Optimal timing and capacity choice with taxes and subsidies under uncertainty

Abstract

We develop a real options model that examines the effect of government's subsidies and taxation policy on the timing and size of investments. We find that a higher depreciation rate or subsidy, or a lower tax rate, accelerates investments. The effect of subsidies on the investment size depends on whether the subsidy is fixed or variable: a fixed subsidy induces smaller size investments, whereas a variable subsidy encourages larger size investments. The tax and depreciation rates do not affect the size of the investment. For revenue-neutral incentive packages, the effect of changes in the above variables on the investment timing and size is not necessarily monotonic and it depends on the instrument of the taxsubsidy policy that is used to keep the new policy revenue neutral. There are also economic contexts in which an increase in the tax rate can accelerate investments of a larger scale.