The Impact of Taxation on the Effective Tax Rate, Operating Risk, and Portfolio Risk Diversification Effectiveness under Risk Pooling

We investigate the impact of a conventional corporate taxation system on an investment project's profitability and risk and on a firm's risk diversification capability. We use the Canadian corporate tax system as a representative of Western countries' conventional non-neutral corporate taxation systems and contrast it with a neutral taxation system. The analysis uses a simple probabilistic NPV stationary model with normally distributed random errors. We show that corporate taxation is doubly regressive, in that both the effective tax rate and the riskiness of a project decrease as its return on investment increases. Diversification capabilities also can be impaired or improved by the conventional non-neutral taxation system.