10. Thus, with an effective 5.87%
tax rate cut, the equity value increases from 5% to 10% for a majority of ﬁrms. Note that this ispurely from tax effects. With possible additional productivity increases, we may expect even higher
changes in ﬁrm values.15
Table 3. Year-by-Year Frequency Distribution of Intrinsic Value Ratio

Intrinsic Value Ratio, VR, is defined as the (V at hypothetical tax rate=35%)/(V at current corporate tax rate=40.87%).
2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

VR≦0.8

3.23

3.83

5.39

3.93

2.39

2.25

2.27

0.38

1.60

4.75

0.80<VR≦0.85

0.75

0.70

0.69

1.09

0.52

0.66

0.27

0.29

0.50

1.45

0.85<VR≦0.90

1.24

1.04

2.52

1.31

0.62

0.94

0.91

0.48

0.20

1.65

0.90<VR≦0.95

2.61

2.32

4.59

3.49

1.77

1.03

1.45

0.95

1.50

4.86

0.95<VR≦1.00

13.17

14.15

22.25

13.96

5.71

3.84

5.54

3.91

5.89

27.38

1.00<VR≦1.05

16.52

14.15

15.71

8.62

6.02

5.34

6.45

5.53

7.19

13.33

1.05<VR≦1.10

42.48

41.65

27.29

38.06

57.94

61.20

64.40

73.76

66.37

29.03

1.10<VR≦1.15

13.04

11.83

11.01

14.83

14.43

14.71

11.35

10.11

9.08

9.19

1.15<VR≦1.20

2.24

3.94

3.44

5.78

4.05

4.12

2.82

1.72

3.19

2.89

1.20<VR

4.72

6.38

7.11

8.94

6.54

5.90

4.54

2.86

4.49

5.48

15

We are not taking into consideration firms’ potential productivity improvements caused bycorporate tax rate cuts. It is subject to our future research. .

34

経営財務研究第 32 巻第 1・2 合併号

Noteworthy is the fact that the slight value decrease can be observed in 2002 and 2009. For
the range of VR within 0.95 and 1.00, 22.25 % of the sample ﬁrms fall into this category in 2002
and the corresponding number is 27.38% for 2009. In other years these numbers are smaller. The
reason why this happens is partly due to the downturn of the economy (see Figure 2). When future
profits are expected to decline along with higher volatility, corporate tax reduction effects will
become smaller because the effective tax rates for the ﬁrms which may incur loss can utilize thetax loss carry forward and, thus the marginal tax rates become smaller than the average tax rates(Kubota and Takehara, 2007). This effect will cancel out the decrease in statutory tax rates and it
cancels (added to) any gain (loss) from deferred tax liabilities (assets). This result has important
implications to ﬁnancial managers, and it suggests that they have to carefully watch the impact ofcorporate tax rate cut and assess its effects upon their ﬁrm values.
Furthermore, from ﬁscal year 2008 to 2009, the percentage of a majority of ﬁrms for which VR
values stayed between 1.00 and 1.10 suddenly decreased from 73.56% (=7.19+66.37) to 42.36%(=13.33+29.03). This means that the percentage of ﬁrms for which positive effects can be expecteddrastically decreased in 2009, which would have attenuated policy effects of the corporate tax ratecut, if the tax cut policy had been enacted in that year. These results demonstrate very important
implications for policy makers on the right timing of policy implementation. Accordingly, in Japan,
Table 4. Industry-wise Frequency Distribution of Intrinsic Value Ratio at the end of June 2009
#Firms VR≦0.8

0.80<VR 0.85<VR 0.90<VR 0.95<VR 1.00<VR 1.05<VR 1.10<VR 1.15<VR
1.20<VR
≦0.85
≦0.90
≦0.95
≦1.00
≦1.05
≦1.10
≦1.15
≦1.20
0.00

14.71

7.35

38.24

14.71

7.35

8.82

2.13

4.26

12.77

10.64

38.30

12.77

2.13

10.64

0.00

12.90

38.71

16.13

16.13

6.45

3.23

0.00

3.41

6.82

Construction

68

4.41

0.00

4.41

Foods

47

4.26

2.13

Textiles & Apparels

31

6.45

0.00

Chemicals

88

0.00

3.41

3.41

3.41

29.55

14.77

27.27

7.95

Pharmaceutical

19

0.00

0.00

0.00

0.00

15.79

5.26

63.16

10.53

5.26

0.00

Glass & Ceramics Products 26

7.69

0.00

0.00

0.00

46.15

15.38

11.54

11.54

3.85

3.85

Iron & Steel

24

4.17

4.17

4.17

16.67

33.33

4.17

29.17

4.17

0.00

0.00

Metal Products

33

6.06

3.03

3.03

6.06

27.27

24.24

15.15

9.09

0.00

6.06

Machinery

88

4.55

1.14

1.14

12.50

23.86

6.82

30.68

7.95

2.27

9.09

Electric Appliances

107

4.67

0.93

1.87

0.93

43.93

17.76

24.30

1.87

2.80

0.93

Transportation Equipment

41

7.32

0.00

0.00

4.88

31.71

21.95

21.95

9.76

0.00

2.44

Precision Instruments

22

0.00

0.00

0.00

0.00

45.45

18.18

22.73

9.09

0.00

4.55

Other Products

37

0.00

0.00

0.00

5.41

40.54

13.51

18.92

8.11

5.41

8.11

Electric Power & Gas

19

5.26

0.00

0.00

0.00

15.79

47.37

26.32

5.26

0.00

0.00

Land Transportation

32

0.00

0.00

3.13

0.00

12.50

9.38

46.88

15.63

0.00

12.50

Warehousing

15

0.00

6.67

0.00

0.00

20.00

13.33

6.67

13.33

26.67

13.33

Wholesale Trade

92

5.43

1.09

1.09

7.61

20.65

7.61

35.87

11.96

3.26

5.43

Retail Trade

37

2.70

0.00

0.00

8.11

21.62

13.51

37.84

13.51

2.70

0.00

Services

67

10.45

2.99

0.00

5.97

14.93

11.94

38.81

8.96

1.49

4.48

35

経営財務研究第 32 巻第 1・2 合併号

if the government ever wanted a tax rate cut, the corporate tax cut should have been enacted in2007 when 79.29% (=5.53+73.76) belonged to this category,
Next, Table 4 reports industry-wide distribution of VR ratios as of June 2009. Industry
classiﬁcation is based on 33 classiﬁcations by the Tokyo Stock Exchange. We imposed the condition
that there are at least 15 ﬁrms in an industry.
Overall, we find positive effects of corporate tax cuts in the food industry, pharmaceuticals,
land transportation, warehousing, retail trade, and services by counting the percentage of firms
whose VR values are larger than 1.00.16 Slight negative effects from counting VR values between
0.95 to 1.00 are observed for chemicals, iron and steel, machinery, electric appliances, precision
instruments and other products. Note the latter group is more heavily equipped. Hence, even if thecorporate tax cut is not as effective as other alternative corporate tax cut policies the policy makercould devise an accelerated depreciation, or shortened estimated life of heavy equipment in order toaugment the smaller effects of the tax rate cut, like the case of the U.S. Tax Reform Act of 1986.17
Table 5 summarizes the characteristics of firms by classifying them by the magnitude of VR
values to further interpret our previous results.
Table 5. Summary of Firms Characteristics at the end of June 2009

Definition of DTA and LCF are the same as in Tables 1 and 2. lnMV denotes the natural
logarithm of market value of equity in million yen and B/M denotes the book-to-market ratioof the firm in percent. μTI and σTI are the drift term and volatility of taxable income divided bybook value of equity in percent. The figures in each cell is the mean value for each category.

16

DTA

LCF

lnMV

B/M

μTI

σTI

VR≦0.8

5.91

6.90

9.93

152.97

‑1.16

15.85

0.80<VR≦0.85

5.02

3.27

10.70

122.12

‑0.87

11.79

0.85<VR≦0.90

5.20

4.54

10.64

126.32

‑1.34

8.58

0.90<VR≦0.95

4.41

2.71

10.21

149.91

‑1.10

9.27

0.95<VR≦1.00

4.54

5.66

10.10

154.23

‑2.66

10.58

1.00<VR≦1.05

7.84

4.07

10.63

146.35

‑2.82

6.37

1.05<VR≦1.10

5.69

1.43

10.54

124.451.12

5.34

1.10<VR≦1.15

5.65

3.17

10.39

134.81

0.35

11.07

1.15<VR≦1.20

5.96

7.34

10.27

128.18

‑0.08

14.30

1.20<VR

5.21

6.06

10.05

150.20

‑0.50

14.49

Although the percentages of the ﬁrms with VR> are high in the construction and in the electric
power and gas industry, for the former industry the realization of earnings is based on thecompletion criterion and for the latter the rates are regulated based on cost-added approach, andthe tax effects of these industries will be different from other industries. Thus, we will not adopt
these industries as typical industries in our study and leave the discussion for our future inquiry.

36

経営財務研究第 32 巻第 1・2 合併号

The ﬁrst column DTA is the balance of net tax deferred assets as reported in Table 2, and thesecond column LCF is the tax loss carry-forward as reported in Table 1. We ﬁnd overall that DTA
is larger for the group with favorable effects of a tax cut, which means that the tax cut causes
favorable effects for firms via the net tax deferred asset account. We infer that the effects are
dependent upon both the trends and the variability of ﬁrms’income before tax and the resultant
income after tax is also dependent upon the balance of deferred tax assets or liabilities and tax
loss carry forward. The effect of tax cut will be, thus stronger, whether it may be appreciation or
deprecation of the ﬁrm values, when the income trends are extremely upward or downward and at
the same time their variability is larger.
As to LCF values, the tendency is not so clear cut. It seems the distributions are similar between
above and below the value of VR 1.00. We ﬁnd that LCF values are the largest again in extreme
points where VR is less than or equal to 0.8 and larger than 1.2 depending on the past trends andvariability of income series for each ﬁrm. Accordingly, we claim that there are extreme losing ﬁrms
with large tax loss carry-forward amounts on one side, but still the tax cut may have either positiveor negative effects. We infer that these effects are caused by joint effects of both DTA and LCF.
However, we cannot identify analytically which element is more decisive in a dynamic context. In
addition, we do not ﬁnd differences in ﬁrm size as measured by the natural logarithm of the total
market value of equity for 10 separate rows. As to the“value”factor, the book-to-market ratio used
in ﬁnancial economics, we ﬁnd that ﬁrms with positive tax cut effects have higher book-to-market
ratios, which means the stock price is low relative to the book value. Therefore, the tax cut effectworks stronger in the so called value ﬁrm group, a group of distressed ﬁrms as judged by capital
market participants which is labeled as“fallen angels”by Fama and French (1993).
The ﬁnal two columns are the mean growth rates of net income before tax and their standard
deviations. Among ﬁrms for which the tax effect is unfavorable (VR 1), the mean growth rate is
all negative as expected. For the favorable tax cut effect group, even though some numbers arenegative, they are uniformly larger than the negative group. For standard deviations, larger values
on the two extreme ends seem to have signiﬁcant roles to make VR much larger or much smaller
than one.
In sum, we have demonstrated with a simulation method that the estimated stochastic processof net income after taking into consideration the outstanding net balance of both DTA and LCA,
reveals the ﬁnal effect of corporate tax cuts on ﬁrm values. It is a new ﬁnding which has never been
explored with the recent data for countries with uniform tax reporting systems like Japan, and it isa new contribution to the literature.

17

Samuelson (1964) is the ﬁrst study which theoretically analyzed the effects of tax depreciation
methods on ﬁrm value as well as social equity between large and small ﬁrms. Note that the higher
accelerated depreciation rates and smaller salvage values were permitted for tax purposes inJapan since 2007.

37

経営財務研究第 32 巻第 1・2 合併号

７

Conclusion and Final Remarks

This paper addressed a fundamental query in changes in ﬁrm values triggered by hypothetical
corporate tax rate cuts. The study is based on micro foundations of simulations of all the ﬁrms listed
in Japan. We utilized the fundamental Ohlson residual income valuation model. To disentangle
the effects on ﬁrm value triggered by corporate tax rate changes, we paid particular attention to
net changes on deferred tax liabilities in equity and contra accounts of deferred tax assets. Future
paths of taxable net income for all individual ﬁrms were generated using the method of Graham(1996) based on the estimated stochastic process of this income. As a discounting rate we use thecost of equity computed from unconditional rolling forward Fama and French three factor modelusing 60 months of past return data.
We measured the effects that these tax rate changes impose on firm values using simulated
future paths of taxable income and the assumed alternative hypothetical statutory tax rates. 18
Our results demonstrate that corporate tax rate changes can enhance the market price of equity
most of the time, while there are cases in which the effects were neutral or even detrimental. These
different results are caused by mixed effects of current provisions that allowed ﬁrms to carry their
tax losses forward and the net balance on ﬁrms’tax deferred accounts on either the debit or credit
side.
Overall, we find that firms’profitability and variability are crucial in identifying the exact
threshold points at which ﬁrms experience value ﬂuctuations from the corporate tax rate change.
Extensions to incorporate parametric changes of firms’productivity as well as profitability bycorporate tax rate cuts (Auerbach, 2002) as well as to introduce individual income taxes forinvestors (Collins and Kemsley, 2000) are our future work.
As a ﬁnal remark, to update the current trend of Japanese tax rates after we had conducted thisresearch, we note the corporate tax rate was reduced 5 % from ﬁscal year 2012 with added smaller
corporate tax for the sake of recovery from the Great Eastern Japan Earthquake, and the similarsmall additional recovery tax is also burdened on personal income and ﬁnancial income tax rates toenhance this recovery from ﬁscal year 2013. The investigation of the effects of these recent tax ratechanges is also subject to our future work.

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18

Note we implicitly assume the “me ﬁrst rule” (Fama and Miller, 1972) holds, and furthermore
assume away the existence of any agency costs between shareholders and debt holders.
Accordingly, the maximization of ﬁrm values and the maximization of the market value of equity
are equivalent.

38

経営財務研究第 32 巻第 1・2 合併号

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39