Gulnara Nolan

Tax, cost of capital, and investment

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Last time I discussed the relationship between the cost of capital and investment.

Given that motivation, the goal of this post is to understand whether investment is responsive to changes in the UCC due to changes in tax settings. This does two things:

  • Provides evidence regarding whether the capital stock will ultimately be influenced by corporate tax policy changes.
  • Helps us understand how changes in the cost of capital can “shift” investment through time, thereby helping economic stabilisation. Note: The cost of capital varies with both taxes and interest rates, so this relates across to monetary policy!

International evidence and our analysis

Hassett and Hubbard (2002) and Zwick and Mahon (2017) give summary estimates of the relationship between the UCC and investment from the literature. Although there is a general consensus that a higher UCC (due to higher taxation) does reduce investment, the timing of the adjustment and the response of investment to different types of tax changes (corporate tax increases vs less generous depreciation allowances) vary significantly.  

The general range for investment responses is that a one percentage point increase in the UCC reduces investment by between 0.5% and 1%.  

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In the New Zealand context the only study of this issue [Fabling et al 2015] found a weak investment response to changes in the UCC.  As a result, we have decided to replicate and extend this result to answer two questions:

  • Is New Zealand really different?
  • If it is, why?

Following Fabling et al 2015, Lynda Sanderson and me have estimated the same form of explicit dynamics model for New Zealand.  Relative to that paper we have made the following changes:

  • Added more years up until 2017.
  •  Changed the lag structure based on new information.
  • Incorporated foreign owned firms into the analysis.

Our findings are currently similar to those reported in the initial NZ research, with only a limited investment response to changes in the UCC.

What we need to ask going forward

Having replicated the results of (Fabling et al 2015) and shown that they continue to hold after changing the form and extending the number of years it does appear New Zealand is different.

But why it is different matters for policy.

  1. If NZ firms just do not respond to tax changes: If firms genuinely didn’t respond to tax changes, the productivity costs (capital deepening) associated with raising revenue from firms would be limited.
  2. If NZ firms face different adjustment costs:  It could be much more difficult for firms to adjust this investment patterns in the short term than firms overseas, due to organisational structure, the types of investments that are made, or high fixed costs associated with investment changes.  In this case New Zealand businesses may respond, but the response may take too long for the method to appropriately measure.
  3. NZ firms do adjust, but along different margins:  If instead New Zealand firms predominantly passed on the tax (through lower wages and higher prices) there may be real costs associated with taxation we cannot measure by focusing on investment alone.

In order to tease out these differences we are in the process of undertaking additional modelling (implicit dynamics) which allows more flexibility for the types of adjustment costs faced by firms.  

As a result, the key takeaway from this is that New Zealand firms do respond differently to tax changes than other firms – but we still need to understand a bit more about why this is the case before we can make use of this in policy work.

Future goals

In the future I’ll start reporting some of these results – with little write ups on the blog.

The goal will be to describe what different models tell us, and how we can think about changes in “investment” for stabilisation and what this also means for changes in the longer term “capital stock”.