The link between investment decisions undertaken by economic agents and corporateincome (profit) taxation is well documented in theoretical studies realized so far. But, the empiricalevidence is very mixed and do not provide clear answers regarding the magnitude of the taxationeffects on investment and the proper transmission channels for these effects. So, we propose toinvestigate the effects of corporate income (profit) tax burden on investment decision for a samplecomposed from EU Member States.corporate income taxation, investment, q theory

Ioan Talpos

Ionel Vancu

English

Research Papers in Economics

Annales Universitatis Apulensis Series Oeconomica, 11(1), 2009 
 
 
  513
CORPORATE INCOME TAXATION EFFECTS ON INVESTMENT 
DECISIONS IN THE EUROPEAN UNION 
 
 
Ioan Talpo 
1 
Ionel Vancu
2 
 
 
ABSTRACT: The link between investment decisions undertaken by economic agents and corporate 
income (profit) taxation is well documented in theoretical studies realized so far. But, the empirical 
evidence is very mixed and do not provide clear answers regarding the magnitude of the taxation 
effects on investment and the proper transmission channels for these effects. So, we propose to 
investigate the effects of corporate income (profit) tax burden on investment decision for a sample 
composed from EU Member States.  
 
Key words: corporate income taxation, investment, q theory  
 
JEL codes: E62, O40, C20 
 
 
Introduction 
Investment decisions undertaken by economic agents are very important for the economy as 
a whole because investments are one of the engines of long term economic growth. 
When  an  economic  agent  has  to  make  an  investment  decision,  there  are  a  variety  of 
variables that are taken into account, among which taxation play a significant role. The economic 
theory suggests that taxation generally distorts the decisions of economic agents and individuals. If 
one refers only to investment decisions, having in mind that corporate profits are the source of 
funds  used  to  finance  an  investment,  corporate  income  taxation  seems  to  be  one  of  its  main 
determinants. The transmission channels of corporate income taxation on investment process and 
the specific determinant fiscal variables are various: the level and dynamic of marginal tax rate, the 
level and evolution of average tax rate, the existence of an investment tax credit or the existence of 
tax deductible depreciation allowances. It is expected that marginal and average tax rates to have a 
negative effect on investment decisions. Empirical studies realized so far confirm this assumption 
and found a stronger effect for marginal corporate income tax rates than for average rates.    
Closely related with corporate income taxation, the fiscal treatment of dividends also has an 
impact on investment decisions. A higher tax rate on dividends constitutes an additional incentive 
to undertake investments. 
Another way in which taxation affects investment decisions is related to capital taxation. Of 
course, a tax on the stock of capital of an economic agent is a strong disincentive to invest. 
 
Literature review and theoretical foundations 
In order to highlight the effects of taxation on investment undertaken by economic agents, 
we will follow a theoretical model based on q Tobin investment theory developed in Myles (2007). 
Tobin  (1969)  argued  that  the  investment  decision  should  be  based  on  some  sort  of  arbitrage 
between the market value of investment (V) and to the replacement cost (K). When the market 
value  exceeds  the  replacement  cost,  the  economic  agent  should  realize  the  investment.  In  the 
opposite situation, the investment should not materialize. According to q theory of investment, the 
investment function is given by: 
                                                       
1 West University of Timisoara, Faculty of Economics and Business Administration, ioan.talpos@feaa.uvt.ro 
2 West University of Timisoara, Faculty of Economics and Business Administration and Beius Fiscal Administration Annales Universitatis Apulensis Series Oeconomica, 11(1), 2009 
 
 
  514
 
( )K q I I =                          (1) 
 
where: 
pK
V
q =                        (2) 
pK    the nominal value of the capital stock 
 
which satisfies the following conditions: 
 
( ) 0 1 I
' =                          (3) 
( ) 0 q I
' >  if  1 q >                        (4) 
( ) 0 q I
' <  if  1 q <                        (5) 
 
If a fraction b of new investment is financed by debt, the economic agent will undertake the 
investment process only if the following condition is satisfied: 
 
0 1 b
pK
V
> − +                      (6) 
 
In order to envisage the taxation effects on investment decision, one could consider a tax credit for 
the reinvested profit and full tax deductible future depreciation allowances. In these conditions, the 
economic agent will carry on the investment if the following inequality holds: 
 
0 Z ITC 1 b
pK
B V
> + + − +
−                    (7) 
 
where: 
B – the present value of tax savings on the existing capital stock; 
ITC – the tax credit for the reinvested profit; 
Z – the present value of future depreciation allowances related with the investment. 
 
If one consider a marginal tax rate for dividends τd and a marginal tax rate for income from capital 
τc the economic agent will reinvest that part of the profit that will endure an increase in the market 
value by 
c
d
1
1
τ −
τ − . In these conditions, the investment will be realized if the following inequality 
holds: 
 
( )( )
( )
0 Z ITC 1 b
1 pK
1 B V
d
c > + + − +
τ −
τ − −                  (8) 
 
Having in mind that the investment cost is fully deductible from the taxable profit before the tax 
and the fact that profits are taxed at a rate τ, the q theory is described by the following function: 
  
( ) Q h
K
I
= , with  ( ) 0 0 h =  and  0 h
' >  
 
where: Annales Universitatis Apulensis Series Oeconomica, 11(1), 2009 
 
 
  515
( )( )
( )
τ −
+ + − +
τ −
τ − −
=
1
Z ITC 1 b
d 1 pK
1 B V
Q
c
                   (9) 
 
The presented model shows that a change in profit tax rate τ could affect only the level of 
the investment rate (Q) but not its sign. The other tax rates τd and τc could affect both the level and 
the sign of the investment rate. It could also be observed that an increase in the tax rate for income 
from capital could make the investment rate even negative, while an increase in the dividends tax 
rate has an opposite effect. More, it could be observed that allowing for an investment tax credit has 
a positive impact on the investment rate. 
These interesting theoretic results are confirmed by numerous empirical studies realized in the 
economic literature. For example, Goolsbee (1998) studied the impact of tax credits and found that 
a 10 percent investment tax credit raises the prices of investment goods by more than 6.5 percent, 
and therefore, much of the increase in investment is absorbed in an increase in price rather than an 
increase in quantity. More recently, Djankov, Ganser, McLiesh, Ramalho and Shleifer (2009) used 
data from a Pricewaterhouse Coopers enquiry for 85 countries and estimated a significant negative 
impact of the effective profit tax rates on investment and entrepreneurial activities. Detailing the 
analysis on the economic sectors, they found that the identified negative correlation is really strong 
for productive sector investment and is weak and insignificant for services sector.    
 
 
Research methodology and results 
In order to envisage this possible connection between taxation and investment undertaken 
by economic agents, we estimated a pool data econometric model of the following general form: 
 
it t i it
'
it it X Y ε + γ + δ + β + α =                      (10) 
 
where:  it Y    dependent variable; 
  it X    the vector of independent variables; 
  α    constant; 
  β   independent variable coefficient; 
  δ    cross section effect (fixed or random); 
  γ   period effect (fixed or random); 
  it ε    random variable; 
  i – number of the cross sections; 
  t – time period. 
 
Our specific model uses as a dependent variable gross fixed capital formation per capital 
(KF) and as an independent variable the average tax burden of corporation tax (on profits) (IP). 
The sample used for the estimation contains time series for the 2000 2007 period for all the 
27 EU member states (Belgium – BE, Bulgaria – BG, Czech Republic – CH, Denmark – DC, 
Germany – GE, Estonia – ES, Ireland – IR, Greece – GR, Spain – SP, France – FR, Italy – IT, 
Cyprus  –  CI,  Latvia  –  LE,  Lithuania  –  LI,  Luxembourg  –  LU,  Hungary  –  UN,  Malta  –  MA, 
Netherlands – OL, Austria – AU, Poland – PL, Portugal – PG, Romania – RO, Slovenia – SN, 
Slovakia – SC, Finland – FI, Sweden – SU and United Kingdom – MB). Data used were collected 
from Eurostat statistical database. 
The specific form of our estimated model is the following: 
 Annales Universitatis Apulensis Series Oeconomica, 11(1), 2009 
 
 
  516
it it it it IP ) KF log( ε + β + α =                    (11) 
 
The estimation results are reported in the following table: 
 
 
 
Table no. 1 
Estimation results 
Dependent Variable: LOG(KF?)     
Method: Pooled EGLS (Cross section weights)   
Sample (adjusted): 2000 2007     
Included observations: 8 after adjustments   
Cross sections included: 27     
Total pool (balanced) observations: 216   
Linear estimation after one step weighting matrix 
White cross section standard errors & covariance (no d.f. correction) 
         
          Variable  Coefficient  Std. Error  t Statistic  Prob.   
         
          C  7.672744  0.065043  117.9635  0.0000 
BE  IPBE  0.290934  0.023726  12.26212  0.0000 
BG  IPBG   0.472052  0.070558   6.690253  0.0000 
CH  IPCH  0.013566  0.025282  0.536600  0.5922 
DC  IPDC  0.358236  0.029121  12.30167  0.0000 
GE  IPGE  0.717698  0.087554  8.197174  0.0000 
ES  IPES  0.056765  0.119975  0.473142  0.6367 
IR  IPIR  0.382960  0.033537  11.41906  0.0000 
GR  IPGR  0.150313  0.038224  3.932375  0.0001 
SP  IPSP  0.255557  0.017090  14.95393  0.0000 
FR  IPFR  0.333465  0.031719  10.51308  0.0000 
IT  IPIT  0.314411  0.021865  14.37963  0.0000 
CI  IPCI  0.069851  0.020100  3.475184  0.0006 
LE  IPLE   0.178394  0.117288   1.520994  0.1299 
LI  IPLI   0.198142  0.112522   1.760926  0.0799 
LU  IPLU  0.265777  0.021577  12.31784  0.0000 
UN  IPUN   0.109834  0.051330   2.139753  0.0337 
MA  IPMA  0.014372  0.017551  0.818871  0.4139 
OL  IPOL  0.279368  0.025581  10.92099  0.0000 
AU  IPAU  0.430009  0.037579  11.44274  0.0000 
PL  IPPL   0.252582  0.068313   3.697431  0.0003 
PG  IPPG  0.121181  0.020796  5.827183  0.0000 
RO  IPRO   0.412996  0.087878   4.699668  0.0000 
SN  IPSN  0.214331  0.031010  6.911662  0.0000 
SC  IPSC   0.106869  0.056951   1.876521  0.0621 
FI  IPFI  0.224497  0.033424  6.716574  0.0000 
SU  IPSU  0.295522  0.025769  11.46805  0.0000 
MB  IPMB  0.268293  0.028646  9.365923  0.0000 
         
            Weighted Statistics     
         
         Annales Universitatis Apulensis Series Oeconomica, 11(1), 2009 
 
 
  517
R squared  0.999554     Mean dependent var  14.81814 
Adjusted R squared  0.999490     S.D. dependent var  12.41056 
S.E. of regression  0.280282     Sum squared resid  14.76892 
F statistic  15605.32     Durbin Watson stat  0.721504 
Prob(F statistic)  0.000000       
         
            Unweighted Statistics     
         
          R squared  0.879905     Mean dependent var  8.067867 
Sum squared resid  16.90266     Durbin Watson stat  0.438357 
         
          Results obtained using Eviews. 
 
The overall validity of the estimated model is appropriate, R squared having a very high 
value  (close  to  one).  More,  as  it  happens  usually  with  pool  data  models,  Durbin Watson  test 
indicates some correlation in the residual variables, but, this not affects the overall quality of the 
estimation. 
The obtained results show that, at a level of statistical significance of 10% the estimated 
independent variable coefficients have statistical relevance for all countries of the sample, excepting 
Czech Republic, Estonia, Latvia and Malta. 
Having in mind that the sign of the independent variable coefficient highlight the nature of 
the  link  between  the  dependent  variable  and  the  independent  variable,  for  6  countries  (all 
developing   former transition   countries (Bulgaria – BG, Lithuania – LI, Hungary – UN, Poland – 
PL, Romania   RO and Slovakia – SC), the obtained results show that between the gross fixed 
capital formation per capita and corporate income (profit) tax there is an inverse connection. Thus, a 
reduction of the level of corporate income (profit) taxation determines, in time, an increase in the 
level of gross fixed capital formation per capita. For all other 17 countries of the sample (all having 
a level of income per capita average and above average) the estimated coefficients are positive, so 
the connection between the two variables is a direct one. This result is at odds with the theoretical 
predictions and it could be explained by the fact that in high income countries, taxation ceased to be 
a major determinant of the investment, other factors playing a bigger role in the investment decision 
of the economic agent. 
   
Conclusions 
Focusing  our  study  on  EU  member  states,  the  estimated  model  showed  that  corporate 
income (profit) taxation has a negative impact for some developing – former transition countries, 
which is consistent with economic theory of investment. This result could be expected if one have 
in mind that at the beginning of the transition all these countries faced two divergent needs: on one 
hand, there was a pressing need to raise the level of private capital in the economy and, on the other 
hand, there was a need to establish a fiscal system able to generate sufficient revenues for public 
purposes.  
An opposite result was obtained for average and above average income countries. For these 
countries,  it  seems  that  there  is  a  direct  connection  between  gross  fixed  capital  formation  and 
corporate  income  tax  burden,  which  contradicts  the  theoretical  predictions.  In  these  countries, 
taxation ceased to be a major determinant of the investment, other factors playing a bigger role in 
the investment decision of the economic agent. 
 Annales Universitatis Apulensis Series Oeconomica, 11(1), 2009 
 
 
  518
References 
 
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CORPORATE INCOME TAXATION EFFECTS ON INVESTMENT DECISIONS IN THE EUROPEAN UNION

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