The Impact of Corporate Taxes on Investment - An Explanatory Empirical Analysis for Interested Practitioners

Investment behavior is influenced by corporate taxation. High taxes hinder investment, whereas low tax rates favor it, especially within a context of cross- border direct investment. This claim is backed by a broad array of highly credible scientific literature. Nevertheless, in the public debate of tax practitioners, it can by no means be considered part of the common consensus. Whilst focusing on other determinants of direct investment sometimes any relevance of the taxation factor is denied. This paper has two overall goals: first, to empirically work out the effect of taxes on investment behavior and second, to document which requirements need to be fulfilled to arrive at a sound conclusion.

The applied Microdatabase Direct Investment (MiDi) by the German Federal Bank covers the direct investment development of German parent companies abroad and that of foreign parent companies in Germany. The paper is structured in a mirror image style covering both of these investment directions. The timeline in question consists of 13 years and ranges from 1996 to 2008. The paper considers firm heterogeneity regarding their respective profit and loss histories and additionally analyzes the tax incentive to establish holding companies. As a robustness check, findings on Germany as a whole are supplemented by a subsample of the strongly export orientated federal state Baden-Württemberg.

The descriptive analysis shows the rapid growth of both inbound and outbound international investment activity in the observed period from 1996 to 2008. The development of Baden- Württemberg corporations has largely been the same as that of Germany as a whole. Since estimations require a minimum amount of variation and different comparison groups, proving the tax rate effect on investment here is only possible in the outbound case, but not in the inbound case.

From the outbound case, I conclude that a by 10 percentage points increased corporate tax rate causes a 5.32% reduction in investment, measured by fixed assets. Accordingly, a by 10 percentage points lower corporate tax rate leads to about 5% higher investments. In a second step, I find empirical evidence that companies with an existing loss carryforward are less concerned with tax rates in their investment decisions. About half of the negative tax rate effect is compensated for firms with an existing loss carryforward. For firms with loss carryforwards, a tax rate increase of ten percentage points therefore only leads to a reduction in investment by 2.54%.

The third step extends the empirical analysis into the research field concerned with corporations’ structures. Especially holding companies are set up by multinational corporations in tax favorable destinations in order for investments to be able to be structured optimally regarding tax. A decrease of ten percentage points in a country’s corporate tax rate causes an increase in the share of holding companies in all subsidiaries in that location by 0.55%. The effect is even stronger regarding withholding taxes. A ten percentage point decrease in withholding taxes causes an increase of 0.80% in holding companies relative to all kinds of subsidiaries.

Dreßler, Daniel (2012), The Impact of Corporate Taxes on Investment - An Explanatory Empirical Analysis for Interested Practitioners, ZEW Discussion Paper No. 12-040, Mannheim.