Home » Effects of taxation on European multi-nationals’ financing and profits

Effects of taxation on European multi-nationals’ financing and profits

WP 2013-03. Executive Summary International restructurings by globally acting enterprises have become a common occurrence in the wake of accelerating globalization and have led to increasing global relocations of economic activities. Besides resource cost and infrastructure, the taxation regime is an important determinant of the geographical development of globalization. The tax regime ultimately affects the profits of a firm, but it also affects the capital structure, i.e. the mix between debt and equity financing of firms, the co-called gearing ratio (or leverage ratio). The capital structure, in turn, affects the entrepreneurial function that can be taken on by a particular enterprise. For example, highly innovative firms using and developing cutting-edge intellectual property tend to need more equity financing than firms performing mature routine functions. Hence the taxation regime may hinder or promote firms’ location of highly innovative industries in a particular jurisdiction by making debt financing more or less attractive relative to equity financing. So far, however, the empirical literature has presented mixed results. The research presented here analyzes a very comprehensive data set obtained from the Amadeus firm-level data base as well as from the OECD spanning a panel of 240,000 firms from 24 European countries for the years 1985 to 2010. By exploiting this extraordinarily rich data set, we reach two important results: – A rise in corporate income tax, irrespective of how they are measured, encourages companies to increase their borrowing (debt) and to reduce their reliance on equity (riskcapital). – While tax increases reduce profit levels and margins, they have mixed effects on the remuneration of equity, since the underlying equity is also reduced. Overall results indicate that taxation has a negative effect on overall firm profits but not on returns on shareholder funds. This is consistent with the observed positive effect of corporate taxation rates on the gearing ratio, i.e. the higher corporate tax rates in a particular jurisdiction the lower the share of equity financing of firms residing in that jurisdiction. This may indicate that high-tax jurisdictions deter valuable investment by multinational enterprises because they provide incentives to locate value-driving business parts requiring more equity financing elsewhere. To download the paper, please, click on the icon below. WP 2013-03

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