Effect of corporate income tax on investment decisions of Indian manufacturing firms

Abstract

This study is an attempt to empirically analyse the effect of corporate income tax on investment of manufacturing firms in India during 2005–2019, using the standard static panel model estimation techniques. It is found that the effective corporate tax rate has a negative and significant impact on the corporate investment. Moreover, the estimated effective tax elasticity is relatively low as compared to the magnitude found in other countries. The adverse impact of tax on investment is higher in private firms than in public firms and higher in pre-economic crisis period than in post-crisis period. The effective rate increases with age and size of firms. It is our hope that these results will be useful to policymakers and other stakeholders to take appropriate strategies to design the corporate tax policy such that it will not hinder business investment in India.

Keywords:

• Investment
• effective corporate tax rate
• Indian manufacturing firms
• panel data methods

JEL Classification::

• D21
• E22
• E51
• H25
• C23

Acknowledgment

The authors are thankful to two anonymous referees for their valuable comments and suggestions.

Notes

1 For a review, refer Hassett and Hubbard (2002).

2 In 1992, the 73rd and 74th Constitutional amendments empowered the urban and the rural local governments as the third tier.

3 For full derivations, see Eklund (2013).

4 However, it is computationally difficult to measure the average Q at the industry level.

5 Fazzari, Hubbard, and Petersen (1987) propose an augmented model within the Q theory framework and examine the importance of a financing hierarchy created by capital market imperfections. They emphasize the importance of cash flow as a determinant of investment spending because of the financing hierarchy in which internal fund has cost advantages over the external fund. They find that these information asymmetries are more pronounced for new firms and for small firms.

6 Studies such as Vartia (2008) also found an adverse effect of taxes on industry level investment. In Vartia study, the estimated user cost elasticity of investment with respect to capital ratio ranged between −0.33 and −1.0. In Schaller (2006), the user cost elasticity for Canada during 1962 to 1999 was −1.6.

7 As the data for many firms are not available for continuous years, the dynamic panel model technique is not attempted in this study.

8 Evidences indicate that at macro level, after the crisis, the investment rate (i.e. investment relative to GDP) declined in household sector and not in private corporate sector.