The effect of corporate taxes on investment and entrepreneurship

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The effect of corporate taxes on investment and entrepreneurship1

Fourth Draft, March 2009

Simeon Djankov, Tim Ganser, Caralee McLiesh, Rita Ramalho, Andrei Shleifer

We present new data on effective corporate income tax rates in 85 countries in
2004. The data come from a survey, conducted jointly with PricewaterhouseCoopers, of
all taxes imposed on “the same” standardized mid-size domestic firm. In a cross-section
of countries, our estimates of the effective corporate tax rate have a large adverse impact
on aggregate investment, FDI, and entrepreneurial activity. Corporate tax rates are
correlated with investment in manufacturing but not services, as well as with the size of
the informal economy. The results are robust to the inclusion of many controls.

1 The authors are from the World Bank, Harvard University, World Bank, World Bank, and Harvard
University, respectively. We are grateful to Mihir Desai for considerable help at the early stages of this
project, to Fritz Foley and especially James Hines for help at the later stages, and to Joel Slemrod for
extensive comments. We are grateful to Kevin Hassett and Aparna Mathur for sharing their data and
helping us to understand the differences between their and our tax variables. We are also grateful to Robert
Barro, Bruce Bolnick, Raj Chetty, Laurence Kotlikoff, Rafael La Porta, Gregory Mankiw, James Poterba,
Lawrence Summers, Matt Weinzierl, the editor, and three anonymous referees for helpful comments.
Shleifer thanks the Kauffman Foundation for support of this research, and Nicholas Coleman for excellent
research assistance.


I. Introduction
The effect of corporate taxes on investment and entrepreneurship is one of the
central questions in both public finance and development. This effect matters not only
for the evaluation and design of tax policy, but also for thinking about economic growth
(see Barro 1991, DeLong and Summers 1991, and Baumol, Litan, and Schramm 2007).
Starting with Jorgenson (1963) and Hall and Jorgenson (1967), many public
finance economists have addressed this topic. A small selection of important studies
includes Summers (1981), Feldstein, Dicks-Mireaux and Poterba (1983), Auerbach
(1983), King and Fullerton (1984), Slemrod (1990), Auerbach and Hassett (1992), Hines
and Rice (1994), Cummins, Hassett, and Hubbard (1996), Devereux, Griffith, and
Klemm (2002), and Desai, Foley, and Hines (2004b). Auerbach (2002), Gordon and
Hines (2002), Hasset and Hubbard (2002), and Hines (2005) survey aspects of this
literature. Generally speaking, this research finds adverse effects of corporate income
taxes on investment, although studies offer different estimates of magnitudes.
In this paper, we present new cross-country evidence on the effects of corporate
taxes on investment and entrepreneurship. The evidence comes from a newly constructed
data base of corporate income tax rates for 85 countries in 2004. We seek to contribute
to the literature in four ways.
First, we use new data for a large cross-section of countries. Most cross-country
studies focus on either some or all of the OECD countries (see especially King and
Fullerton 1984 and Devereux et al. 2002, 2003), and hence do not provide much
information about the developing world. Hassett and Mathur (2006) use a large data set
of tax rates for 72 countries over 22 years to investigate the effects of taxes, including


corporate taxes, on wages rather than investment. Their data come from the AEI
International Tax Database, which relies on summaries of tax rates produced by
accounting firms, including PricewaterhouseCoopers, as well as the International Bureau
of Fiscal Documentation2. Hassett and Mathur have time series data, which we do not.
On the other hand, we have more complete information on depreciation and the treatment
of labor taxes in the calculation of corporate tax rates3.
Second, we construct a new database of corporate (and other) tax rates that are
comparable across countries. Our data, assembled jointly by the World Bank,
PricewaterhouseCoopers, and Harvard University, come from a computation of all
relevant taxes applicable to the same standardized domestic enterprise, called
TaxpayerCo, operating in each country. In many instances, these rates differ sharply
from statutory corporate tax rates. The methodology of computing taxes for a
standardized enterprise may provide a different perspective on corporate tax rates than
just working with the statutes, although it is necessarily limited by the representativeness
of case facts. Furthermore, we do not collect information on taxes paid by individuals4.
Third, in addition to standard data on aggregate investment and foreign direct
investment (FDI), we put together new data on entrepreneurship. These data come from
the relatively new World Bank Entrepreneurship Survey, which seeks to produce
comparable business registration data for a large number of countries. We use this
survey to construct measures of business density and formal entry.

2 PwC has previously published tax rates for multiple countries, which have been used by Hassett and
Mathur and others. Their rates have also been published by the World Bank’s Doing Business reports.
These reports cover more countries than we do, but do not contain as detailed information as we use.
3 The correlation between the rates we compute and the Hassett-Mathur rates is only about .5. We return
to their measures later in the paper.
4 We check the robustness of our results to the inclusion of personal tax rates, but do not pursue an
integrated analysis of personal and corporate taxes (see, e.g., Auerbach 1979 and Graham 2003).


Fourth, as pointed out by Davis and Henrekson (2004), corporate income taxes
might differentially affect investment in different sectors, as well as influence the
allocation of resources between the formal and the informal sector. To address these
issues, we use the World Bank’s Enterprise Surveys to construct separate machinery
investment measures for manufacturing and services. We also use the Global
Competitiveness Report estimates of the size of the informal sector. We then assess the
impact of corporate taxes on investment in manufacturing and services separately, as well
as on the size of the informal economy.
Research in public finance has developed elaborate constructs of corporate tax
rates that are relevant to particular investment decisions. In some instances, statutory
rates measure the correct marginal tax rates. Hall and Jorgenson (1967) started an
extensive literature on how to compute the economically correct marginal tax rates using
assessments of profitability of future projects. But average rates might also be relevant
for investment decisions if firms are credit constrained or if they make discrete
investment choices (Devereux and Griffith 2003). In this paper, we remain agnostic as to
which is the correct rate, and present a variety of measures and their effect on investment.
The principal corporate income tax measure we use is the effective tax rate that
TaxpayerCo pays if it complies with its country’s laws, defined as the actual corporate
income tax owed by the company relative to pre-tax profits. Unlike much of the
literature, we can actually compute that rate under our case facts. Since TaxpayerCo is a
new company, we compute both the 1st year effective tax rate, and the 5-year tax rate
taking account of the present value of depreciation and other deductions. Our data reveal
a consistent and large adverse effect of corporate taxes on both investment and


entrepreneurship. A 10 percentage point increase in the 1st year effective corporate tax
rate reduces the aggregate investment to GDP ratio by about 2 percentage points (mean is
21%), and the official entry rate by 1.4 percentage points (mean is 8 %).
To check the robustness of our results, we consider several additional potential
determinants of investment and entrepreneurship. These include other taxes, including
additional taxes imposed on the firm as well as the VAT and the personal income tax,
measures of the cost of tax compliance, estimates of tax evasion, security of property
rights, economic development, regulation, trade openness, inflation, and seignorage.
Some of these factors affect some measures of investment and entrepreneurship, but they
do not eliminate the large adverse effect of corporate taxes.
Finally, our data enable us to ask, in a cross-country context, whether corporate
taxes encourage debt as opposed to equity finance (see Modigliani and Miller 1958,
Auerbach 1979, Miller 1977, Graham 1996, Mackie-Mason 1990, Desai, Foley, and
Hines 2004a). We find a large and significant positive association between the effective
corporate tax rate and the aggregate debt to equity ratio.
The next section of the paper describes our data. Section 3 presents summary
statistics. Section 4 presents the basic results on corporate taxation, investment, and
entrepreneurship. Section 5 concludes.

II. Data
We collect our data from PricewaterhouseCoopers accountants and tax lawyers.
We describe a standardized business and ask them essentially to fill out its tax return, as
well as to provide supporting information and relevant tax schedules. Two rounds of this


exercise were conducted, in January 2005 and 2006. This paper uses data covering the
tax system effective in fiscal year 20045.
The sample consists of 85 countries covered by Djankov et al. (2002). It includes
27 high income, 19 upper-middle income, 21 lower-middle income, and 18 low income
countries. In addition to 22 rich OECD countries, 10 are in East Asia, 17 are in Eastern
Europe, 13 in Latin America, 6 in the Middle East, 14 in Africa, and 3 in South Asia.
The data are constructed using a standardized case study of a business called
“TaxpayerCo.” TaxpayerCo is a taxable corporation operating in the most populous city
in the country. It is liable for taxes charged at the local, state/provincial, and national
levels. It is 100% domestically and privately owned and has 5 owners, none of whom is
a legal entity. TaxpayerCo performs general industrial/commercial activities: it produces
ceramic flower pots and sells them at retail. It does not engage in foreign trade or handle
products subject to a special tax regime. Ceramic pots were chosen because they are
made in every country, and face no industry-specific tax regime.
TaxpayerCo employs 60 people: 4 managers, 8 assistants and 48 workers6. All
are nationals and were hired on January 1st. One of the managers is also an owner.
Employees of the same hierarchical status earn the same wage. All employees are
younger than 40 years and all workers are younger than 26 years. All employees worked
and earned the same salary the year before and none of the employees is disabled.
Managers became subject to social security taxes prior to 1993 while assistants and
workers only became subject to social security taxes after 1993.

5 The survey presents respondents with financial statements for calendar year 2004. We always consider
the data for calendar year 2004, even when fiscal year is different from calendar year.
6 Sixty employees is a somewhat arbitrary number for a mid-size firm, which was chosen because it is the
world-wide average employment in firms in the World Bank’s Enterprise Survey.


The company started operations on January 1st 2004. On the same date, it bought
all the assets. It owns one plot of land, a building, machinery, one truck, 10 computers
and other office equipment. The building is used for production, storage and offices. It
has 10,000 square feet of floor space on a 6,000 square foot land plot. The machinery is
classified as light machinery for tax purposes. The value of computer assets is equally
divided between hardware and software. Other office equipment is composed of standard
office tables, chairs, one copier, one fax machine, one scanner and 10 phones.
We created TaxpayerCo’s financial statements as if TaxpayerCo were operating
in a tax free world. All variables in these financial statements were simple multiples of
the country’s income per capita in local currency (from the World Bank). The statements
as well as the case of the U.S. using the actual values are presented in Table 1. Panel A
describes the balance sheet, and Panel B the profit and loss statement. The multiples
were chosen to be typical for a mid-size manufacturing firm. We specified that
TaxpayerCo keeps 50% of after-tax profits as retained earnings and distributes the other
50% as dividends. In a tax-free world, retained earnings are then half of pre-tax earnings
(equal to 79 times GNI per capita per Table 1), or 39.5 times GNI per capita. However,
the actual amount of retained earnings is a function of the tax system and, therefore, is
not included in the pre-tax Table 1.
We sent these statements to the PricewaterhouseCoopers office in Washington,
D.C., from which they were distributed to the country offices. One response was
prepared per country. PwC respondents in each country calculated the taxes that
TaxpayerCo must pay in its first year of operation. Respondents also provided the full


tax schedules for corporate income taxes7, labor taxes8 for which the statutory incidence
is on the employer, property tax, asset and capital tax, turnover tax, business license tax,
financial transactions tax, but also VAT and sales taxes. Respondents further described
all applicable deductions and exemptions. They informed us of the full depreciation
schedules for all assets, so we could compute depreciation allowances for TaxpayerCo.
Respondents also recorded the deductibility of advertising expenses, machinery repair
expenses, interest expenses, and of each applicable tax. Taxes at all levels of government
were included. Our analysis focuses on corporate income taxes, although we use the
additional tax and compliance cost data provided by PwC for robustness checks9.
For each tax, PwC respondents described the frequency and the process for
payment, e.g., whether the tax could be paid electronically or required payment in person.
The time it took to prepare, file and pay TaxpayerCo’s taxes was also recorded.
All data thus collected was subsequently discussed and checked with PwC
personnel in the sample countries10. The data was also double-checked with information
provided by the International Bureau for Fiscal Documentation. Discrepancies were then
addressed through further discussions with PwC country offices.

7 All taxes levied on corporate income are considered corporate income taxes for the purposes of this
analysis, regardless of the name given to them.
8 All charges levied on labor for which the statutory incidence is on the employer are considered labor
taxes, whether they are called labor taxes, social security contributions, or something else, whether they are
requited or unrequited, and whether they are paid to a public or private agency. We try to unbundle the
mandatory accident insurance contribution from the labor taxes. Wherever we can obtain information on
the contribution rate for the mandatory accident insurance contribution, we do not include it in the labor
taxes to be consistent across countries. Many countries only mandate that employers have an accident-at-
work insurance in place for their employees, but we could not find rates applicable to TaxpayerCo.
9 We do not have enough information to integrate personal income and dividend taxes with corporate
income taxes. We do not consider minor taxes, such as waste collection and vehicle taxes. Taxes on real
estate transactions and capital gains taxes are not included because they do not come up in the case facts.
10 Data for the Kyrgyz Republic and Mongolia were provided by PwC’s Kazakhstan office.


Tax variables
Table 2 describes the main variables. We start with the tax variables, and divide
their presentation into three groups: corporate income tax measures, other tax measures,
and tax administration measures. We compute three corporate income tax rate variables:
the first is the traditional statutory corporate income tax rate, while the remaining two are
based on the actual taxes owed by TaxpayerCo as computed from survey responses.
Appendix A presents the values of tax variables for all of the sample countries.
1. Statutory corporate tax rate. This is the tax rate a company has to pay on
marginal income assuming that it is in the highest tax bracket, taking into account federal,
state, and local rates. We account for the deductibility of some taxes for the purposes of
calculating the tax base. In Switzerland and the U.S., for example, state income taxes are
deducted from the federal income tax base11.
2. 1st year effective corporate tax rate. This is the actual first year corporate
income tax liability of TaxpayerCo relative to pre-tax earnings (79 times GNI per capita
per Table 1), taking account of all available deductions. Appendix B illustrates the exact
steps used in the calculation of this tax variable, and the next, for the case of Argentina.
3. 5-year effective corporate tax rate. This rate takes account of actual
depreciation schedules going 5 years forward. The numerator is the present value of
actual corporate tax liabilities of TaxpayerCo over 5 years, where only depreciation

11 It is possible that TaxpayerCo faces a lower statutory tax rate than the maximum. We computed the
statutory corporate income tax rate applicable to TaxpayerCo. Worldwide, it is 1.5 percentage points lower
on average than the maximum rate, but across countries is very highly correlated with the highest statutory
rate. We have run our regressions using the statutory rate applicable to TaxpayerCo, and they are generally
weaker than those for other rates. A plausible interpretation of this is that it is the maximum statutory rate
that is relevant for aggregate investment, which is what we use as the dependent variable. We therefore do
not discuss the marginal rate applicable to TaxpayerCo any further in the paper.


deductions change over time. The denominator is the present value of pre-tax earnings,
assumed to be the same every year. We discount both taxes and profits at 8 percent12.
The effective corporate tax rate, both in its 1st year and 5-year versions, does not
fully reflect all the complexities that public finance theory suggests are relevant to
corporate decision-making (see, e.g., King and Fullerton 1984). Our measures have the
advantage of extreme simplicity and transparency, and may plausibly correspond to what
profit-maximizing entrepreneurs look at when they evaluate investments. We present the
basic ingredients of the computation of corporate taxes for a large number of countries, to
see whether, in their simplest form, they influence investment and entrepreneurship.
In addition to the corporate taxes, we use four other tax rates in our analysis, the
first three of which come from our survey, and the last from other PwC data:
4. Labor tax. This is the sum of all labor-related taxes payable by TaxpayerCo,
including payroll taxes, mandatory social security contributions, mandatory health
insurance, mandatory unemployment insurance, and any local contributions that depend
on the payroll or number of employees. The denominator is pre-tax earnings of
TaxpayerCo. Because our research design focuses on firms and not on their workers (or
shareholders), only taxes with statutory incidence on the employer are included. We use
the first year of operations. We do not have data on taxes paid by individuals, even if
they are withheld by TaxpayerCo.
5. Other taxes. This is the sum of all taxes payable by TaxpayerCo in the first
year of operation that enter the profit and loss statement where the statutory incidence is
on the firm, other than corporate income and labor tax. It is the sum of all property taxes,

12 In our main calculation of the 5-year effective tax rate, we do not take inflation into account. However,
in our robustness checks, we both control for inflation and consider the effect of non-indexation of
depreciation deductions, emphasized by Auerbach and Jorgenson (1980).