The new IREF paper of Stefan Lutz, from the University of Manchester, UK, and the Universidad Complutense de Madrid, Spain, points out that if it is apparent that companies do not welcome taxation, the main reason is that taxes reduce profits: shareholders are disappointed and the prospects for investments and development are penalized. This paper, however, concentrates on how companies react to taxation by changing their “gearing ratio”, i.e. the compositions of the financial resources at their disposal by investigating a panel of 240,000 European firms during the 1985-2010 period.
The previous literature has produced mixed results, in that some authors have argued that the equity/debt ratio does not change significantly as a consequence of taxation; instead, other authors have maintained that the gearing ratio does change, but that the variation depends on the nature of taxation. By exploiting this extraordinarily rich amount of data, Stefan Lutz reaches two important results:
– Independent of the nature of the tax, taxation definitely encourages companies to increase their borrowing (debt) and to reduce their reliance on equity (risk-capital).
– Higher taxation has mixed effects on the remuneration of equity. This is due to the fact that taxation and higher indebtedness cut profits, but since the amount of equity is also smaller, the net effect is ambiguous.
Hence, the lesson for high-tax jurisdictions is straightforward. When they increase the tax level, authorities
– do affect the profitability of the firm, but do not necessarily hit the “rich”, since investors (rich and poor) simply refrain from risking their money and opt to share a smaller pie among a smaller amount of capital;
– encourage entrepreneurs to migrate towards legislations/countries that are more generous towards those more willing to risk their assets to finance their ideas;
– lose innovative industries, where risk is greater, but growth prospects and rewards are also greater;
– make the financial system more fragile, since lenders/banks end up taking risks that under more moderate tax conditions they would decline to accept.
Click here to read the full study: Effects of taxation on European multi-nationals’ financing and profits