Effect of Taxation on the Investment Decision in Firms - Research Paper Example

Running Head: Effect of Taxation on the Investment Decision in Firms Effect of Taxation on the Investment Decision in Firms This paper will examine the effects of taxation on the high risk investment decisions that are taken by the firms. AS risk is an important factor in every business decision, this paper explains the various aspects that need to be considered in high risk decision making and then explains the effect of taxation on investment decisions. Introduction Taxes are one of the important instruments by which governments collect money to fund public facilities. Taxes though important have to be used tactfully by the government as both personal and corporate taxes have far reaching effects. A realistic tax policy in a developing country can ensure large availability of vital foreign funds and investments and therefore give a boost to the economy. The government dishes out sops to specific sectors and fulfills its task of generating enough growth in high risk sectors. The investment decision of firms depends upon various factors like the political will and stability, the infrastructure and the tax regime. The taxes levied on corporate investments also have a direct bearing on the profitability of these firms; hence they become a vital factor while taking any investment decisions. This therefore makes tax rates an important instrument with governments who manipulate it to ensure economic growth of a country. This paper examines the effect of taxes on investment decisions of the firms. It explains the various factors that affect firms functioning in the high risk taking sectors and the various instruments available with the government by which they can assist these firms to attain a better economic growth both for the firms and the country. In the end a case study of the steps taken to promote investments in the European Union amplifies the points made in the paper. Factors affecting investments The profits that a firm earns are directly affected by the rate of taxes that are levied on its produce. This has a bearing on its investment capacity. The poor infrastructure and institutional facilities combined with high tax rates can make any country a poor investment destination for firms. The tax system is an effective tool in the hands of the government to encourage those sectors which require investments of long gestational periods or poorly developed sectors where there is a need of capital investment. By altering the tax rates governments can shift the investments from more lucrative to high risk sectors by giving cuts in corporate tax and accelerated depreciation so as to increase the post tax profitability of the firm. This will lead to long run growth of the business as well as the economy. The effects of the proposed tax cuts like the capital gain tax, import duty exemption or local indirect taxes should be measured in relation to the expenditure change that they can offset. Such reductions in tax rates increase the firm’s investment capability. Lower taxes help to reap a higher profit by the firms. The role of the government The government hands out large incentives to firms that are keen to invest in high risk sectors but which are good for the overall growth of the country. These sops can be in the form of tax holidays, import duty exemptions, exemption from custom duties etc. The firm’s investment decision is greatly influenced by these tax exemptions. Other major factors that also affect the investments are the political and economic stability of the nation, infrastructure facilities, transport system, roads etc. These factors have an important bearing as they make the environment more conducive for investment, tax rebates are important but cannot be the sole incentive for investment. Especially in the case of MNC and FDI, studies reveal that the investors are mostly influenced by the market, political factors and tax rebates which are being offered. The government attracts foreign investment in targeted high risk sectors by giving huge tax cuts thereby increasing the capital inflow to the economy. Though this may decrease short term fiscal revenue but in the long run it gives boost to the specific industries which would bring greater benefits to the country. Lowering of corporate tax is a long term profit earning mechanism for the firms. A tax holiday on the other hand gives a direct boost to the company’s as soon as they begin earning income by giving larger profits. These tax holidays give a major boost to the establishment of new companies. Different sectors have different requirements of tax rebates. Export oriented firms tend to be affected largely by the tax rebates being offered on the export and import duties. These firms have to face stiff global competition and generally operate with very small margins. These firms being global in nature tend to compare tax rates across countries and may tend to shift base completely to lower tax regimes. Hence tax sops can be an important incentive to retain such firms. Manufacturing firms often seek incentives related to depreciation of their plant and machinery as their bulk expenditure is in their infrastructure costs rather than other service oriented costs. The financial stability of the smaller companies have greater dependence on the tax rebate that are offered directly by the government as they are not capable to employ expensive tax avoidance strategies. They would rather benefit directly from tax cuts in place and increase their profit margins. Advantages of Tax allowances on Investment Hasset (1999) propounds that reductions in corporate tax rates foster new investments. This encourages the entrepreneur to take a long term view of the situation when planning his investments. It also benefits the government because by targeting the current capital spending the allowances cause less revenue leakage than a tax holiday. The government can also share the capital costs with the entrepreneur and reap a portion of the profit as well. Projects that have large break even periods suffer in comparison with those that have short payback time. The firms with large break even time will benefit if they can get tax reductions for their capital expenditures like borrowed finance, cost of machinery etc. Some countries give a tax holiday to the special high risk sectors like export processing zones (EPZ) for extended periods with additional tax sops like totally removing import and custom duties on machinery and production inputs. The regulated sectors like the energy and infrastructure are very sensitive to any change in governmental policies and tax rates as their pricing and therefore the profitability is largely dependant on the sops that they get from the government. The government in order to maintain regular investment in these sectors follows a three point approach. Firstly it gives the required tax deductions on borrowed capital secondly it removes the diplomatic barriers required for easy investment and thirdly it gives support in the case of risk and uncertainty. This can be done by giving cuts in corporate income tax, capital gains tax and depreciation benefits. The size of the firms changes their risk taking capabilities. Larger firms have more cushion and avenues to diversify risk as compared to smaller firms. MNC can diversify country specific risks by spreading their investments across various economies. The smaller firms working in the unorganized or the informal sector do not have such luxuries to manage their risks. A major constraint that the high risk firms operate under is the little availability of external finance and credit. This can adversely affect the growth of these firms. The financial infirmity market rigidness added to the governmental policies and taxation burdens make these high risk ventures a very difficult proposal for profit making. Hence venture financing, tax breaks and co investment by the government are essential to make these ventures work and sustain economic growth of the country. Case Study The success of entrepreneurial ventures in the United States during 1980’s created a unbalance between the US and the European economies.(Razin 1990) The 1988 Risk Capital Commission of the European Union laid out an action plan and provided a policy framework according to which the most effective way to increase the success rate of entrepreneurial ventures is to reduce the existing imperfections in the capital and labour market across the European sub continent and to create stock markets specially targeting the high growth companies. This would in turn increase the supply of capital to the high risk companies and thus try and imitate the US success model. In 1990’s the EU took some more remarkable steps. First they introduced the Euro at the financial and the product market; this substantially increased the pace of development. Secondly the supply of capital to the new high risk startups increased dramatically making the environment more conducive for the entry of other companies. Thirdly they created several new equity markets targeted at young innovative firms providing companies with a chance to raise substantial amounts of equity capital at an early stage. The policy changes made have a favorable effect on financing the new entrepreneurial ventures. For example the conversion of the European Investment Fund in to a major investor venture capital fund has committed a large portion of EU budget to the nurturing of well managed venture capital firms. Studies based on US have shown that venture backed companies are more effective innovators. Glenn Hubbard shows in his findings that a progressive tax system would have favorable effect on new venture start ups. On the other hand when taxes are heavy they act as a major hurdle. Small businesses are a major source for generating employment and growth and innovation and also help ensure a competitive business environment flattening of marginal rate structure could increase the rate of the small business formation so a preferential tax policy may be warranted. Conclusion The taxes that are levied on firms have a direct affect on its investment decisions. The government uses the sops in taxes to ensure better participation of the corporate sector in high risk areas and in projects which have long breakeven time. The tax cuts in imports and customs are effectively used to lure investments from across borders thereby giving the required impetus to the economy. Works Cited Alm J, Martínez Jorge V, Mark 2006 The Challenges of Tax Reform in a Global Economy  Springer Razin Assaf, Slemrod Joel 1990 Taxation in the Global Economy University of Chicago Press Edmiston kelly, mudd shannon 2003 Tax structures and FDI the deterrent effects of complexity and uncertainty  Original from the University of Michigan Anne Lou A. 2000 Foreign Direct Investment in Emerging Economies: Corporate Strategy and Investment Behaviour. Routledge Hasset Kevin A. 1999 Tax Policy and Investment American Enterprise Institute Brink Charlotte H 2004 Measuring Political Risk: Risks to Foreign Investment  Ashgate Publishing, Ltd. Read More