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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.

Taxation

Why to pay taxes

Undoubtedly, the Government requires ‘revenues’ in order to fund the Public sector expenditure. In their book, Parkin & King (1992) argue that Government sector expenditure can be mainly divided into the following four categories: Expenditure on goods and services, Subsidies, Transfer payments and subsidies, and Debt interests.

On the other hand, the main sources of the revenues needed are:

  • Taxes
  • Royalties: Proceeds reserved by the government for permitting other economic agents to exploit and make use of public property.
  • Money creation: An inflation tax
  • Borrowing: From individuals, firms, and institutions (domestic or abroad)
  • Profits and interest: On government run business and loans made by other governments.
  • National insurance contributions: Amount paid by the employers to the public in order to insure themselves through the government against possible illness, unemployment, and retirement.

 Although, we will appreciate the aforementioned alternative ways through which public expenditure can be funded, taxation is the main source of income.

Depending on which of the aforementioned figures (revenues and expenditure) is the greater we can define the financial surplus as when revenue exceeds expenditure and the financial deficit as when expenditure exceeds the income. The surplus or deficit is usually presented as a percentage to the GDP.

Tax Base - direct and indirect taxes

Depending on the specific time and from the particular ideology of each country, taxes are levied either on income and / or on expenditure.

Taxes on income, include :

(Direct taxes)

  • The personal income tax: The sum of income from various sources is calculated and then taxed in total
  • The corporation tax: Mostly is a percentage on company profits
  • Taxes on Capital: Taxes on property, Capital gain taxes, etc

Taxes on expentiture, include :

(Indirect taxes)

  • Value added tax (VAT)
  • Taxes on tobacco, alcohol, and petrol.

One of the traditional criteria used for the classification of taxes as direct and indirect has been the ability of shifting the tax to another person. In practice we can consider as direct taxes those on income and property and those on expenditure as indirect.

It can be argued that developed counties are mainly based upon direct taxes, i.e. individual and corporate taxation. On the contrary, the developing countries are based mostly on indirect taxes, i.e. VAT.

Tax rates and tax income

It can be argued that in the short run, an increase on income tax rates (up to a specific point) will in turn increase the government’s revenues and as a consequence reduce the financial deficit [1]

However, should continue the increase of tax rates after a specific point, the tax revenues will start to decrease   due to the substitution effect.[2]

The above is illustrated by the Laffer[3] curve, which draws the relationship between income tax and taxation rate.

Laffer suggested that as the tax rate increases , the tax income increases as well , but up to a maximum point (A) that represents the optimum tax rate where the maximum amount of tax income could be collected. After the specific point, should continue the tax rate to increase , the tax revenue will start decreasing . In other words, we have the emergence of the substitution effect. A lack of incentives would lead to a fall in income and therefore a fall in income tax. The end – point is undoubtedly a tax rate of 100 %, where no one would be willing to work and so income tax would reach the zero point.

How tax incentives influence investments

The private investment behaviour is primarily influenced by the maximization of the profit. In other words, when carrying out an appraisal of a prospective investment, the extent of corporate tax, on net profits, is of major importance. . Thus ‘pure’ net profit 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 and consequently to ‘present’ the minimal taxable income.

Specifically, some items that influence the investment through taxation could be the following:

  • Accelerated depreciation

Allows the firm to a faster write-off of its assets and as a consequence reduces the taxable income.

  • Various tax credits.

For those firms that will be activated into specific sectors of the economy or   regions of the country that deem significant for national economic policy.

  • Reduced cost of capital

For example, the amount of taxable interest or lease payments.

 


Assignment (abstract), Public Finance, Manolis Sp. Anastopoulos, University of Leicester.

[1]In the long run, a high tax rate is without doubt a disincentive for investment – savings that most probably will lead to an increase of financial deficit

[2] Individuals due to their reduced disposal income will start to substitute leisure time for additional income since they will be unwilling to work harder than before

[3] Dr. Arthur Laffer was an advisor to President Reagan of USA in the early 1980s but despite that, he become quite well known through his ‘curve’ Time magazine included him among ‘The Century’s Greatest Minds’ (Greater Talent Network Inc, 1999-2002)