The Investment Effect of Taxation Evidence from a Corporate Tax Kink

This paper exploits bunching of firms at a tax kink as quasi-experimental variation to identify the effect of a tax rate change on investment, and explore how this effect interacts with variation in capital depreciation rates. The idea is that firms with a taxable income slightly above the kink have an incentive to reduce their income to bunch at the kink, and increasing investment is one possible strategy for that. This means that bunching of firms should be accompanied by a spike in investment at the kink. Building on the standard bunching framework, I estimate the frequency distribution of firms around the kink, and the share of bunchers with excess investments at the extensive and intensive margin.

I apply this approach to administrative tax return data for the universe of UK firms from 2001-2007, and show that investment by small firms significantly responds to a tax rate change. I find large and significant spikes in the share of capital investors and median capital costs at the 10k kink. The spikes are larger in 2002-2005 when the kink is larger, and for quickly depreciating capital items, which yield larger tax reductions. I estimate that extensive margin investments explain 7.7-19.2% of bunching and intensive margin investments explain 4.3-16.8% of bunching. Evidence from subsample analysis supports the interpretation of the observed behaviour as real investment rather than evasion or avoidance.