What do we Know about Intensive and Extensive Tax Margins of Business Behaviour?
Ruud A. de Mooij1 and Sjef Ederveen2
Abstract
Corporate taxes exert a variety of effects on business behaviour. A wealth of recent empirical evidence assesses the magnitude of these behavioural margins of taxation. This articles offers an up-to-date review and aims to provide common ground by computing for each distortion the semi-elasticity of the corporate tax base. We pay particular attention to international investment. It is not a priory clear whether marginal investment decisions or discrete locations are most important here. Using an extension of the meta data base of De Mooij and Ederveen (2003), we explore the extent to which existing studies reveal differences in effect size between the intensive and extensive margins of investment.
1
Erasmus University Rotterdam, CPB, CESifo, Tinbergen Institute and Oxford University Centre for Business Taxation. E-
mail:
[email protected]. 2
Ministry of Economic Affairs, the Netherlands. E-mail:
[email protected]. 1
1
INTRODUCTION Corporate taxes influence business behaviour in several ways. For instance, firms exploit tax arbitrage opportunities between the corporate and non-corporate organizational form, they switch between debt and equity finance for their investment, or they reduce investment in response to tax. Multinational firms can further choose to allocate their income in foreign affiliates if taxes are lower there or they modify location decisions in response to tax. On the quantitative importance of each of these behavioural margins of taxation is a wealth of empirical evidence. There is, however, little common ground for comparing different distortions. Which effects are most important in quantitative terms? This articles offers an upto-date review of empirical studies on various decision margins and aims to provide common ground by computing the impact of different margins on a nations’ corporate tax base. The paper starts by reviewing empirical studies on five decision margins of business tax: organisational form, corporate financial policy, profit shifting, domestic investment and international investment. While most studies in the literature – including most literature reviews – focus on the significance of the statistical relationships, this article concentrates on effect sizes. The reason is that effect size is particularly relevant for policy makers. Indeed, the sole conclusion that taxes matter for firm behaviour will not satisfy policy makers who are responsible to design tax policy. They require information about the (relative) importance of tax effects as well as the tax parameters that cause these effects. The paper makes the effect size of different behavioural effects to tax comparable by computing the semi-elasticity of the tax base at each margin. This indicator measures the percentage change in the corporate tax base in response to a 1%-point change in the appropriate measure of tax. Its interpretation is intuitively appealing because it can be related to the revenue consequences of changes in the corporate tax rate. More specically, if we pre-multiply the semielasticity of the tax base by the current tax rate, it gives the revenue-effect induced by the behavioural response. For instance, if the tax rate is 25%, a semi-elasticity of − 1 implies that an ex-ante £ reduction in corporate tax yields only 75 pence of revenue ex-post because of this behavioural response to the tax. This article pays special attention to international investment choices. Theory is ambiguous on whether international investment decisions are driven primarily by the company tax burden at the margin of new investment or by the average tax burden on company profits, which applies to e.g. discrete location choice. We extend the meta data base of De Mooij and Ederveen (2003) to assess the difference between the intensive and extensive investment margins to tax on the basis of existing studies.
2
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BUSINESS TAXATION AND FIRM DECISION MARGINS This section discusses five behavioural responses to business taxation. For each decision margin, we provide a short comprehensive review of recent empirical studies, sometimes by referring and extending earlier literature reviews. In discussing empirical studies, we concentrate on effect sizes. The aim is to arrive at a consensus estimate of the semi-elasticity of the total corporate tax base for each of the five margins. The semi-elasticity is defined as
(∂B / ∂τ ) / B , where B denotes the corporate tax base and τ the corporate tax rate. While this gives us a rough idea of the relative size of different behavioural margins, our approach neither does justice to specific circumstances in practice e.g. in certain countries, sectors or times, nor does it take away the uncertainty about effect sizes. Moreover, it only captures partial effects, not taking account (general equilibrium) interactions. The only purpose is to simply translate existing insights from empirical studies into a policy-relevant indicators measuring the size of distortions induced by business taxation.
2.1
Organisational form In most countries, incomes earned in sole proprietorships are subject to the personal income tax. Incomes earned in (closely or widely held) corporations are first subject to corporate income tax and are then possibly taxed again at the personal level via taxes on profit distributions or realized capital gains (whereby sometimes double-tax relief is applied). The different tax treatment of corporate versus non-corporate income creates arbitrage opportunities. Indeed, if corporate income would be taxed lighter than non-corporate income, people would have an incentive to become entrepreneur, while entrepreneurs would have an incentive to incorporate so as to reduce their tax liability. Yet, decisions on legal form of business are not only made on the basis of tax. For instance, some businesses organized in the corporate form may collect substantial non-tax benefits, such as gains from limited liability or the advantage of attracting capital. Others may incur costs from incorporation, e.g. due to capital requirements or legal obligations. Non-tax costs and benefits should therefore be weighed against the net tax advantage of corporate versus noncorporate income. Empirical evidence should guide us on how large the effects of taxation are. A modest literature has explored the impact of taxes on the choice of legal form. Most of these studies use statutory corporate tax and top personal income tax rates as proxies for the tax burden on corporate and non-corporate income. Earlier studies reviewed in e.g. De Mooij and Nicodeme (2008), find that the effects of taxation are small, suggesting that non-tax factors are more important in determining legal form. Most of these studies use time series variation to identify the impact of tax. Goolsbee (2004) criticizes this approach as the variation in tax rates over time is small, making it difficult to properly identify tax effects. Goolsbee (2004) then uses 3
cross-section data for US States and industries in the retail trade sector in 1992. He explores the impact of taxes for several indicators on the size of the corporate sector, including the share of companies, employment and sales. His estimates suggest a larger semi-elasticity of the corporate tax base with respect to the corporate tax rate than earlier studies. In particular, a 1%point increase in the tax differential between the two legal forms would change the share of corporate assets (and hence the corporate tax base) by 0.4%. De Mooij and Nicodeme (2008) use a panel of European data on the corporate share of companies and the corporate share of employment in different European countries between 1997 and 2003. For alternative specifications and indicators, they report an even larger semi-elasticity of the tax base of around − 1.0.3 A semi-elasticity of the total corporate tax base between − 0.4 and − 1 would mean that a 10%-point higher tax rate on corporations ceteris paribus reduces the corporate share of business by between 4% and 10%. Such an erosion, however, is accompanied by an expansion of the personal income tax base. The overall revenue implications for the government will therefore be smaller than the erosion of the corporate tax base suggest. Avoiding arbitrage through the legal for of business requires that the tax difference between alternative legal forms is minimised.
2.2
Corporate financial policy While interest on debt is deductible from the corporate tax base as a cost, the return on equity is generally not. For national investors, the difference in the tax treatment of debt and equity can sometimes be partly compensated by taxes at the personal level. Yet, for international investors there is no such offset. As a result, debt is almost everywhere tax favoured relative to equity. It induces firms to increase their leverage, thereby causing an erosion of the corporate tax base and a distortion in asset portfolios. Recent financial innovations − such as the arrival of hybrid financial products − seem to have increased this financial arbitrage. The question is how large the impact of corporate taxation is on a firms’ financial policy. On the one hand, the optimal source of finance generally depends on various non-tax factors, such as the risk of bankruptcy in case of the high debt ratio, or the importance of financial distress or agency costs. Moreover, thin capitalization rules may put limitations on the use of debt finance. On the other hand, taxes may create a substantial advantage of debt over equity, thereby affecting a firms’ financial policy. A number of studies aim to identify the impact of taxation on the financial leverage of firms. Graham (2003) reviews several studies using time series data and concludes that most studies report only small tax effects. However, an important problem of the earlier empirical literature 3
This effect is still small compared to the evidence in Gordon and Slemrod (2002) who report a semi-elasticity of 3.0 for the
share of personal income in total income. 4
is that identification is difficult in light of the small variation in tax rates over time. More recent studies using cross-section variation between companies typically report larger effects. For instance, Gordon and Lee (2001) exploit the variation in statutory tax rates between small and large companies in the US. Controlling for other factors that possibly explain the difference between a small and large firms, they find that a 1%-point reduction in the corporate tax rate reduces the debt/asset ratio at the margin by 0.36%-point. Thin capitalization also matters for international investment. Headquarters investing in subsidiaries abroad can choose between debt and equity finance. The tax burden on the income earned depends on this choice of finance. When financed by debt, the interest is deductible for the subsidiary in the host country and taxed in the home country of the parent. When financed by equity, the dividend of the subsidiary is taxed at the rate of the host country and repatriated dividends are untaxed in the country of the parent if that country uses an exemption system (which is the case in continental Europe). To minimize the tax liability, a parent company will therefore prefer debt finance for subsidiaries located in high-tax countries and equity finance for subsidiaries in low-tax countries. Recent empirical studies explore the impact of taxation on the financial policies of multinationals, thereby using cross-country variation in tax rates. Altshuler and Grubert (2003) use data on foreign affiliates of US multinationals and estimate the effect of tax rates on the debt/asset ratio. They report a semi-elasticity of − 0.4, i.e. a 1%-point higher tax rate reduces the share of debt by 0.4%. Similarly, Desai et al. (2003) arrive at a semi-elasticity of − 0.25. These elasticities seem of similar size as the response of debt/asset ratios in the national context. Abolishing the discrimination between debt and equity is possible by either allowing a deduction for the cost of equity (as under the allowance for corporate equity) or by disallowing a deduction for the cost of debt (as under the comprehensive business income tax). A semielasticity between − 0.25 and − 0.4 means that, if a corporate tax rate is 30%, removing this discrimination would increase the debt/asset ratio by between 7.5 and 12%-point.
2.3
Multinational profit shifting Across countries, taxable income of a multinational is divided among its affiliates on the basis of separate accounting. It means that the accounts of each affiliate terminate at the border (the water’s edge) and that profits within these borders are taxed according to the rules and the rate of the country where the subsidiary resides. This allocation of profits on the source basis is often arbitrary, however. For instance, where should the multinational allocate shared costs and returns? And how should it value intrafirm deliveries or services? Due to this arbitrariness, multinationals have opportunities to manipulate this allocation and reduce the overall tax liability of the company. Separate accounting indeed allows for international tax arbitrage, which erodes the base of a nation’s corporate tax. 5
One important route for shifting multinational profits is the manipulation of transfer prices. Following the OECD Transfer Pricing Guidelines, transactions between entities of a multinational company in different countries should be traded on the basis of arms-length prices, i.e. prices that would apply to market transactions between unrelated parties. For a number of goods and services, however, there is no outside market. The uniqueness of many intangibles, such as brand names and intellectual property rights, makes it impossible to determine arms-length prices. It leaves the freedom for multinationals to determine their own prices on a discretionary basis. By charging an artificially low price for goods that are transferred from high-tax to low-tax countries, a multinational can reduce its overall tax liability. There is a rapidly growing literature showing that international profit shifting is an important phenomenon with big implications for government revenues. The character of these studies is diverse, which makes it difficult to infer a comparable indicator of the effect size. For the purpose in this paper, we rely on a handful of studies estimating the impact of statutory tax rate differentials on aggregate measures of profitability. The results of these studies are usually interpreted as indirect evidence of profit shifting. The estimates directly measure the quantitative importance of income shifting for the corporate tax base of a country. De Mooij (2005) summarizes these studies and reports that, on average, the reviewed studies yield a semielasticity of the tax base of − 2, i.e. a 1%-point higher corporate income tax rate in a country reduces the reported taxable profits by 2%. This figure suggests that the behavioural response associated with profit shifting is relatively large. It may explain why countries compete aggressively over their corporate tax rates, which caused a steady decline in rates over the last decades (see e.g. Loretz, 2008). As the incentives for profit shifting are driven by international differences in statutory corporate tax rates, the only way to eliminate these arbitrage opportunities is through international cooperation, e.g. by introducing a common (minimum) tax rate.
2.4
Aggregate investment Neo-classical theory suggests that investment is driven by the Jorgenson concept of the cost of capital. The idea is that firms accumulate capital as long as the return to investment exceeds the cost of finance and depreciation. Due to decreasing returns to scale, there is a marginal project that just breaks even, i.e. which earns a return that precisely matches the cost. In the presence of taxation, the pre-tax rate of return on the marginal investment project is defined as the cost of capital. To determine the effect of corporate taxes on investment, we need to asses: (i) the impact of the corporate tax on the cost of capital; (ii) the impact of the cost of capital on investment. The first effect depends on the initial corporate tax system and can be illustrated by a simple 6
example. Assuming equity-financed investment, the cost of capital (c) depends on the corporate tax (τ) in the following way
c=
1 − τA (r + δ ) 1 −τ
(2.1)
where A denotes the net present value of tax allowances in percent of the cost of an investment and r+δ is the pre-tax cost of capital. This expression shows that the corporate tax rate exerts no effect on the cost of capital if A = 1, which is the case under an allowance for corporate equity or a cash-flow tax. Intuitively, these systems turns the corporate tax effectively into a nondistortionary rent tax. With smaller tax allowances (i.e. A < 1), corporate taxes raise the cost of capital. On the second effect, there are two strands of empirical literature. One directly estimates the elasticity of the cost of capital on investment. Hassett and Hubbard (2002) review this literature and conclude that an elasticity between − 0.5 and − 1.0 is a good reflection of it. Alternatively, one can divide the substitution elasticity between labour and capital by the labour income share in production to infer the investment elasticity of the cost of capital indirectly. Chirinko (2002) provides a careful assessment of this empirical literature and concludes that a value between 0.4 and 0.7 is most plausible for the substitution elasticity. Assuming a labour income share of 80%, we again obtain an elasticity of investment to the cost of capital between − 0.5 and − 1. For our purpose, we need to determine the size of the impact of the corporate tax on the cost of capital. Instead of the corporate tax rate, we measure this impact by the effective marginal tax rate (EMTR). It is defined as the difference in the cost of capital in the presence and in the absence of tax, in percentage of the pre-tax cost of capital, i.e. EMTR = (c− r− δ)/c. Hence, as long as the corporate tax raises the cost of capital in (2.1), the EMTR is positive. The EMTR is a summary indicator measuring how distortionary the corporate tax system is for marginal investment decisions. From the definition, we can now derive for the semi-elasticity of investment (I) with respect to the EMTR. ∆Log ( I ) = α∆Log (c) =
α 1 − EMTR
∆EMTR
(2.2)
where α stands for the investment elasticity of the cost of capital (i.e. the value between − ½ and − 1). A number of studies have computed EMTRs using information from tax codes. They usually report positive values for equity-financed investment but negative values for debtfinanced investment, which is due to the deductibility of nominal interest. Hence, the corporate tax provides a net subsidy to investment financed by debt. The weighted average of the EMTRs is usually reported to be positive, however, indicating that the corporate tax system reduces 7
investment on balance. Its value is generally small, however. For an EMTR of say 10%, the semi-elasticity of investment to the EMTR lies in the range of − 0.55 to − 1.1. These investments only earn a marginal return, however, no economic profit. To the extent that the corporate tax base consists of economic rents, a 1% increase in capital yields a smaller than 1% increase in the corporate tax base. For instance, if (quasi)rents would constitute half of the corporate tax base, the semi-elasticity of the corporate tax base via the channel of marginal investments would be halved to a range between − 0.3 and − 0.6. Apart from marginal investment decisions, capital formation may be affected by a firm’s internal funds in the presence of liquidity constraints. Such constraints may arise from asymmetric information between creditors and investors. Indeed, banks usually have less information than firms about the chance that an investment project will yield a sufficiently high rate of return. Banks will then be reluctant to provide credit. This applies in particular to new and innovative firms who do not yet have a reputation. These firms therefore rely on retained earnings (or venture capital) as a source of finance for new investments. A lower average tax burden on these firms will relax credit constraints by improving their own liquidity position and allow them to finance increase investment. Empirical evidence provides support for the positive impact of net internal funds on investments (see Hubbard, 1997, for an overview). Given the limited number of studies and the large diversity of approaches, we are not able to present a consensus elasticity of the tax base for this channel.
2.5
Foreign investment Foreign investment is part of total investment, which we discussed in the previous subsection. There are some special features, however, that relate in particular to foreign capital and not domestic capital. This subsection therefore pays special attention to the impact of taxes on foreign investment. There are two alternative views on how corporate tax policies affect cross-border investment. The first view is the neoclassical approach, which follows the same logic as section 2.4. Assuming that capital is mobile across countries, investors will seek the most profitable investment opportunities across the globe. This ultimately equalizes the after-tax rates of return in all locations. The relevant tax for investors in deciding about the size of their foreign direct investment (FDI) is then the EMTR. It applies to, for instance, multinationals that have already established foreign subsidiaries and who decide on how much to invest in each of these locations. The second view considers discrete location choices. It may apply, for instance, to investments that are lumpy. Alternatively, it can be relevant for multinationals that earn a firmspecific economic rent. For instance, (quasi) rents associated with patents, brand names, knowhow or market power are typically mobile across borders. A firm earning such a rent can decide 8
on the location of its plants based on the total tax bill. For this decision, the average effective tax rate (EATR) on corporate income matters, not the EMTR. Indeed, the higher is the tax burden on the income earned in a location, the lower is the probability that a firm will locate its plant. These alternative theories are not necessarily conflicting. Indeed, firms may first decide on the location of their plants and then, conditional on location, determine the amount of investment. For the first choice, the EATR matters; for the second choice the EMTR matters. It leaves open the question what we can say about the most relevant decision margin. How sensitive are the intensive and extensive investment margins to corporate tax? Which part of the corporate tax system (and, therefore, which indicator of tax) induces the largest behavioural effects? Empirical evidence should guide us to the most likely answers. We discuss this in section 3.
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INTENSIVE AND EXTENSIVE MARGINS OF FOREIGN INVESTMENT There is a large literature exploring the impact of corporate taxes on international capital flows. The typical study in this literature regresses a measure of the company tax burden on a measure of foreign capital flows or stocks, thereby controlling for other factors that affect investment. Surveys by Hines (1999), Devereux and Griffith (2002) and De Mooij and Ederveen (2003) conclude that according to most of this literature, company taxes have a significantly effect on foreign investment. The literature is heterogeneous in a number of respects. First, studies adopt alternative measures of capital: some use aggregate data on FDI (time series, cross section and panels), others rely on measures for property, plant and equipment (mainly US investment abroad), and again others adopt count data on the number of foreign locations. Second, studies use different measures of the tax burden: some use statutory corporate tax rates (sometimes for US states on inward investment), others rely on the EMTR, the EATR, or average tax burdens computed from micro or macro data. Finally, studies differ in their way of identifying the tax effect on investment. For instance, some consider the tax regime in the country where the parent company resides (credit or exemption), studies differ in the control variables they use, and researchers use different theoretical specifications and econometric methodologies. This section uses previous empirical findings to assess the most relevant decision margin for international firms, i.e. marginal investment versus discrete location. To that end, we use a previously constructed meta sample on the semi-elasticity of foreign investment (De Mooij and Ederveen, 2003). The sample is a collection of 351 estimates originating from 25 different studies in the literature. The semi-elasticities reflect a uniformly defined indicator for the effect size and measure the percentage change in foreign capital in response to a 1%-point change in 9
the tax rate. Apart from the semi-elasticity, the meta data base contains information about the underlying primary studies, such as the type of capital data and the type of tax indicator used. De Mooij and Ederveen (2003) explain the systematic variation in study outcomes on the basis of a large variety of study characteristics. 4 This paper extends that previous meta analysis in two directions. First, we add six recent studies to the sample. Second, we concentrate on a particular classification of studies regarding the use of capital data and the use of tax indicators. This aims to shed light on the differences in effect size for location choice versus marginal investment choice.
3.1
The meta data base Appendix A summarizes how we constructed our meta database. It describes the methodology followed in De Mooij and Ederveen (2003) and adds information from another six studies. Overall, the new meta sample contains 449 observations for the semi-elasticity of foreign investment. As in the previous study, we removed outliers that are outside the range of plus and minus two times the standard deviation from the mean. It leaves us with a sample of 437 observations. Figure 1 shows the distribution of semi-elasticities in this new meta sample, where the x-axis shows intervals of values for the semi-elasticity and the y-axis shows the number of observations in each of these intervals.
Figure 1
Distribution of semi-elasticities in the entire meta sample
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Series: SEMI_ELASTICITY Sample 1 500 IF (DUBIOUS=0) AND ((Y2>(@MEAN (Y2,"1 500 if dubious = 0")-2*@STDEV(Y2,"1 500 if dubious = 0")) AND Y2(@MEAN (Y2,"1 500 if dubious = 0")-2*@STDEV(Y2,"1 500 if dubious = 0")) AND Y2
