Kinky Tax Policy and Abnormal Investment Behavior

This paper documents tax-minimizing investment, in which firms accelerate capital purchases near fiscal year-end to reduce taxes. Between 1984 and 2013, average investment in the fourth fiscal quarter (Q4) is 37% higher than the average of the first three fiscal quarters. Q4 investment spikes also occur internationally. We use research designs based on variation in firm tax positions and the 1986 Tax Reform Act to show tax minimization causes spikes. Spikes are larger when firms face financial constraints or higher option values of waiting until year-end. Models without a purchase-year, tax-minimization motive are unlikely to fit the data. ∗The views expressed here are ours and do not necessarily reflect those of the US Treasury Office of Tax Analysis, nor the IRS Office of Research, Analysis and Statistics. We thank Andy Abel, Heitor Almeida, Jediphi Cabal, Mike Devereux, Martin Feldstein, John Guyton, Jim Hines, Martin Jacob, Justin Murfin, Tom Neubig, Mitchell Petersen, Annette Portz, Jim Poterba, Josh Rauh, Lisa Rupert, Joel Slemrod, Michael Smolyansky, Amir Sufi, and seminar and conference participants for comments, ideas, and help with data. We thank Thomas Winberry and Irina Telyukova for sharing code used for our quantitative model. We thank Tianfang (Tom) Cui, Francesco Ruggieri, and Iris Song for excellent research assistance. Xu thanks Mendoza College of Business at University of Notre Dame for financial support. Zwick gratefully acknowledges financial support from the Neubauer Family Foundation, Initiative on Global Markets, and Booth School of Business at the University of Chicago. When proposing tax changes, policymakers often appeal to the effect of taxes on corporate investment. These proposals presume a model of how firms respond to taxes. Research going back to Hall and Jorgenson (1967) has made much progress in characterizing this model and estimating the size of investment responses to taxes. However, because most research relies on quasi-experiments based on non-random tax changes, the extent to which estimated tax effects reflect unobservable firm or macroeconomic factors remains unclear.1 This body of research has also identified patterns at odds with the standard representativefirm, user-cost model. Some tax instruments have large effects on investment, while others do not. The immediacy of tax benefits appears to play a larger role in driving firm responses than the standard model predicts. Small and mid-market firms yield larger elasticities than large firms, leaving open the question of whether the firms that drive aggregate activity respond to taxes. Furthermore, because we cannot observe public firms’ tax positions from financial accounts, efforts to identify tax effects for these firms face problems with measurement error.2 This paper presents novel evidence of how tax policy affects business investment. We develop a new measure of investment behavior, which is simple, transparent, and most importantly, orthogonal to low and medium frequency firm-by-time and policy shocks. Our approach allows us to remove time-varying omitted factors coinciding with the identifying variation we exploit, thus addressing one of the key concerns with existing empirical work. We demonstrate the first order importance of taxes for corporate investment behavior and further illustrate that tax asymmetry—in particular, the immediacy of the incentive to respond—matters critically for fitting the data. We begin by documenting a robust but hitherto unappreciated stylized fact about investment behavior among public companies in the US. Firms frequently backload their investment near fiscal year-end, leading to quantitatively significant spikes in capital expenditures (CAPEX) 1The literature relying on policy-induced variation includes Cummins, Hassett and Hubbard (1996), Goolsbee (1998), Chirinko, Fazzari and Meyer (1999), Desai and Goolsbee (2004), House and Shapiro (2008), Edgerton (2010), Becker, Jacob and Jacob (2013), Yagan (2015), Ljungqvist and Smolyansky (2014), Zwick and Mahon (2017), Giroud and Rauh (2016), and Ohrn (2016). Hassett and Hubbard (2002) survey the early research and offer a consensus view, which is mostly consistent with subsequent findings. 2Yagan (2015) finds dividend taxes do not affect corporate investment. Suárez-Serrato and Zidar (2016), Giroud and Rauh (2016), and Ohrn (2016) find meaningful effects of tax rate changes on firm location, investment, and employment. Zwick and Mahon (2017) find depreciation incentives have a significant effect on investment that is more pronounced for small firms than for large firms, with a response driven by the immediacy of realized tax benefits. Edgerton (2010) uses financial accounting data to study the role of corporate tax asymmetries and finds less evidence that immediacy matters for public firms, while acknowledging measurement limitations may drive these results.