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Corporate taxes and investment when firms are internationally mobile

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Abstract

In this paper, we analyse the passthrough from corporate taxes to investments by including two novel channels into a DSGE model for a small open economy. We capture both how foreign firms relocate and invest in the country when corporate taxes are reduced and how the inflow of FDI increases exports which spills over to domestic firms, that then increase their investment further. Our extended model allows us to study the importance of both transmission mechanisms and how they interact through crowding out effects. The corporate tax cut becomes self-financed when FDI-export spillovers are included, but only if other countries do not follow suit and lower their corporate tax rates. The largest self-financing contributions come from increases in various labor and consumption tax bases. A reduction in profit shifting further contributes to financing the tax cut. Our findings suggest that corporate tax levels internationally are not in equilibrium and that there are large fiscal incentives to further cut corporate taxes and reap the benefits from increased tax bases.

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Notes

  1. DSGE models often assume, for simplicity, that households invest in fixed capital that they subsequently rent out to firms. Our more realistic depiction of the investment process allows us to describe the effect of tax changes on investment more accurately. Note also that housing investment is exogenous and not affected by corporate tax rates.

  2. We do not take account of the issuance of new equity, as underwriting commissions and other fees tend to make issuance a more costly alternative than retained earnings or debt (Alstadsæter & Fjærli, 2009).

  3. For details, see Aursland et al. (2019). An important purpose of this setup, which builds on the so-called main course theory developed by Aukrust (1977), is to preserve the competitiveness of the exposed sector and to ensure a high level of employment.

  4. This is in line with Norway’s Allowance of Shareholder Tax system as the model is calibrated to Norway. However, this has no significant bearing on the results of this study.

  5. Note that these fixed mobility costs could be negative, implying a ceteris paribus benefit of producing abroad.

  6. Note that this assumption is motivated by numerical convenience rather than empirical fact but involves no loss of generality. Any initial steady-state allocation of firm location could be calibrated without changing our results. The key calibration moment, as will be shown later, is the range of fixed mobility costs across firms.

  7. This assumption is a slight relaxation of the assumption in Becker and Fuest (2011), where all firms are owned by domestic households. They show, however, that a symmetric setup with locals and foreigners holding shares in both domestic and foreign firms does not change the result in any important way.

  8. The assumption of the nature of the distribution has no important implications for our results since it is the sensitivity of the number of firms locating abroad to a given tax rate change that drives our result. This elasticity will be calibrated to match an empirical target; see the calibration Sect. 3.

  9. The corporate tax rate abroad, \(\tau ^F_t\), is calibrated such that it implicitly captures capital depreciation allowances; see the calibration section. Thus, we do not explicitly model capital depreciation allowances, as opposed to the case of domestic firms; see Sect. 2.3.

  10. We assume that the foreign real interest rate is fixed. However, the results remain practically unchanged even if we impose the movements of the domestic real interest rate on the interest rate abroad.

  11. We set the center of the interval, a, to the steady-state value of the threshold mobility cost, i.e. \(a={\widetilde{c}}_{ss}\), thereby ensuring that in steady state the threshold mobility cost exactly halves the interval \([(1 - b) a, (1 + b) a]\). In this way, \(n^D\) is set at 1 in the steady state as described above.

  12. To see this, consider the two extreme cases: When \({\widetilde{c}}\) is at its lowest possible value, namely \((1-b)a\), zero firms will locate abroad as none has a lower fixed cost than the threshold value. If, on the other hand, the threshold value equals the maximum value of the interval, namely \((1+b)a\), then all firms in \(i \in [0,2]\) locate abroad.

  13. In theory, FDI could potentially also spill over to technology as discussed e.g. by Borensztein et al. (1998) and Smarzynska Javorcik (2004). However, we have not included this channel as the empirical evidence suggests that the productivity spillover (if any, see Görg and Strobl, 2001) would only affect a narrow category of firms, which yields a very small change in aggregate productivity (see Alfaro et al., 2004).

  14. Note that taking the logarithms of both sides of equation 6 yields \(\ln X_t \approx \ln Y_t^{TP} - \eta _{TP}\ln P_t^x + \xi _X(n_t^D-1)\), which roughly corresponds to Equation 3 in O’Sullivan (1993).

  15. If \(\xi _X=1\), then export demand simply increases linearly with the number of domestic firms. If \(\xi _X>1\), as will be the case in our calibration, firms relocating to the home country tend to be more export-oriented than those already in. Conversely, firms that are more export-oriented tend to leave the country first in the case of corporate tax hikes. Note that we have numerically checked that export demand cannot become negative for a realistic calibration and tax shock size.

  16. The firm payments associated with the risk premium, i.e. the debt servicing costs in excess of the bank’s lending rate, are assumed to be redistributed in a lump-sum fashion to the Ricardian household.

  17. Note that Eq. (12) represents profits after interest payments, which in accounting is typically referred to as earnings before income taxes (EBT).

  18. Note that some models abstract from tracking the cost basis of capital stock for tax purposes and instead apply the tax depreciation rate to the productive capital stock. If the tax depreciation rate is higher (lower) than the economic depreciation rate, such an approximation would overestimate (underestimate) the value of future depreciation allowances and bias the effect of the depreciation channel, which is discussed later.

  19. A more intuitive way of expressing the equation for cost basis of capital is \(K^{\tau ,NOM}_{t+1} = P_t P^I_t I_t + (1-\delta _\tau ) K^{\tau ,NOM}_t\), where \(K^{\tau ,NOM}_t = P_t K^{\tau }_t\) is the nominal cost-basis of capital stock for tax purposes. Thus, the nominal value of the capital stock accumulates with the nominal value of investments. However, since the whole model uses the CPI as its numeraire, we keep track only of the taxable capital stock deflated by the CPI. This, however, has no bearing on our results.

  20. Note that the cost of equity financing usually captured by \(\frac{r }{1-\tau }\), is expressed in nominal terms here as also the right-hand side, the cost of debt, is given in nominal terms.

  21. Consider an investment project that is solely financed by retained earnings. This would lead to a fall in the debt-to-capital-ratio \(b_t\) as the capital stock increases, while debt levels remain constant. This, in turn, would lower the cost of borrowing below the cost of equity and the firm would thus not minimize its cost of funding. Conversely, an investment project solely financed by debt would bring the profit-maximizing condition (15) out of balance by increasing the cost of borrowing beyond the cost of equity. Marginal investment is thus always going to be financed partly by debt and partly by equity, thereby preserving the equality of the respective marginal funding costs.

  22. Hypothetically, one could also construct a model in which marginal investment is financed by debt only so that a reduction in corporate taxes would not affect investment decisions. However, we have opted for the more realistic option of allowing both financing channels to play a role, with the firm being able to choose optimally between them.

  23. The model is calibrated to the Norwegian mainland economy at the quarterly frequency in a two-step procedure. First, a subset of the parameters that determine the steady state are chosen such that the model’s deterministic steady state replicates a number of long-run empirical moments, while the remaining steady-state parameters are set either according to microeconomic evidence or by following related models. Second, we chose values for the parameters, which only affect the dynamic behaviour of the model, in order to obtain a good match with VAR studies on the Norwegian business cycle. The full set of model parameters is summarized in Appendix B.3.

  24. Note that this measure implicitly captures country-specific allowance rules for capital depreciation so that we refrain from explicitly modelling allowance rules abroad.

  25. \(A^F\) only governs the scale of output of those firms that could potentially move to Norway, not of all firms in the global economy. In contrast, the size of the total global economy is assumed to be considerably larger than Norway’s, in line with our small open economy assumption.

  26. There is considerable uncertainty in both factors. Measured in terms of foreign direct investment relative to overall investment, the share of internationally mobile capital in Norway is roughly 15%, while based on foreign ownership data, the share would come to well over 20%. The Swedish Ministry of Finance has used an estimate of 25 %. Choosing a middle- way strategy, we follow Mooij and Ederveen (2008) and choose − 0.65 as our target.

  27. Given our calibration, about 15% of those firms that eventually move, do so within one year of a change in corporate taxation.

  28. The countries are Albania, Argentina, Australia, Austria, Belgium, Brazil, Bulgaria, Canada, Chile, China, Colombia, Costa Rica, Croatia, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hong Kong, Hungary, Iceland, India, Indonesia, Ireland, Israel, Italy, Japan, Korea, Latvia, Lithuania, Luxembourg, Malta, Mexico, Netherlands, New Zealand, North Macedonia, Norway, Poland, Portugal, Romania, Russia, Saudi Arabia, Serbia, Singapore, Slovak Republic, Slovenia, South Africa, Spain, Sweden, Switzerland, Turkey, UK and USA.

  29. Further information about the VAR estimates is available in Appendix, Section E. Appendix also considers a multivariate VAR as a robustness check.

  30. The initial corporate tax rate 28% follows from the calibration and corresponds to the tax rate in Norway before the 2014–2019 tax reform. The sensitivity analysis in section C considers, however, different starting levels for the corporate tax rate.

  31. Total investment is given by \(n^D_t I_t\). We measure the intensive margin as the change in \(I_t\) (investment per firm in the home country) and the extensive margin as the change in \(n^D_t\) (number of firms located in the home country).

  32. The details in this regard are not important for the results and only affect the initial response of foreign investment. We assume that 20% of the initial capital stock is produced using domestic resources, and the rest is transferred or bought from abroad using the existing real capital or proceeds thereof.

  33. The long-run intensive margin response is considerably smaller than the partial equilibrium estimate in Mooij and Ederveen (2008). One reason to that is that the after-tax market interest rate depends on equity premium, which in turn decreases with the increasing corporate tax rate. That effect is relevant also in the absence of firm relocation. Another important effect is that the foreign investment crowds out a significant part of the domestic investment response. This intensive margin general equilibrium effect is elaborated further in Sect. 5.2.

  34. The benefit to shareholders is measured as the long-run increase in total (domestic and foreign) dividends. The benefit to the employed is calculated as the long-run aggregate increase in the wage bill among those who had already been employed pre-reform. The benefit to the unemployed and those outside the labor force is calculated as the change in their aggregate labor/transfer income. The total effect of the tax relief is then defined as the sum of all three effects. For the model without location decisions, the corporate tax incidence is quite different: 81% of the total tax relief goes to firms, while only 15% goes to domestic workers, and 4% to domestic unemployed.

  35. The studies include Arulampalam et al. (2012), Felix (2007), Gravelle and Smetters (2006), Harberger (2008), Hassett and Mathur (2006), Mutti and Grubert (1985), Randolph (2006), and Fuest et al. (2018) see Table 13.15 in NOU (2014) for an overview.

  36. See Appendix A.5 in Annex for further discussion about the government budget constraint.

  37. These follow from small changes in prices, the interest rate and the unemployment level.

  38. In these models, business taxation is proxied through a capital tax (only), which applies to the capital stock of the firm. Sørensen (2014) states that a rise in the effective capital tax rate could be implemented by a rise in corporate income tax or broadening of the respective tax base.

  39. The contribution from firm relocation is 0.08 percentage of GDP, and the contribution from profit shifting is from 0.01 to 0.04 percentage of GDP depending whether we use the estimate of tax base elasticitity of profit shifting from Heckemeyer and Overesch (2017) or Mooij and Ederveen (2008), respectively.

  40. The Laffer curve shows the long-run relationship between tax rates and revenue.

  41. In the absence of a corporate tax cut, there is a balance-neutral budget. To isolate the effects coming from the corporate tax cut, we assume any surplus or deficit caused by the tax cut is not met by any other tax adjustments, see Appendix A.5 for details.

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Acknowledgements

The views expressed in this paper are those of the authors and do not necessarily represent those of Statistics Norway, the Norwegian Ministry of Finance, Deutsche Bundesbank or the Eurosystem. We are grateful to Thor Andreas Aursland, Nina Bjerkedal, Geir Bjertnæs, Brita Bye, Yngvar Dyvi, Håkon Frede Foss, Frode Olav Finsås, Inga Heiland, Kristine Høegh-Omdal, Erling Holmøy, Birol Kanik, Thomas Klev, Terje Skjerpen, Thor Olav Thoresen, Håkon Tretvoll, two anonymoys referees, and seminar participants at the Norwegian Ministry of Finance for helpful comments and discussions. The responsibility for any errors lies entirely with us.

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  1. Statistics Norway, Postboks 2633 St. Hanshaugen, 0131, Oslo, Norway

    Thomas von Brasch

  2. Norwegian Ministry of Finance, Postboks 8008 Dep., 0030, Oslo, Norway

    Ivan Frankovic & Eero Tölö

  3. Deutsche Bundesbank, Wilhelm-Epstein-Straße 14, 60431, Frankfurt, Germany

    Ivan Frankovic

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von Brasch, T., Frankovic, I. & Tölö, E. Corporate taxes and investment when firms are internationally mobile. Int Tax Public Finance 30, 1297–1330 (2023). https://doi.org/10.1007/s10797-022-09748-8

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