The impact of enterprise income tax on firm investment

What is it about?

How to stimulate enterprise investment is a dilemma facing most countries, and tax incentives are frequently used as a solution. The importance of tax incentives for the fixed asset investment of enterprises has attracted much attention in previous literature. This study re-examines the impact of the effective enterprise income tax rate on fixed asset investment of enterprises and presents new empirical evidence based on the administrative structure of China. Using enterprise-level data from the ASIE, this paper exploits China's Income Tax Revenue Sharing Reform in 2002 as a quasi-natural experiment to recheck the impact of effective enterprise income tax rate on fixed asset investment by RD design. This paper makes several contributions to our understanding of the impact of tax incentives on fixed asset investment in developing countries, from the perspective of China. First, the reform effectively changes tax collection. The Income Tax Revenue Sharing Reform in 2002 reduced the effective tax rate of post-reform founded enterprises by 11%. This result is robust to a series of robustness checks on the identifying assumption. Second, ETR has a consistently negative and significant (statistically and economically) impact on fixed asset investment. Specifically, fixed asset investment improves by 0.7% for every 1% decrease in ETR. Third, tax avoidance is an important channel through which effective tax rate affects fixed asset investment. Our paper provides suggestive evidence that a low effective tax rate can stimulate enterprises' fixed asset investment by easing internal financial constraints by decreasing tax avoidance activities. Last but not least, the reform reduces the effective tax rate for domestic enterprises, irrespective of their ownership or enterprise scale. Nonetheless, the impact of the effective tax rate on enterprises' fixed asset investment depends on several factors. The results show that enterprises' fixed asset investment can be weakened if the enterprise is a local SOE, relatively large and with a low SA index.

Featured Image

Why is it important?

The importance of clarifying the effect of EIT incentives on FAI is self-evident. First, when global economic growth slows down, it is a popular option for governments to use tax incentives to stimulate enterprises' investment behavior in the short term. The Trump administration in the US is a typical example. As soon as Donald Trump took office in 2017, he immediately imposed an unprecedented tax reform plan. What followed was a wave of tax cuts around the world (Hannon, 2017). This seismic wave of government-driven tax incentives aims to stimulate domestic economic recovery and enterprises' investment behavior. Although EIT incentives are adopted by governments around the world to stimulate domestic investment and attract foreign investment, the outcomes remain unknown. Meanwhile, we should take into account the costs of implementing tax incentives. When countries adopt EIT incentives to stimulate investment, they also have to bear the huge fiscal pressure caused by the policies. Therefore, we must carefully treat the role of EIT incentives in stimulating enterprise investment, figure out the relationship between effective EIT rate and fixed asset investment, and be able to achieve the goal of boosting the economy by using EIT incentives properly. Second, although a large amount of literature has studied the effect of EIT incentives on fixed asset investment based on different countries' data, they did not reach a unanimous conclusion. Because the existing literature's conclusions are inconsistent on the effect of EIT incentives in stimulating fixed asset investment, we would like to recheck how the EIT incentives influence enterprises' fixed asset investment under the administrative structure of the world’s largest developing country, China.

Perspectives