Academic journal article Economic Inquiry

Tax Uncertainty and Investment: A Cross-Country Empirical Examination

Academic journal article Economic Inquiry

Tax Uncertainty and Investment: A Cross-Country Empirical Examination

Article excerpt


Spanning a period of nearly 100 years of economic research, a substantial body of literature has developed with the goal of explaining the behavior of investment over time. (1) Although many of these studies have considered the implications of tax policy for investment in an uncertain world, most have also implicitly assumed that the tax policy itself does not contribute to the uncertainty. The problem is that tax policy can be very uncertain in many cases, (2) and to date we know little about the consequences, especially from an empirical standpoint. More generally, empirical evaluations of uncertainty and investment are very limited compared with the development of theoretical analyses (Calcagnini and Saltari 2000), and the case of tax uncertainty is no exception.

This article sets out to fill part of the intellectual void by empirically investigating the impact of volatility in effective tax rates on investment in a cross-section of countries, namely, the 15 countries of the European Union (EU), the United States, and Japan. In doing so, I first estimate tax rate volatility using an ARCH specification with data on effective capital tax rates. I then provide panel regression results, using the system generalized method of moments (GMM-Sys) estimator of Arellano and Bover (1995) (see also Blundell and Bond 1998), which suggest that the volatility of effective tax rates on capital have a significant negative impact on investment per worker in these countries.

The remainder of the article proceeds as follows. Section II briefly reviews the existing literature on tax policy uncertainty and investment as well as existing empirical studies of uncertainty (in general) and investment. Section III develops the empirical model I employ to estimate the relationship between tax volatility and investment. Section IV then presents an analysis of effective tax rates in the EU countries, the United States, and Japan, followed by a discussion of the data and econometric issues in section V, and an examination of the effects of tax rate volatility on investment in section VI. Section VII provides concluding remarks.


Tax Policy Uncertainty and Investment

Although most of the voluminous literature on tax policy and investment under uncertainty ignores observed randomness in tax policy, a recent set of literature has begun to explore these issues in some detail, mostly through simulation. (3) The basic premise underlying these studies is that because output price uncertainty tends to retard investment (Pindyck 1988), (4) tax uncertainty might be expected to harm investment as well (Hassett and Metcalf 1999). Further credence to a negative relationship between tax uncertainty and investment is given by the business community's mantra that "they cannot make plans if they don't have confidence in the tax structure" (Bizer and Judd 1989, 223). These simulation studies, however, demonstrate that the impact of tax uncertainty depends crucially on the source and nature of the uncertainty. Contrary perhaps to conventional wisdom, in some cases increased uncertainty can be shown to have positive effects on investment, growth, or welfare.

Bizer and Judd (1989) simulate the economic effects of introducing random tax policy in a dynamic general equilibrium model. They find that if random tax rates or credits are serially correlated, the target capital stock falls when taxes are high and rises when taxes are low. Their more interesting case considers independently and identically distributed random tax shocks. In this case the authors find that randomness in investment tax credits generates large fluctuations in investment, which have the effect of reducing both utility and production (because both are concave functions) as well revenue. (5) They find that variance in future tax rates, however, is not important for long-term investments and in fact raises nontrivial mounts of revenue at a welfare cost that is never more than the cost associated with raising an equivalent amount of revenue with a permanent increase in a deterministic tax rate. …

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