Corporate Taxes, Investment Frictions, and the Macroeconomy

The effects of corporate taxation on the economy have been a constant in policy discussions in many countries for a long time. The ultimate consequences of how firms are taxed and how this impacts private investment, production, and the overall functioning of the economy are still subject to academic and public debates.

In BSE Working Paper Nº 1312, The Macroeconomics of Partial Irreversibility,” Isaac Baley (UPF, CREI, BSE) and Andrés Blanco (U Michigan) propose a methodology to examine the macroeconomic implications of corporate taxes when firms are subject to investment frictions. Their critical innovation is to think of “after-tax investment frictions,” a concept that simplifies the complex interactions between corporate taxes and investment frictions. This idea, together with a novel sufficient statistics approach, allows them to characterize and quantify the channels through which corporate taxes affect the macroeconomy with microdata.

What are investment frictions, and how do they affect firms’ choices?

When making investment choices, firms face two types of frictions. The first friction consists of fixed capital adjustment costs. These costs reflect the time, effort, and other expenses associated with upsizing or downsizing the capital stock, such as searching for suppliers or buyers of capital goods, disrupting production, restructuring plants, and retraining workers. Fixed adjustment costs render investment lumpy; capital is only changed infrequently and by significant amounts.

The second friction consists of a price wedge that makes new capital more expensive than used capital. The price wedge reflects asymmetric information in the capital goods’ quality, imperfect substitutability, obsolescence, and intermediary fees. In addition, the wedge renders investment partially irreversible because buying capital and selling it afterward entails a loss. Exposed to a price wedge, firms operate with caution: In times of high productivity, firms do not scale up as quickly, and in times of low productivity, firms prefer to hold onto their capital to avoid the price penalty.

Both frictions reduce firms’ ability to respond to changes in their environment and slow the reallocation of capital toward the most productive firms, ultimately hurting the economy by lowering aggregate productivity.

How does corporate tax policy enter the picture?

Despite their sizeable impact on the allocation of capital and productivity, investment frictions cannot be influenced directly by policymakers in most cases. However, the authors show that corporate taxes can indirectly change the effective size of investment frictions. Let us consider firms’ corporate income tax on their profits to see this. When deciding on an investment, firms care about the fixed cost relative to after-tax profits; thus, a lower corporate tax rate means higher profits and, effectively, a smaller after-tax fixed cost. Additionally, to the extent that the tax code allows deductions of capital losses from firms’ taxable income, a lower corporate tax rate is equivalent to fewer deductions and, effectively, a larger after-tax price wedge.   

A direct consequence of their analysis is that investment frictions and corporate taxes jointly shape capital allocation in the economy. Moreover, because corporate income taxes move effective investment frictions in opposite directions, the relative importance of the two frictions crucially matters for understanding the macroeconomic implications of changes to the corporate tax structure. 

How does the allocation of capital affect the macroeconomy?

Capital allocation, measured as the dispersion in the marginal product of capital across firms, has been central in explaining differences in aggregate productivity and long-run economic growth across countries. The authors show that capital allocation is also a key driver of capital valuation – the average market value of firms – and capital fluctuations – the speed at which aggregate shocks propagate across the economy. According to their quantitative analysis, those economies with lower after-tax investment frictions feature better capital allocation, lower capital valuation (because capital is more abundant), and faster propagation of shocks. Then, improving capital allocations can enhance economic growth and minimize business cycle fluctuations. Corporate taxation is one way to do so.

Corporate tax reforms can have sizeable macroeconomic effects.

The authors apply their novel methodology to assess the impact of lowering the corporate income tax rate. Their exercise is motivated by the general trend observed across OECD countries in the last 40 years, with a median reduction in the top corporate income tax rate of 17 percentage points, from 42% in 1980 to 25% in 2020, as shown in Figure 1.

They use data on Chilean manufacturing firms from the Annual Manufacturing Survey between 1980 to 2011 to estimate and calibrate critical parameters of the model and then evaluate the effects of moving from a high corporate tax regime to a low corporate tax one. Through the lens of their calibrated model, a corporate income tax cut always increases aggregate productivity (reduces the dispersion in marginal products of capital across firms, see Panel A) and lowers capital valuation (since capital becomes more abundant, see Panel B).

However, regarding the effects on capital fluctuations, the results critically depend on the size of the price wedge and its tax treatment (see panel C). With an empirically relevant price wedge and deductible capital losses, the corporate tax cut makes fluctuations more persistent (black solid line); in turn, without a price wedge (dotted blue line) or without deductibility of capital losses (dashed red line), the tax cut makes fluctuations less persistent.

More generally, comparing the results across the various model configurations shows essential differences in the size and sign of the elasticities of aggregate outcomes concerning corporate taxes. This study thus highlights the need to adequately model and measure the complex interactions between investment frictions and corporate taxes.

Figure 1. Macroeconomic Effects of Lowering the Corporate Income Tax Rate

Note: Stars correspond to the median values of the top corporate tax rate in the OECD: 1980 = 42%, 2020 = 25%. Solid black line = non-zero price wedge and deductible losses; Dashed blue line = non-zero price wedge without deductions; Dotted red line = no price wedge.

What are the lessons for policymakers?

To summarize, the authors put forward a new channel for policy intervention: Corporate tax policy can change the effective size of fixed costs and price wedges – technological constraints or market prices typically outside the control of a policymaker. As a consequence, tax policy can structurally change the long-run behavior of aggregate capital (its allocation, valuation, and fluctuations) and the macroeconomy more broadly.