Intervention Impact of Tax Reform Act on the Business Failure Process

Article excerpt

ABSTRACT

This paper investigates the impact of the intervention of Tax Reform Act on the business failure momentum. The data covers the period January 1967 through December 1986 and divided into pre-and post-event periods for both large and small business failures. We employ intervention analysis with transfer function modeling for the full data set and maximum likelihood time-series regression on the pre- and post-event periods. After controlling for the new business formations, we find the Tax Reform Act is instrumental in extending the memory of business failure momentum and amplifying the domino effect. These results also echoed in the intervention analysis. However, the impact of the intervention of Tax Reform Act is found to be more pronounced for large businesses than for small businesses.

INTRODUCTION

Business failure is generally viewed as an exogenous factor. Overall perception is that bankruptcy is a condition created by external factors that are beyond the control of the firms. Bankruptcy Reform Act of 1978 may be viewed as one of these external factors. Subsequently (early and mid 1980's), many firms sought to avoid the bankruptcy procedure by privately resolving conflicts among themselves. Between 1980-1986, 91 of the 192 (or 47%) defaulting NYSE and ASE companies were reorganized privately (Jensen, 1999). There are numerous motivations that can be attributed to these private workouts. In addition to the 40% continuity requirement that reflects a liberalization compared to 50% rule governing taxable acquisitions; avoidance of bankruptcy costs (legal and others), loss of tax carryforwards (in case of liquidation), decrease in value of the firm due to negative market perception. Shrieves & Stevens (1979) in their paper viewed these similar factors as a rationale for private workout arrangements. Jensen (1999) argues the popularity of private workout arrangements in the early 1980s was a natural market response to the high costs and time delays imposed by the bankruptcy procedure.

The objective of this paper is to analyze the effect of the Tax Reform Act on business failure process. We hypothesize, by encouraging private workout arrangements; the Tax Reform Act of 1978 enhanced the impact of the externalities of business failures, what has been characterized as a "domino effect" (see, Campbell & Choudhury, 2002).

Our sample consists of monthly observations of the number of business failure obtained from Dun and Bradstreet Corporation. This sample covers the period of January 1967 through December 1986. After dividing the sample observations into pre- and post-event periods, we examine the intervention effect of the Tax Reform Act on the business failure momentum for both large and small firms. We control for the new business incorporations and due to the presence of autocorrelation, maximum likelihood estimation method is used. Pre-event period providing a benchmark, we find the Tax Reform Act is instrumental in extending the memory of business failure and amplifying the domino effect. This suggests that the Tax Reform Act have impacted firms to accelerate private workout process by providing economic incentive. Our results contribute to the literature by documenting the constructive externalities of business failure and associating alternative recontracting procedures with dissimilarity in business failure momentum.

Following section summarizes the related literature on business failure. In the third section we discuss our data selection and research methodology. Results of our analyses are discussed in section four and we summarize our findings in section five.

RELATED LITERATURE

Bankruptcy issues and its impact on the capital market have been studied by many researchers (Baxter, 1967; Stiglitz, 1972; Kraus & Litzenberger, 1978; Scott, 1976). One of the most continuing issues in the bankruptcy literature concerns the efficiency of corporate bankruptcy. …

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