We examine government decisions on subsidizing investments in the private sector and discriminating among firms in its support programs. By taxing corporate profits, the government may affect corporate investment decisions, causing firms to invest less than what would be socially optimal. Investments that are desirable from the standpoint of social welfare may be rejected by shareholders, which may ultimately lead to the collection of fewer taxes. We analyze the conditions for optimal subsidies for investments carried out by the private sector. We find that high-risk ventures that generate substantial spillover activity are prime candidates for government incentive schemes.

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In this article, we conduct a theoretical analysis of government incentives for private investment activity. We focus on two major questions: First, under what conditions is a government justified, from an economic viewpoint, in supporting investment activities undertaken by private firms? Second, under which conditions is supporting an investment in R&D projects more economically justifiable than support of an investment in a traditional low-tech project?

In our analysis, we focus on the microeconomic interaction between the government and a specific pure-equity firm. Our approach is based on a partial equilibrium solution, within the framework of Modigliani and Miller's (1958, 1963) (M&M) modeling of corporate valuation. We assume that there are no taxes other than corporate taxes, and that within this framework all markets are in equilibrium. Following Modigliani and Miller (1958, 1963), we let governments "negotiate" with firms to maximize the total net value to all stakeholders.

We view the government as an economic agent that collects taxes from corporations based on simple, uniform tax rules, and which provides a basket of services to the entire population. Unlike the majority of academic papers in the public finance area, we assume that a government acts as an economic agent. Its objective is to enhance public welfare and in order to jointly achieve a higher level of public welfare, it "negotiates" with private firms. Therefore, the government takes into consideration the present value of its net tax collection from each new investment made in the private sector. Through its traditional tax rules, governments may affect and alter the investment decisions of the firm, causing a distortion in the allocation of resources throughout the economy. We examine the conditions under which the government may provide investment subsidies to an individual company to generate economic benefits and enhance the public welfare.

In this article, we analyze the welfare effect of subsidies extended differentially to specific projects, rather than as an across-the-board tax break. We find that subsidizing industrial R&D is not necessarily inefficient and can benefit individual firms, industries and the economy as a whole.

We adopt a microeconomic approach, looking mainly at the firm's level and modeling the decision-making process for corporate investments and how those investments affect social welfare. We do not presume to prove an optimal corporate tax schedule that eliminates or minimizes tax distortions. Rather, we take the tax regime as given: corporate taxes are levied at a uniform rate on accounting...