Small Business Incorporation and Investment: The Role of Corporation Tax Michael Devereux and Li Liu Centre for Business Taxation, University of Oxford Public Economics UK, University of Bristol May 7-8, 2014 Devereux and Liu (Oxford) Small Business Incorporation 8/5 1 / 25
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Small Business Incorporation and Investment:The Role of Corporation Tax
Michael Devereux and Li Liu
Centre for Business Taxation, University of Oxford
Public Economics UK, University of BristolMay 7-8, 2014
Devereux and Liu (Oxford) Small Business Incorporation 8/5 1 / 25
Motivation:Why Do Small Businesses Incorporate?
Limited liability?
Separation of ownership and control?
Devereux and Liu (Oxford) Small Business Incorporation 8/5 2 / 25
Motivation:Why Do Small Businesses Incorporate?
Limited liability?
Separation of ownership and control?
Devereux and Liu (Oxford) Small Business Incorporation 8/5 2 / 25
Number of Businesses in the UK, By Employment
0 1,000,000 2,000,000 3,000,000
Sole proprietorships
Partnerships
Companies
0 employees 19 employees1099 employees 100 or more employees
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Why Do Small Businesses Incorporate?
Limited liability?
Separation of ownership and control?
Better access to external finance for more investment?
Information for lenders better if incorporated, and improves over time
Lower tax
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What is the Role of Corporation Tax?
Lower CT induces firms to incorporate conditional on personal tax
Lower CT increases post-tax cash flow for companies and allowsfinancially-constrained companies to invest more
Lower CT reduces cost of capital for companies and provides greaterincentive to invest
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Our empirical approach
Use population of UK corporation tax records in 2001/02 - 2008/09
so data only on corporations, not unincorporated businesses
Explore the UK 2006 abolition of zero starting rate as a quasi-naturalexperiment
examine effect on incorporation, andeffect on investment, via cost of capital and cash flow
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Results
Estimate a significant positive effect of tax savings to incorporationOn average, a 1 percentage point increase in tax saving raises probability ofincorporation by 2% to 4%
Estimate effects of CT on investment by companies through 2 channels:
a higher user cost of capital, anda reduction in internal cash flow available for investment
Effects of cash flow diminish with company age
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Some Existing Literature
Corporate Investment and Financial ConstraintsTheoretical models of capital markets with asymmetric information: e. g.Stiglitz and Weiss (1981), and Myers and Majluf (1984)Empirical literature: Fazzari, Hubbard and Peterson (1988), Bond andMeghir (1994), Bond and Van Reenen (2007)
Taxes, Risk Taking and EntrepreneurshipMackie-Mason and Gordon (2002), Cullen and Gordon (2007)
Taxes and the Choice of Organizational FormGoolsbee (2004), de Mooij and Nicodeme (2008), Da Rin et al. (2011),Elschner (2013) and Liu (2014)
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Basic Setup with Corporation Tax
+TC oC i n t
+Te x tC o C
+Tunince x tC o C ,
fl o wc a sh
e x te r n a lin te r n a lI
AI
AM P
C oC
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Following a Decrease in the Corporation Tax
e xt e r n a li nt e r n a l
fl o wc a shn e tH ig h e r e xt e r n al
AM P
C oC
+TC oC i n t
n e wTe x t
C o C ,+
+Tunince x tC o C ,
n e wTC o C
,i n t
+
IAI
Devereux and Liu (Oxford) Small Business Incorporation 8/5 10 / 25
Data
Population of UK corporate tax returns (CT600), 2001/02 to 2008/0910.7 million observations for 2.5 million companiesDetailed and precise information on taxable profits and how they aredetermined
Around 90% of the tax records matched with company accounts in FAME
Year of Incorporation: FAMEInvestment: qualifying expenditure on machinery and plant, including
qualifying expenditure for FYA (CT600, Box 118),
long-life assets and integral features (Box 120), and
other machinery and plant (Box 121).
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Policy Reform to the Zero Starting Rate: Marginal TaxRate in 2002/03
0.1
.2.3
.4.5
0 20k 40k 60k 80k 100k 120k 140kTaxable Income
Retained Earnings SelfEmployment IncomeDevereux and Liu (Oxford) Small Business Incorporation 8/5 12 / 25
Zero Starting Rate Abolished in 2006/07
0.1
.2.3
.4
0 20k 40k 60k 80k 100k 120k 140kTaxable Income
Retained Earnings SelfEmployment Income
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Tax Gains to Incorporate: Retained Profit
Tax Gains to Incorporate (%): Average Tax RateSelf-Employment Income -Average Tax RateCorporate Profit
cit : number of newly incorporated businesses in income bin i of £100 attime tγi : income bin dummiesλt : time dummiesTax_Gainit : the difference between average tax rate for observedcorporate profit, and the corresponding average tax rate if the corporateprofit were earned as self-employment incomeXit : other observed firm characteristics that may matter for incorporationAssociated error term can be additive or multiplicative depending onfunctional form
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Baseline Specification: Model Comparison
Estimation Model Log Linear Poisson Negative PoissonGLM Binomial Pseudo-MLE
Firm FE Y Y YYear FE Y Y YNo. Obs 526,457 381,499 381,499
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Conclusions
Evidence thatincorporation decisions depend on scale of tax advantageinvestment of companies affected by exogenous change to cash flowcash flow effect greater for younger companies, consistent with cost ofexternal finance falling as banks have access to more information
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