How do Net Operating Loss Carryforwards Affect Firm Investment Decisions?

Abstract

We investigate whether the existence of net operating loss (NOL) carryforwards affects firm investment decisions. When a firm has a large NOL carryforward sufficient to reduce taxable income to zero, any tax benefit from new investments is not received immediately, but rather adds to the NOL carryforward and is deferred until a future year. Thus, these investments may have a lower net present value, as compared to firms without NOL carryforwards. We examine the relation between NOL carryforwards and four types of investment — capital expenditures, R&D, foreign subsidiary investment, and intangibles — and find a significantly negative relation. We create a new measure of NOL carryforwards focusing on useable NOLs created during overall loss years. Our results are robust to using four different measures of NOL carryforwards as well as two measures of the marginal tax rate. In sum, when firms become non-taxable, as evidenced by the existence of NOL carryforwards and a decline in the marginal tax rate, managers reduce tax-favored investments as the expected tax benefits from these investments decline.