Incorporation for Investment

One aspect of the Centre’s research programme is the effects of taxes on decisions made by small businesses. Two related questions that we address are: (i) why do small businesses incorporate?; and (ii) are there any non-tax benefits from incorporation? A popular view is that small firms choose to incorporate in order to benefit from limited liability or the separation of ownership and control, but the value of these benefits is very restricted for small companies. We investigate instead whether small firms find it easier to raise finance if they are incorporated.

To investigate the role of corporation tax on small business incorporation and investment, we use confidential, anonymised data from the population of UK corporation tax records between 2001 and 2009, available in the HMRC Datalab. To identify the effects of tax we rely on a number of changes to the tax rate schedule for small companies during this period.

To identify the effects of corporation tax on the decision to incorporate, we compare the distribution of taxable income of newly incorporated firms at different points in time. Consistent with corporation tax being an important factor in the incorporation decision, we find substantial evidence that there were more incorporations of businesses with levels of taxable income that created the greatest tax advantage relative to being unincorporated.

But incorporation itself is of only secondary interest if it has little impact on the behaviour of the businesses. We therefore also study investment of new companies. In particular, we ask whether the  greater information requirements on incorporated businesses are associated with a greater willingness of banks to provide finance. More specifically, as more information becomes available over time for new companies, we test indirectly whether access to finance becomes easier the longer businesses have been incorporated. If so, this should be reflected in higher investment. We do find that financial constraints on new companies diminish over time, consistent with these hypotheses.

This suggests that a tax benefit to incorporation has a positive effect on the economy, by inducing businesses to incorporate, and also to help such newly incorporated business raise additional finance to support higher levels of investment.

Michael Devereux and Li Liu, CBT Working Paper 16/07