Restricting the Tax Deductibility of Interest Is Bad for Investment
ResearchRestricting the tax deductibility of interest expenses will result in a markedly lower degree of indebtedness of multinational corporations, thus raising taxable profits. At the same time, however, companies’ investment decisions react much more sensitively to tax rates at locations that restrict the deductibility of interest for tax purposes. This is shown by empirical research, based on comprehensive data on German foreign direct investment, that was jointly conducted by researchers at the Ifo Institute, Munich and the Centre for European Economic Research, Mannheim.
The effects demonstrated in the study are of importance for the impending reform of German company taxation. The Federal Government is considering to extend existing restrictions on the tax deductibility of interest expenses. Restricting the interest deductions in Germany, however, may well have negative effects on the investment of domestic companies.
The study, conducted with balance sheet data of foreign affiliates of German multinationals provided by the Deutsche Bundesbank, investigates the effect of corporation taxes and restrictions on debt financing at various locations on the debt financing and investment of foreign affiliates. The findings confirm that a high tax rate coincides with higher indebtedness and reduced investment. Limits on the tax deductibility of interest expenses have the effect that affiliates in the countries concerned employ less debt financing. At the same time, investment of the affiliates is shown to display much greater tax sensitivity. The increased tax sensitivity of investment results from the higher costs of investment financing, as the company must now also earn the taxes on previously tax-exempt value-added components.
In summary, the restrictions on interest deductions considered in the context of the company tax reform may not only have undesirable consequences on the willingness to invest and thus on growth. Rather, these negative real effects also jeopardise the higher volume of profit tax revenue the Federal Government is hoping to achieve with this measure.
Contact
Prof. Dr. Thiess Büttner, Phone: +49/89/9224-1319, E-mail: buettner@ifo.de