Increase in federal taxation devastates investment rates

Due to the COVID-19 pandemic and the war in Ukraine, governments around the world are struggling with expanding debt levels. In Germany, for example, the debt to GDP ratio increased by more than 10 percentage points from 2019 to 2021 , not yet including the economic impact of the war in Ukraine. As debt rises, governments are facing increasing pressure to create further fiscal revenues. Key proposals to do so are raising taxes for individuals (e.g. Ayaz et al. 2022) or for firms.

However, raising taxes creates a trade-off: while in the short term, higher taxes may lead to additional tax revenues, it may also reduce investment and therefore inhibit economic growth, resulting in lower tax revenues in the long term. While the theoretical predictions on this effect of taxes on investment are clear (Hall and Jorgenson, 1967), empirical evidence is still scarce.

This policy brief provides novel empirical evidence on the causal effect of increasing corporate taxes on firm investment, based on our recent working paper (Link et al. 2022). 2 The study combines unique data on investment plans and their realizations of firms in the German industrial sector and data on more than 1,400 local tax changes in the specific system of business taxation in Germany.

We show that firms reduce their investments if corporate taxes were increased. An increase of corporate tax rates to stabilize fiscal revenues would be especially costly during recessions. We conclude that fiscal policy should therefore avoid higher corporate taxation in times of economic crisis. Moreover, our results have implications for the optimal design of fiscal federalism in Germany. Strong dependencies of municipalities on local business tax revenues should be avoided, as they can be very harmful during recessions.