Post on 15-Aug-2020
Small Business Incorporation and Investment:The Role of Corporation Tax
Michael Devereux and Li Liu
Centre for Business Taxation, University of Oxford
Public Economics UK, University of BristolMay 7-8, 2014
Devereux and Liu (Oxford) Small Business Incorporation 8/5 1 / 25
Motivation:Why Do Small Businesses Incorporate?
Limited liability?
Separation of ownership and control?
Devereux and Liu (Oxford) Small Business Incorporation 8/5 2 / 25
Motivation:Why Do Small Businesses Incorporate?
Limited liability?
Separation of ownership and control?
Devereux and Liu (Oxford) Small Business Incorporation 8/5 2 / 25
Number of Businesses in the UK, By Employment
0 1,000,000 2,000,000 3,000,000
Sole proprietorships
Partnerships
Companies
0 employees 19 employees1099 employees 100 or more employees
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Why Do Small Businesses Incorporate?
Limited liability?
Separation of ownership and control?
Better access to external finance for more investment?
Information for lenders better if incorporated, and improves over time
Lower tax
Devereux and Liu (Oxford) Small Business Incorporation 8/5 4 / 25
What is the Role of Corporation Tax?
Lower CT induces firms to incorporate conditional on personal tax
Lower CT increases post-tax cash flow for companies and allowsfinancially-constrained companies to invest more
Lower CT reduces cost of capital for companies and provides greaterincentive to invest
Devereux and Liu (Oxford) Small Business Incorporation 8/5 5 / 25
Our empirical approach
Use population of UK corporation tax records in 2001/02 - 2008/09
so data only on corporations, not unincorporated businesses
Explore the UK 2006 abolition of zero starting rate as a quasi-naturalexperiment
examine effect on incorporation, andeffect on investment, via cost of capital and cash flow
Devereux and Liu (Oxford) Small Business Incorporation 8/5 6 / 25
Results
Estimate a significant positive effect of tax savings to incorporationOn average, a 1 percentage point increase in tax saving raises probability ofincorporation by 2% to 4%
Estimate effects of CT on investment by companies through 2 channels:
a higher user cost of capital, anda reduction in internal cash flow available for investment
Effects of cash flow diminish with company age
Devereux and Liu (Oxford) Small Business Incorporation 8/5 7 / 25
Some Existing Literature
Corporate Investment and Financial ConstraintsTheoretical models of capital markets with asymmetric information: e. g.Stiglitz and Weiss (1981), and Myers and Majluf (1984)Empirical literature: Fazzari, Hubbard and Peterson (1988), Bond andMeghir (1994), Bond and Van Reenen (2007)
Taxes, Risk Taking and EntrepreneurshipMackie-Mason and Gordon (2002), Cullen and Gordon (2007)
Taxes and the Choice of Organizational FormGoolsbee (2004), de Mooij and Nicodeme (2008), Da Rin et al. (2011),Elschner (2013) and Liu (2014)
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Basic Setup with Corporation Tax
+TC oC i n t
+Te x tC o C
+Tunince x tC o C ,
fl o wc a sh
e x te r n a lin te r n a lI
AI
AM P
C oC
Devereux and Liu (Oxford) Small Business Incorporation 8/5 9 / 25
Following a Decrease in the Corporation Tax
e xt e r n a li nt e r n a l
fl o wc a shn e tH ig h e r e xt e r n al
AM P
C oC
+TC oC i n t
n e wTe x t
C o C ,+
+Tunince x tC o C ,
n e wTC o C
,i n t
+
IAI
Devereux and Liu (Oxford) Small Business Incorporation 8/5 10 / 25
Data
Population of UK corporate tax returns (CT600), 2001/02 to 2008/0910.7 million observations for 2.5 million companiesDetailed and precise information on taxable profits and how they aredetermined
Around 90% of the tax records matched with company accounts in FAME
Year of Incorporation: FAMEInvestment: qualifying expenditure on machinery and plant, including
qualifying expenditure for FYA (CT600, Box 118),
long-life assets and integral features (Box 120), and
other machinery and plant (Box 121).
Devereux and Liu (Oxford) Small Business Incorporation 8/5 11 / 25
Policy Reform to the Zero Starting Rate: Marginal TaxRate in 2002/03
0.1
.2.3
.4.5
0 20k 40k 60k 80k 100k 120k 140kTaxable Income
Retained Earnings SelfEmployment IncomeDevereux and Liu (Oxford) Small Business Incorporation 8/5 12 / 25
Zero Starting Rate Abolished in 2006/07
0.1
.2.3
.4
0 20k 40k 60k 80k 100k 120k 140kTaxable Income
Retained Earnings SelfEmployment Income
Devereux and Liu (Oxford) Small Business Incorporation 8/5 13 / 25
Tax Gains to Incorporate: Retained Profit
Tax Gains to Incorporate (%): Average Tax RateSelf-Employment Income -Average Tax RateCorporate Profit
20
10
0
10
20
Tax
Gai
ns to
Inco
rpor
ate:
Ret
aine
d Pr
ofit
0 20 40 60 80 100Corporate Taxable Profit (£1,000)
2002/032003/04 2006/072007/08
Devereux and Liu (Oxford) Small Business Incorporation 8/5 14 / 25
Number of Newly Incorporated Firms
0
10000
20000
30000
Num
ber o
f New
Com
pani
es
0 20 40 60 80 100Corporate Taxable Profit (£1,000)
2002/032003/04 2006/072007/08Devereux and Liu (Oxford) Small Business Incorporation 8/5 15 / 25
The Causal Effect of Tax Incentives on Incorporation
E (cit|Tax_Gainit,Xit) = exp (γi + λt + βtaxTax_Gainit + Xitβx)
cit : number of newly incorporated businesses in income bin i of £100 attime tγi : income bin dummiesλt : time dummiesTax_Gainit : the difference between average tax rate for observedcorporate profit, and the corresponding average tax rate if the corporateprofit were earned as self-employment incomeXit : other observed firm characteristics that may matter for incorporationAssociated error term can be additive or multiplicative depending onfunctional form
Devereux and Liu (Oxford) Small Business Incorporation 8/5 16 / 25
Baseline Specification: Model Comparison
Estimation Model Log Linear Poisson Negative PoissonGLM Binomial Pseudo-MLE
Tax Gains:Retained Profits 0.043*** 0.042*** 0.046*** 0.042***
(0.001) (0.004) (0.001) (0.002)
Income Bin FE Y Y Y YYear FE Y Y Y YNo. of Observations 6,000 6,000 6,000 6,000No. of Income Bins 1,000 1,000 1,000 1,000
Devereux and Liu (Oxford) Small Business Incorporation 8/5 17 / 25
Full Model Specification
Coefficients lower (1.9% to 2.2%) if based on tax saving for distributeddividends
Effects robust to
inclusion of covariates. such as turnover, total asset, and number of workers
exclusion of the bunching region
industry-level estimation controlling for industry fixed effects,industry-specific time trend, and industry-level covariates
heterogeneous responses across different industries
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Investment Equation
Static Specification:
IitKi,t−1
= ∆ ln Yit − σ∆ ln CoCit + di + ηt + εit
IitKi,t−1
: investment undertaken by company i in year t, scaled bybeginning-of-year book value of tangible asset Kt−1; approximation for
∆ ln Kit + δi
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Excess Sensitivity to Cash Flow
IitKi,t−1
= ∆ ln Yit − σ∆ ln CoCit − γtax∆Taxi,t−1
Ki,t−1+ di + ηt + εit
∆Taxi,t−1 : one-year lagged increase in tax bill after abolishing the zerostarting rate; =∆τi,t−1· Taxable Profiti,t−1,where t = 2007 or 2008
Instrumented with ∆τi,t−1, change in the statutory marginal tax rate dueto exogenous changes in the tax system
Allow γtax to depend on "age" ie. time since incorporation
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Changes in the Cost of Capital
.224
.226
.228
.23
.232
.234
Cos
t of C
apita
l
0 20 40 60 80 100 120 140Corporate Taxable Profit (£K)
2002/03 2006/07Devereux and Liu (Oxford) Small Business Incorporation 8/5 21 / 25
Increase in Tax Liability 2006/07, £000
050
010
0015
0020
00In
crea
se in
Tax
Lia
bilit
y (£
)
0 50 100 150Corporate Taxable Profit (£K)
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Excess Sensitivity to Cash Flow: Empirical Findings
Static Specification(1) (2) (3)
∆ ln Yit 0.125*** 0.139*** 0.138***(0.002) (0.003) (0.003)
∆ ln CoCit -1.895*** -1.696*** -1.677***(0.066) (0.084) (0.086)
∆Taxi,t−1Ki,t−1
-0.783*** -1.371***
(0.260) (0.229)∆Taxi,t−1
Ki,t−1×Ageit 0.090***
(0.035)
Firm FE Y Y YYear FE Y Y YNo. Obs 561,486 381,499 381,499
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Excess Sensitivity to Cash Flow: Empirical Findings
Error-Correction Specification(4) (5) (6)
∆ ln Yit 0.354*** 0.354*** 0.352***(0.003) (0.004) (0.004)
∆ ln CoCit -1.052*** -0.911*** -0.904***(0.060) (0.070) (0.071)
ECit−1 -0.481*** -0.519*** -0.516***(0.003) (0.006) (0.007)
∆Taxi,t−1Ki,t−1
-0.352*** -0.725***
(0.211) (0.178)∆Taxi,t−1
Ki,t−1× Ageit 0.057*
(0.029)
Firm FE Y Y YYear FE Y Y YNo. Obs 526,457 381,499 381,499
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Conclusions
Evidence thatincorporation decisions depend on scale of tax advantageinvestment of companies affected by exogenous change to cash flowcash flow effect greater for younger companies, consistent with cost ofexternal finance falling as banks have access to more information
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