John R. Graham
Duke University, Durham, NC 27708
Clifford W. Smith
University of Rochester, Rochester, NC 14627
ABSTRACT
Convexity of the effective tax function provides an incentive to reduce volatility of taxable earnings through hedging, thereby lowering the expected corporate tax liability. We use simulation methods to investigate whether major features of the tax code induce convexities. We find that on average the tax function is convex, although in circumstances it is concave (providing a disincentive to hedge). Tax loss carrybacks and carryforwards increase the earnings range over which there is a tax incentive to hedge; other features of the tax code have a minor impact. Among firms facing convex tax functions, the average tax savings resulting from a 5% reduction in the volatility of taxable earnings are about 5.4% of expected tax liabilities, although in cases, the savings exceed 40%.