Higher Taxes and Their Impact on Investment: Evidence from European Countries

Companies differ in many respects. There are scores of small companies but just a few big ones. While ownership is concentrated in the case of entrepreneur-led businesses, ownership structures are typically fragmented in the case of big, manager-led businesses¹. Given these differences, it may be assumed that different companies respond differently to tax charges.

With corporate taxation affecting some companies more than others, dissimilarity between companies plays an important role for political decision-makers. Most countries therefore offer R&D tax incentives to encourage innovation and growth.

Fiscal policy should support capital transfers

As a rule, financial bottlenecks are experienced by young, innovative companies where high investment and financing needs go hand in hand with low equity. Such companies tend to generate higher returns on capital. Big, well-funded businesses obviously do not face these problems and may even suffer due to over-investment. Instead of uniform treatment for all companies, fiscal policy should support the transfer of capital from less profitable to more profitable enterprises, encourage dividend distributions in big companies and grant small, fast-growing companies selective tax incentives. By definition, specific approaches would result in different treatment of different companies in all of these cases.

This study has developed an analytic framework which systematically correlates companies’ investments with their organisational and financial framework conditions. Analysis shows that entrepreneur-led companies and manager-led companies operate within very different financial parameters and that both groups are also heterogeneous in themselves due to different ratios of equity to investment needs.

The results of the study are based on a panel of 35,092 enterprises in 17 European countries and cover the period 2004 to 2012. Graph 2 shows that, on an empirical basis, investment always depends on equity, albeit to a different extent. Theoretical analysis implies that even well-funded companies which encounter no problems in financing investments and taking out debt capital are slightly restricted due to fiscal reasons. By contrast, the impact of an even higher liquidity ratio on fiscally restricted, entrepreneur-led companies is more than twice as high. Furthermore, a severely restricted group was identified which not only pays no dividends but has also exhausted its capacity to take out additional debt capital.