Real Effects of Corporate Taxation: A Review

Abstract

In this study, I review the empirical literature on the real effects of corporate taxation. I define real effects broadly as firms' investment responses, corporate risk taking, capital structure choices, and aggregate outcomes such as GDP growth. I base my analysis on 79 empirical studies on the investment effects of corporate taxation and contrast these results to theoretical predictions. Consistent with theory, there seems to be a consensus that higher corporate tax rates reduce corporate investment, foreign direct investment (FDI), aggregate growth, and innovation. Similarly, many papers examine bonus depreciation, which consistently increases investment. At the same time, there is little evidence on the employment effects of corporate taxes and on the role of several tax base elements in shaping investments. Importantly, the role of tax avoidance (opportunities) in the tax effect on investment has received very little attention from the empirical literature over the past two decades. I also derive several other potential avenues for future research.

Keywords:

• Corporate taxation
• Literature review
• Real effects
• Investments
• Employment
• Tax avoidance

JEL Classification:

• M48
• M41
• H25
• H26

Acknowledgments

I thank Hervé Stolowy (the editor), two anonymous reviewers, Lisa Hillmann, Stefan J. Huber, Harm Schütt, Cinthia Valle Ruiz, Robert Vossebürger, and Thorben Wulff for helpful comments on previous versions of the paper. I particularly thank Alissa Brühne for excellent co-authorship on the previous, longer version of this paper that had a different research question and a much broader focus on the determinants and consequences of tax avoidance. The current paper partly builds on Brühne Jacob (2020) and is an extended, more comprehensive version of their Sections 2 and 6, with a focus on real effects and an updated sample for this research question. I also thank Alissa Brühne for very helpful comments on this paper. I further thank Constance Kehne, Robert Vossebürger, and Thorben Wulff for excellent research assistance. I acknowledge funding by the German Research Foundation (Deutsche Forschungsgemeinschaft), Project-ID 403041268 – TRR 266 Accounting for Transparency.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 I call these real effects because changes in firms' labor and capital input are key drivers of overall economic growth (e.g. Solow, 1957). Labor input choices, for example, comprise the number of employees, the mix of high- versus low-skilled employees, or the location of employees. Capital input refers to the amount of fixed or intangible assets.

2 I, of course, acknowledge clear limitations of the DJJM framework when it comes to more complex investment decisions, for example, under tax (policy) uncertainty. Such topics are, for instance, covered by Alvarez et al. (1998), Diller et al. (2017), Hassett and Metcalf (1999), and Niemann and Sureth (2013).

3 The literature explores such limitations to understand the consequences of the limited tax deductibility of executive pay on the level and composition of executive compensation (Bird, 2018; Bornemann et al., 2021; De Simone et al., 2020; Hall & Liebman, 2000; Luna et al., 2020; Niemann & Sureth, 2000). A recent working paper by Bornemann et al. (2021) further shows that firms cut investment activity because they cannot fully pass on the higher tax burden to executives, due to limited deductibility.

4 These predictions generally hold when the parent company faces a high tax rate. Consider a firm that invests in all available projects with a positive net present value (NPV) in Country A (with a tax rate of 35%) and in Country B (with a tax rate of 20%). If the tax rate in Country B is cut to 15%, then the firm now considers additional projects to be profitable (i.e. all projects that had a negative NPV at a tax rate of 20% but now have a positive NPV at the rate of 15%). This does not mean that the firm will automatically shift activities from Country A to Country B. The prediction is that, following a tax cut, investments in Country B will increase to reach profit-maximizing input levels (in Country B). This happens, irrespective of the level of taxes in the parent country, although there could be dependency, which is not captured in the simple DJJM framework.

5 I use the business activity category to capture outcomes such as the number of establishments or business entry rates.

6 See https://www.erim.eur.nl/about-erim/erim-journals-list-ejl/ (accessed February 20, 2021).

7 The list of journals included in the Scientific Journal Rankings ranking is available at https://www.scimagojr.com/journalrank.php?area=2000https://www.scimagojr.com/journalrank.php?area=2000 (accessed February 20, 2021).

8 Based on Brühne and Jacob (2020), the Web of Science search queries uses the search words tax avoidance, tax planning, tax shelter, tax aggressiveness, income shifting, profit shifting, and effective tax rate to identify studies on the determinants and consequences of tax avoidance. To identify real effects studies, I use search string combinations of the search words tax, corporate, firm, effect, consequence and the real effects search words capital, investment, labor, wage, employment, dividend, financing, intangible, research, R&D, innovation, patent, location, resource allocation, bonus depreciation, productivity, input, operations, repatriation, welfare, incidence, inequality, offshore, mergers, and acquisitions.

9 I use a 10% level (two-tailed) cutoff to describe a result as significant.

10 One recent paper by Kim et al. (2020) is excluded from the quantitative synthesis as it does not fit the framework of taxes to be paid by the firm. They show spillover effects of foreign tax changes to domestic investment of U.S., which increase following tax cuts abroad.

11 The result in the opposite direction stems from Klemm and Van Parys (2012), where, in one of many regressions, the coefficient is significant in the opposite direction of the prediction.

12 Since I focus on investment decisions, I do not review the large literature on the role of dividend and capital gains taxes on the payout policy of firms. Evidence on the effect of payout taxes on dividend and/or share repurchase decisions is provided, for example, by Brown et al. (2007), Blouin et al. (2011), Chetty and Saez (2005), Hanlon and Hoopes (2014), Jacob and Jacob (2013), Jacob and Michaely (2017), Korkeamaki et al. (2010), and Moser (2007).

Additional information

Funding

This work was supported by German Research Foundation [Project-ID 403041268 – TRR 266 Accounting for Transparency].