Stimulating investment through incorporation

This research project examines the effect of incorporation in stimulating small business investment. We start by examining the extent to which businesses incorporate in response to the tax gains available from doing so. To do this, we explore a 2006 UK tax reform that lowered the tax gain to incorporation for companies with relatively low levels of profit, and identify the change in the number of new incorporations at different profit levels. Using confidential corporation tax return data from the HRMC Datalab, we find evidence of substantial tax-motivated incorporation: we find that a one percentage point reduction in the tax gain reduced the number of new incorporations by 4.5 percent. Second, we examine the impact of incorporation on investment, via the access of small companies to external finance, by analysing their response to changes in tax liabilities generated by tax reform. We find that, on average, a £1 reduction in the post-tax internal funds of newlyincorporated firms  would reduce their investment by 90 pence, consistent with them facing severe financial constraints. However, this impact on investment gradually diminishes after incorporation, consistent with incorporation improving access to external finance.

Michael P. Devereux and Li Liu. CBT Working Paper 16/07