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ABSTRACT
This paper examines the effect of labour protection laws on tax planning and capital investment. Exploiting a major reform that introduced firing costs in Italy for firms with fewer than 15 employees but left firing costs unchanged for larger firms combined with matched employer-employee data, I show that the rise in firing costs led small firms to increase tax avoidance and capital investment relative to larger firms. Robustness and placebo tests suggest that the results are causal. Overall, the findings indicate that tax avoidance allows small firms to generate internal funds to substitute labour for capital when employment protection becomes stronger.
Acknowledgement
I am especially grateful to the Fondazione Rodolfo Debenedetti (http://www.frdb.org) for providing the matched employer-employee data. The current paper partly builds on De Vito et al. (Citation2019), whose previous version was circulated under the title ‘Avoiding Taxes to Fix the Tax Code’, with a specific focus on Italy.
Disclosure statement
No potential conflict of interest was reported by the author(s).
Notes
1 I use the terms “tax avoidance” and “tax planning” interchangeably throughout the paper (Wilde and Wilson Citation2018).
2 Discussions with practitioners confirmed that these tax avoidance strategies were write-offs of receivables, the depreciation of capitalized research and development expenses (R&D), and provisions for future expenses and/or losses, which appeared in the tax return but not in the income statement. Importantly, this anecdotal evidence is consistent with prior literature suggesting that managers primarily employ tax avoidance strategies that reduce the effective tax rate (ETR) and produce both a cash-flow benefit and a financial-statement benefit (Armstrong et al. Citation2012; Graham et al. Citation2014).
3 The House of Representatives provides a detailed timeline of events at http://legislature.camera.it/.
_dati/leg10/lavori/schedela/trovaschedacamera.asp?pdl = 4446 (last accessed April 3, 2022).
4 Similar to Cingano et al. (Citation2016), I do not use the capital-to-labour ratio as the dependent variable, because the identification strategy relies precisely on the number of a firm’s employees.
5 Alternatively, I employ administrative region – year fixed effects and find unchanged results.
6 I include leverage to control for its effect on tax avoidance for the average firm in the sample beyond the reduction of debt due to EPL. In untabulated tests, the results are unchanged when it is excluded. Note, also, that the Italian GAAP allows firms to capitalize R&D. Hence, the variable intangibles also captures tax strategies related to the use of R&D tax incentives.
7 The Company Accounts Data Service is a joint venture between the Bank of Italy and the Italian Banking Association to gather high-quality information on borrowers with the Italian legal forms Società per azioni (s.p.a.), Società a responsabilità limitata (s.r.l.), and Società in accomandita per azioni (s.a.p.a.). Note, also, that the sample ends in 1991 because in 1992 the Italian Parliament introduced an extraordinary property tax on firms’ real estate (i.e. Imposta Straordinaria sugli Immobili). This could bias the results. Hence, for consistency, the effect of the reform on tax avoidance and investment is tested using the two years before the reform (1988–1989) and the two years after it (1990–1991).
8 See Article 83 of the Italian Tax Code at https://def.finanze.it/DocTribFrontend/decodeurn?urn=urn:doctrib:TU:1986-12-22;917_art83 (last accessed September 16, 2022). Discussions with practitioners also confirmed that the time window for filing financial statements overlaps with the time window for filing tax returns. Firms usually end the fiscal year in December 31 and file simultaneously financial statements and tax returns in spring of next year. This timing overlap allows small firms to quickly implement many tax avoidance strategies.
9 The data were randomly sampled by the Fondazione Rodolfo Debenedetti and confidentially provided to me upon request.
10 Since my chosen bandwidth is sufficiently narrow, the sample size is almost balanced on each side of the 15-employee threshold, with 183 treated firms and 169 control firms. Note, also, that my sample is smaller than that of Cingano et al. (Citation2016) because of missing tax data.
11 The calculation is as follows. First, I retrieve exchange rates from Datastream and convert each variable into real U.S. dollars. Second, I multiply the average pre-tax income of the treated firms by the coefficient estimate in column (2) of Panel A of (= USD 468,420 × 0.0459), to obtain USD 21,500.