How tax incentives influence investment

Undoubtedly, the private investment behaviour is primarily influenced by the maximization of the profit. In other words, the extent of the corporate taxes that has to be paid on the net profits is of major importance (tax incentives) when carrying out an appraisal of a prospective investment. Thus ‘pure profits’ although reduces the income shown on Financial statements, sounds welcomed when a firm considers payable taxes. To this regard, it would be to the firm’s benefit should allowed by the tax legislation to deduct the maximum cost items they could and consequently to ‘present’ the minimal taxable income.

Here below, we will refer to some items that influence the investment through taxation in a directly or indirectly way.

• Depreciation. It is known, that depreciation allowance actually reduces the acquisition price of an asset equally to the present value[1] of the depreciation allowance. The smaller the period over the depreciation is calculated the larger the benefit for the company.

• Accelerated depreciation[2].  Is a method that allows the firms to a faster write-off of their assets and as a consequence affects the taxable income by reducing it. Thus encourage investment. In a recent article (Ritholtz 2004) accelerated depreciation is referred as essentially an intriguing corporate tax cut and as one of the more important changes in tax legislation passed by President Bush.

The aspect of inflation

Are investments promoted as designed during inflationary periods?

As we know, inflation causes fictitious profits (higher replacement value of an asset) that also taxed. Therefore, by reducing the number of years over which an asset could be depreciated (generous tax depreciation provisions) we actually compensate the additional tax burdens that caused by inflation.

• Tax credits. A tax credit program (reduced taxes) undoubtedly motivates investment but it is also the primary means of directing investment towards those activities (sectors of the economy) or regions of the country (regional economic development) that deemed the most significant for the boosting of the economic growth.

• The cost of capital. Assuming a firm is considering to a partly finance of its new project through a banking loan (debt) instead of issuing shares (equity) under following fixed terms and conditions:

1. The tax policy allows firms to deduct interest payments from the taxable income
2. The interest rate is 4%
3. The after tax profits are € 100
4. The corporate tax rate (T) stays at 40 %

Τhe following calculation will show the real interest that the company will pay.

Tax shield

4% ∙ (1- T) = 4% ∙ (1- 0.4) = 4% ∙ 0.6 = 2.4%  -- which is the real interest rate.

• € 100 (Profits) – € 40 [ i.e € 1,000 ∙ 4% (Interest)] = € 60
• € 60 ∙ 40% (tax rate) = € 24 (Tax bill) that represents the 4 % of the loan amount of € 1,000.

As a result, if the amount of interest is taxable, it reduces the real interest rate. In other words it reduces the cost of capital, which in general has a positive impact upon investment.

• Mergers and acquisitions (M&A). Undoubtedly the M&A are demanding for both vendors and acquires since under considerable analysis and assessment it will be to the benefit of both parties involved.

As stated in an article (Ruegger 1999 partner of Simpson Thacher & Bartlett Llp) the worldwide M&A volume for announced transactions in 1998 was close to $2.5 trillion, in 1997 over $1.5 trillion, and in 1996 over $1 trillion.

Certainly, the firm’s main target when using the M&A is the enhancement of market share. However, it can be argued that possible tax incentives can also consist a considerable motive for a firm to proceed to an activity in question.

For example, the legislation may allow the ‘transfer’ of some tax credits to the buying company or offers a reduced tax rate.

Author: Manolis Anastopoulos.  Assignment (part) in Public Finance, University of Leicester.

[1] Present value (PV) = FV / (1+i) .The calculation of PV is called discounting.

[2] Accelerated depreciation is especially popular for writing-off assets that most probably will be replaced before the end of their useful life.