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We show that when large corporations are subject to a different tax system than smaller firms, the agency cost of under‐ and overinvestment is significantly altered. In contrast to the findings in the literature, the gap between the first‐ and second‐best investment trigger prices do not move in lockstep with variations in the corporate tax rate, as in the case of a linear tax system. We show that the gap can either widen or shrink, depending on the tax policy design and regime. In addition, we find that the agency cost under a progressive tax regime is considerably larger than the agency cost under a regressive tax regime when equityholders have to bear all the investment costs. These results are reversed when managers have the ability to issue additional debt to finance the firm's expansion and transfer part of the investment costs to bondholders.

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