Saturday, 13 May 2017

Companies don't make investment decisions based on tax rates

If you cut tax rates, will companies invest more ? This is almost a religious belief in a certain party in a certain country in the world. Is it justified  ?

The answer, in my opinion, is mostly No.

Companies make investment decisions based on markets, sales projections, competitive advantage, margin potential, scalability and the like.  These are extremely complex business variables and occupy 90% of the time and effort that goes into a business decision.

The tax line is one of the last lines in the cash flows of an investment proposal. It is certainly important, but hardly a determiner of whether the investment goes ahead or not.

There are a few instances when the tax rate indeed becomes a determining variable in the decision. For example, in India, there have been many instances where the government, in an effort to stimulate an underdeveloped part of the country has allowed zero income tax rates for operations located in those areas. In such a case, the tax rate becomes a determiner of the location of the investment; not the investment per se. Nobody puts up a factory just because the tax rate is zero. They put up a factory because the business opportunity is compelling. Having decided to invest, they may choose to locate it in a low tax zone.

The other instance when a tax rate becomes a determiner of investment is if the tax rate is ridiculously high.  For example if the marginal tax rate is 90%, nobody will invest even if the business opportunity is compelling (M. Melenchon's supporters, are you listening ?). But if you cut the tax rate from 35% to 15% , it's a nice bonus, but it will not add one dollar of investment which otherwise would not have been made.

Further, companies make investments based on a 7 or 9 year time horizon. If one President cuts tax rates this year, what stops the next President from increasing it 3 years from now. So its almost inconceivable that a company which would otherwise have not made the investment, will rush to now make it because of the tax cut.

The argument that a major tax cut on companies, will spur investment growth is mostly flawed. It will however have the following consequences

It will improve corporate profits (for after all tax is a cost) and therefore both the investible surplus and/or dividends in the hands of shareholders. It will increase the wealth in the hands of those who are shareholders. They may spend it which will have a beneficial impact on the economy.

It will correspondingly increase the deficit that the government runs, and therefore the nation's borrowings. That will push the cost of borrowing and inflation.

But will it also increase tax revenues and therefore make the measure revenue neutral. Mostly No. But there is one big exception in the US, which will be the subject matter of the next post.


Sriram Khé said...

I am with you on this ... in my intro class, I almost always remark that there are one too many variables that go into the investment and location decisions that businesses make, and tax rates are merely one of those variables. While insanely high rates definite party-poopers, one cannot make any meaningful projection on whether a, say, 27% rate will provide that much more than a 36% rate ... Nobody listens to me, I hope they are at least listening to you.

Looks like you are setting us up to perhaps talk about the "double taxation" in the US, and will end up talking about Apple's ocean of cash. We might end up differing there. But, that is for the next time ;)

Ramesh said...

When a concept becomes a dogma, almost bordering on religious zealotry, it is extremely dangerous. That's what has happened with the GOP on tax cuts. Many in the party are seasoned businessmen. They should know. But it has almost become a doctrine and you can't be a Republican if you are not a believer.

Its sad, for in economic policy I am much more Republican than Democrat. And yet there is no place for the likes of me in that Party if I were a citizen.

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