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developed countries. Until fiscal year 2011, for Japanese large corporations, the
national corporate tax rate was 30%, the prefecture tax rate 5% and the city tax rate
12.3%, adding up to an effective tax rate of 40.78%, which is applicable to our sample
of Tokyo Stock Exchange listed firms.
We focus on individual firms' financial statement data and investigate effects of tax
rate cuts on firm value by utilizing the accounting residual income valuation model,
and identify conditions under which the effects of tax rate changes are favorable,
neutral, or rather detrimental. Furthermore, in doing so, we take into consideration
both tax loss carry-forward allowances and changes in net deferred tax assets and
liabilities. Unlike Kubota and Takehara (2012), where the straightforward method by
Graham (1996) is used to compute time series income before tax, we use a
microsimulation approach (Shahnazarian, 2011). That is, actual data from each item
of firms' assets are used to estimate micro-based firm production functions, and then
extrapolate the future net income path before the corporate tax. Next, by discounting
the stream of this future income on an after-tax base, we compute the fundamental
value of firms in which the cost of equity estimates are based on estimates from the
unconditional Fama and French three factor model (Fama and French, 1993).
Section 2 discusses the motivation of our study and raises our research agenda.
Section 3 formulates the process by which corporate investment evolves over time
based on items from financial statements and the corresponding valuation model.
Section 4 explains our data, reports basic observations, and explains the simulation
method we employ. Section 5 reports the simulation results and Section 6 concludes.
2
Taxation and Firm Value
2.1
Motivation
Corporate tax shield benefits or tax burdens arise from two sources: from debt or non-
debt sources. In this paper we focus on the latter. When Japanese firms incur losses,
they can extend their tax-loss shield against future income, like in many other
countries. Note that in the U.S., it can be charged to both future and past income.
2
Hence, these allowances from non-debt sources help firms decrease their future tax
burden and possibly reduce the cost of capital.
The Japanese financial reporting system and the tax reporting system follow the so-
called uniform reporting system like other continental European countries.
3
However,
from fiscal year 1999, the tax deferral account in balance sheets was admitted to be
recorded in consolidated financial statements on the condition that such an accrued
amount is expected to be reversed with a high probability within five years. In spite of
this new tax-timing difference allowance, the Japanese system can still be classified
2
In Japan, the current Corporation Tax Act (Article 57 Paragraph 3) allows for firms with
reported losses to deduct their losses against their future profits up to a maximum of nine
years. This used to be seven years. Also, the provision of tax loss carry-back allowances is
provided, although this has not been implemented since 1992 except for the firm liquidation
case.
3
See Cummins et al. (1994) for these classifications.
