Corporate Taxes and Investment

The net cost of the government equals the change of tax revenues plus the additional revenue changes via the behavioral response.

A one percentage point reduction in the local business tax reduces the tax burden of the median firm and thus overall tax revenues by €19,800.

As tax cuts increase firm investment, future firm profits should also increase, resulting in higher tax revenues of the municipalities. The median investment-revenue ratio amounts to 3% in the microdata of the ifo Investment Survey. Hence, the median firm invests approximately €1.4 million each year. Given an estimated semi-elasticity of 3, a one percentage point decrease in the local business tax is associated with an increase in investment of the median firm by roughly €42,000.

The paper calculates the behavioral response separately for reasonable lower and upper bounds of the elasticity of firms’ profits with respect to changes in investment, i.e., assuming that increased investment maps into increased future profits with half of the median profit margin (2.2%) or with five times the median profit margin (22%). For the median firm that increases investment by €42,000, this translates into higher profits between €924 and €9,240. As the average local business tax rate is approximately 15%, this leads to an increase in tax revenues between €139 and €1,386.

The estimated upper margin on net costs is then €19,800 – €139, the lower margin is €19,800 – €1,386, and the average is €19,038.

Firms are the beneficiaries and their willingness to pay is equal to €19,800 (the change of the tax burden). The net cost of the government equals the change of tax revenues plus the additional revenue changes via the behavioral response (€139 to €1,386). Given this, the paper estimates an MVPF in the range between 1.01 and 1.08 (average = 1.04).

The paper notes that, as investment is not the only margin of adjustment through which firms may respond to changes in the local business tax, the true MVPF is likely to be larger.