Small Business Incorporation and Investment: The Role of Corporation Tax

Small Business Incorporation and Investment: The Role of Corporation Tax Michael Devereux and Li Liu Centre for Business Taxation, University of Oxfor...
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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 Bristol May 7-8, 2014

Devereux and Liu (Oxford)

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Motivation:Why Do Small Businesses Incorporate?

Limited liability?

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Motivation:Why Do Small Businesses Incorporate?

Limited liability? Separation of ownership and control?

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Number of Businesses in the UK, By Employment

Companies

Partnerships

Sole proprietorships

0

1,000,000 0 employees 10-99 employees

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2,000,000

3,000,000

1-9 employees 100 or more employees 8/5

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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

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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 allows financially-constrained companies to invest more Lower CT reduces cost of capital for companies and provides greater incentive to invest

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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-natural experiment examine effect on incorporation, and effect on investment, via cost of capital and cash flow

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Results

Estimate a significant positive effect of tax savings to incorporation On average, a 1 percentage point increase in tax saving raises probability of incorporation by 2% to 4%

Estimate effects of CT on investment by companies through 2 channels: a higher user cost of capital, and a reduction in internal cash flow available for investment

Effects of cash flow diminish with company age

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Some Existing Literature

Corporate Investment and Financial Constraints Theoretical 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 and Meghir (1994), Bond and Van Reenen (2007)

Taxes, Risk Taking and Entrepreneurship Mackie-Mason and Gordon (2002), Cullen and Gordon (2007)

Taxes and the Choice of Organizational Form Goolsbee (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 C oC

T +

C o C e x t , uninc

T+

C o C ext

T +

C o C int

MP

c a s h fl o w i n te r n a l

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I

A

A

I

e x te r n a l

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Following a Decrease in the Corporation Tax C oC

T +

C o C e x t , uninc

T + ,n e w

C o C ext

T +

C o C int

MP

T + ,n e w

A

C o C int

i nt e r n a l H i g h e r n e t c a s h fl o w Devereux and Liu (Oxford)

I

e xte r n a l

A

I

e x t e r n al Small Business Incorporation

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Data

Population of UK corporate tax returns (CT600), 2001/02 to 2008/09 10.7 million observations for 2.5 million companies Detailed and precise information on taxable profits and how they are determined

Around 90% of the tax records matched with company accounts in FAME Year of Incorporation: FAME Investment: 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).

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0

.1

.2

.3

.4

.5

Policy Reform to the Zero Starting Rate: Marginal Tax Rate in 2002/03

0

20k

40k

60k 80k Taxable Income

Retained Earnings Devereux and Liu (Oxford)

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100k

120k

140k

Self-Employment Income 8/5

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0

.1

.2

.3

.4

Zero Starting Rate Abolished in 2006/07

0

20k

40k

60k 80k Taxable Income

Retained Earnings Devereux and Liu (Oxford)

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100k

120k

140k

Self-Employment Income 8/5

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Tax Gains to Incorporate: Retained Profit Tax Gains to Incorporate (%): Average Tax RateSelf-Employment Income Average Tax RateCorporate Profit

Tax Gains to Incorporate: Retained Profit

20

10

0

-10

-20 0 Devereux and Liu (Oxford)

20

40 60 Corporate Taxable Profit (£1,000) Small Business Incorporation

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100 8/5

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Number of Newly Incorporated Firms

Number of New Companies

30000

20000

10000

0 0

20

40 60 Corporate Taxable Profit (£1,000) 2002/03-2003/04

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80

100

2006/07-2007/08 8/5

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The Causal Effect of Tax Incentives on Incorporation

E (cit jTax_Gainit, Xit ) = exp (γi + λt + βtax Tax_Gainit + Xit βx ) cit : number of newly incorporated businesses in income bin i of £100 at time t γi : income bin dummies λt : time dummies Tax_Gainit : the difference between average tax rate for observed corporate profit, and the corresponding average tax rate if the corporate profit were earned as self-employment income Xit : other observed firm characteristics that may matter for incorporation Associated error term can be additive or multiplicative depending on functional form

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Baseline Specification: Model Comparison

Estimation Model Tax Gains: Retained Profits

Income Bin FE Year FE No. of Observations No. of Income Bins

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Log Linear

Poisson GLM

Negative Binomial

Poisson Pseudo-MLE

0.043*** (0.001)

0.042*** (0.004)

0.046*** (0.001)

0.042*** (0.002)

Y Y 6,000 1,000

Y Y 6,000 1,000

Y Y 6,000 1,000

Y Y 6,000 1,000

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Full Model Specification

Coefficients lower (1.9% to 2.2%) if based on tax saving for distributed dividends 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: Iit Ki,t

1

= ∆ ln Yit

σ∆ ln CoCit + di + η t + εit

Iit Ki,t

: investment undertaken by company i in year t, scaled by 1 beginning-of-year book value of tangible asset Kt 1 ; approximation for ∆ ln Kit + δi

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Excess Sensitivity to Cash Flow

Iit Ki,t

1

= ∆ ln Yit

σ∆ ln CoCit

γtax

∆Taxi,t Ki,t 1

1

+ di + η t + εit

∆Taxi,t 1 : one-year lagged increase in tax bill after abolishing the zero starting rate; =∆τ i,t 1 Taxable Profiti,t 1 ,where t = 2007 or 2008 Instrumented with ∆τ i,t 1 , change in the statutory marginal tax rate due to exogenous changes in the tax system Allow γtax to depend on "age" ie. time since incorporation

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.224

.226

Cost of Capital .228 .23

.232

.234

Changes in the Cost of Capital

0

20

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40

60 80 100 Corporate Taxable Profit (£K) 2002/03

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2006/07

120

140

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0

Increase in Tax Liability (£) 500 1000 1500

2000

Increase in Tax Liability 2006/07, £000

0

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50Small Business Incorporation

100

150

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Excess Sensitivity to Cash Flow: Empirical Findings

∆ ln Yit ∆ ln CoCit ∆Taxi,t Ki,t 1

1

∆Taxi,t Ki,t 1

1

Static Specification (1) (2) (3) 0.125*** 0.139*** 0.138*** (0.002) (0.003) (0.003) -1.895*** -1.696*** -1.677*** (0.066) (0.084) (0.086) -0.783*** (0.260)

Ageit

-1.371*** (0.229) 0.090*** (0.035)

Firm FE Year FE No. Obs

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Y Y 561,486

Y Y 381,499

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Excess Sensitivity to Cash Flow: Empirical Findings Error-Correction Specification (4) (5) (6) 0.354*** 0.354*** 0.352*** (0.003) (0.004) (0.004) -1.052*** -0.911*** -0.904*** (0.060) (0.070) (0.071) -0.481*** -0.519*** -0.516*** (0.003) (0.006) (0.007)

∆ ln Yit ∆ ln CoCit ECit 1 ∆Taxi,t Ki,t 1 ∆Taxi,t Ki,t 1

1

-0.352*** (0.211)

1

Ageit

-0.725*** (0.178) 0.057* (0.029)

Firm FE Year FE No. Obs Devereux and Liu (Oxford)

Y Y 526,457

Y Y 381,499

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Conclusions

Evidence that incorporation decisions depend on scale of tax advantage investment of companies affected by exogenous change to cash flow cash flow effect greater for younger companies, consistent with cost of external finance falling as banks have access to more information

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