Do corporate taxes reduce investments? Evidence from Italian firm-level panel data

Abstract

This paper uses an Italian firm-level panel data-set over the period 1994–2006 to investigate the nexus between corporate taxation and investment. Studying the effects of corporate taxation on investment at the micro level has two advantages. Firstly, investment is free of aggregation biases and secondly, the firm-level dimension allows asking whether the effects of corporate taxation differ across firms with different characteristics. In the empirical analysis, we employ a Generalized Method of Moments estimator, which permits us to handle not only the dynamic structure of the model and of the predetermined or endogenous explanatory variables, but also firm-specific factors, heteroskedasticity, and autocorrelation of individual observations. We find that corporate taxes distort investment decisions. The results are robust to the inclusion of many controls.

Keywords:

• investment decisions
• corporate taxes
• effective tax rates
• GMM estimator

JEL classifications:

• C23
• G31
• H25
• H32

Public Interest Statement

This paper investigates the relationship between corporate taxation and investment choices. The linkage between corporate taxation and firm economic performance has received persistent attention in both the academic literature and policy debates. One of the main drivers of economic growth is investment and how corporate taxes affect investment behavior of firms is, indeed, a question of great importance. Our results suggest that corporate taxes play a relevant role in shaping firms’ investment propensity. As expected, findings support the debate on the high level of business taxation in Italy, which has been at the heart of the corporate tax reforms enacted starting from 1998. International tax competition calls for further reforms to lower firms’ tax burden to foster enterprises’ investment and competitiveness.

Acknowledgments

The authors would like to thank the Editor and two anonymous referees for their useful comments and suggestions. Daniela Federici wishes to thank the Honors Center for Italian Universities (H2CU). The usual disclaimer applies.

Notes

1. This is in line with the literature (see Devereux & Griffith, 1998; Egger et al., 2009). Indeed, considering that other companies own a relevant part of companies and that this choice cannot be modeled, personal taxation may not be so relevant and could lead to biased estimates of effective tax rates.

2. We calculate the share of tangible fixed assets, intangible fixed assets, and stock of current assets over total assets, for each firm.

3. The debt–equity ratio is the ratio between current and non-current liabilities and company total assets. From the analysis, we exclude firms for which the debt–equity ratio is negative or greater than 1.

4. This is a regional tax paid by corporations and unincorporated firms on their value added net of depreciation and amortizations, i.e. with no deduction of interest expense and labor costs from the tax base. Therefore, IRAP strengthens the neutrality features of the overall corporate tax system.

5. In the actual system, the statutory rate is 27.5%. Normal profits derive from net annual capital increase multiplied by the imputed rate of 3% and are deducted from taxable profits in line with the ACE scheme.

6. Calculation of effective tax rates is exogenous from the actual behavior of firms and therefore, implicitly assumes that firms are eligible to the DIT allowance and the investment provision. Obviously, if this was not the case, the effective tax rates would be higher: in 2001 39.2% (EATR) and 26.2% (EMTR).

7. As explained in Section 2, the changes enacted in 2001 strongly weakened the DIT allowance which was also made optional to the new (and generous) investment tax relief. Calculation of the effective tax rates reflects the assumption that companies opt for the tax credit rather than the DIT system.

8. The sample is representative of the Italian economic structure.

9. The application of the Euler equation to the analysis of firm-level investment is motivated by the need of incorporating expectations about the future profitability of investment plans. Firms’ optimal investment path is estimated by removing the shadow value of capital (by equating the Euler equation to the first-order conditions for investments) and substituting expected values by their realized values.

10. Following the literature on dynamic investment functions, firm assets weight the dependent and independent variables (except the dummy variables).

11. To implement the system GMM estimator, we use the xtabond2 command in STATA introduced by Roodman (2009). Although the two-step estimator is asymptotically more efficient, the reported standard errors tend to be downward biased (Arellano & Bond, 1991; Blundell & Bond, 1998). To compensate, xtabond2 makes available a finite-sample correction to the two-step covariance matrix derived by Windmeijer (2006). This can make two-step robust estimations more efficient than one-step robust, especially for system GMM.

12. For a review on GMM methods and a comparison of its performance with OLS and panel data regression (fixed and random effects), see Roodman (2009).

Additional information

Funding

Funding. The authors received no direct funding for this research.

Notes on contributors

Valentino Parisi

This contribution is part of a wider research project concerning the effects of corporate taxation on entrepreneurship dynamics. The research interest is motivated by new insights in the light of the recent literature which emphasize the role of heterogeneity within firms. Our focus has been the role of corporate taxation in shaping investment as well export behavior at the firm level. The effect of corporate taxes on investment and entrepreneurship is one of the central questions in both tax policy and economic growth.