Investment responses to tax policy under uncertainty
Periods of stability offer an important policy opportunity to encourage investment through tax incentives. However, during recessions, the impact of such a stimulus is weak for firms with a high exposure to elevated uncertainty.
This paper finds that where uncertainty is relatively low, tax incentives have strong positive effects on average investment. But where uncertainty is high, the story is different: there is vast heterogeneity in investment responses. Firms that are sheltered from elevated uncertainty still respond strongly to the policy, but firms that are exposed to high uncertainty have a much smaller response.
The paper uses confidential corporation and personal tax returns data, merged with VAT returns and trade data from the Ministry of Finance in Poland, to study the impact of tax incentives on investment at different points in time and for different groups of firms. It uses the introduction of 100 percent expensing of the cost of plant and machinery (instead of depreciating such costs over a number of years) to pin down the impact of investment tax incentives. Two policies were implemented in the same country, two years apart: once during a period of economic stability, and once during a period of very high uncertainty. This is the first paper to explore the effects of uncertainty on the effectiveness of incentives in a quasi-experimental setting with firm-level variation using administrative data.
Trends in average investment across treatment and control groups, low volatility (top panel) and high volatility (bottom panel) periods
These findings show that elevated uncertainty may be contributing to the lower response to tax policy during recessions, limiting the impact of supply-side stimulus measures such as investment tax incentives during downturns. In such periods, demand-side instruments such as direct government spending may be more effective in generating output, at least in the short run.