RDP 2025-01: Are Investment Tax Breaks Effective? Australian Evidence 1. Introduction

Business investment is crucial for economic growth and prosperity. It contributes to productivity, the key driver of living standards, by raising the amount of capital each worker has to use (capital deepening) and by embodying technological advances. Business investment also plays an important role in economic cycles: while it only accounts for around 11 per cent of GDP in Australia, it has long been recognised as being one of the most volatile components of output across the cycle (Kydland and Prescott 1982). Given these long- and short-term considerations, it is unsurprising that policymakers across the globe have in the past designed policies to promote investment both during ‘normal’ times and in response to adverse economic shocks.^[1]

Australia has been no different. Over the past two decades numerous investment tax breaks (ITB) have been introduced in Australia to stimulate investment. These have been used as a structural tool to raise investment in normal times and as a cyclical tool to stimulate investment during downturns, such as the global financial crisis (GFC) and the COVID-19 pandemic. While the exact details of the various policies differed, each increased the (net present) value of depreciation expenses that firms could use to lower their taxable income. Hence, such policies generated a fiscal cost in terms of forgone tax revenue. For example, the tax incentives introduced in 2019 in Australia to support investment for medium-sized businesses were estimated to cost the government $400 million over the four years after its implementation (Parliament of the Commonwealth of Australia 2019). It is therefore important to understand the effects of these policies so that we can assess whether they are cost effective. Moreover, understanding the effectiveness of these policies can also help with forecasting by providing a sense of their macroeconomic effects.

In this paper, we examine the effectiveness of seven distinct policies implemented between 2009 and 2021 in stimulating additional investment in Australia. Examining a suite of policies under varying macroeconomic conditions for one country can allow us to better understand the macroeconomic context in which ITB policies can increase or fail to increase investment and which design features may lead to policy success or failure. We will focus on identifying additional investment that would not have happened in the absence of the policy distinct from subsidies of existing investment plans or shifts in the timing of investment.

High-quality, unique data make this possible. We use data from the Australian Bureau of Statistics (ABS) New Capital Expenditure (CAPEX) survey and administrative tax return data from the Australian Tax office, both accessed using the ABS Business Longitudinal Analysis Data Environment (BLADE). We use two different approaches to identifying the effects of these policies, both of which leverage the cut-offs for eligibility using firm size as captured by turnover: difference in differences (DD), and regression discontinuity design (RDD).

We find strong evidence that the policies implemented during the GFC increased investment, consistent with Rodgers and Hambur (2018). However, there is little evidence of other policies implemented during the 2010s, or the COVID-19 pandemic, having a substantive effect on firm investment.

These findings suggest that ITB can be an effective countercyclical tool, but their effectiveness is likely to be highly dependent on the nature of the economic downturn. For example, they seem more likely to be effective in a downturn caused by a dislocation in credit markets, compared to a pandemic where the economy is partly shut down. Beyond countercyclical policy, smaller policies targeted at structurally raising the level of investment during normal economic times seem of limited benefit. This does not mean that such policies will never be effective. For example, it may be that the policies we studied were too small to have an appreciable effect, or were implemented in periods of policy uncertainty. But the results do suggest the something would need to be different before we would expect a substantial investment response.

This paper makes a number of contributions to the literature. First, it adds to our knowledge of business investment incentives. By considering seven distinct policies with different rules and different eligibility criteria implemented under different macroeconomic conditions, but in a single country, it allows us to learn about heterogeneity of effects with respect to firm size, program rules and cyclical economic conditions.

Second, we provide evidence on the role of dividend imputation in dampening the effects of ITB, building on Rodgers and Hambur (2018). These findings contribute to the debate on the ‘old’ and ‘new’ views of corporate finance. We find that unincorporated businesses, who are not subject to imputation, respond far more strongly to ITB. This is consistent with the old view where the marginal source of funds is external, rather than internal. However, for the GFC policy, incorporated companies also responded to ITB, though by less than unincorporated businesses. This suggests that either ITB affected investment through non-traditional channels, like easing financing constraints that may have been particularly binding during the GFC, or there may be heterogeneity amongst incorporated firms in their financing approach. Some may fund investment from retained earnings (the new view), whereas others may be more dependent upon external funding. If this funding is from non-domestic sources, dividend imputation may be less relevant and ITB policies may decrease the cost of capital and stimulate investment.

Third, we provide the first comprehensive study of business investment incentives in Australia, expanding the scope of policies beyond those previously considered. Finally, we provide some initial evidence that corporate tax rate cuts for small businesses appear to have stimulated additional investment. This is an area for further detailed analysis.

The rest of this paper is set out as follows. Section 2 gives an overview of the policies used in Australia. Section 3 gives an overview of the literature on the effect of investment incentive policies. Section 4 provides an overview of our data. Section 5 outlines our identification strategies and Section 6 presents our results. Sensitivity analysis is included in Section 7 and Section 8 concludes.

Footnote

For example, the United States, the Netherlands, and South Korea all used investment tax incentives during the global financial crisis (GFC). More recently, the 2017 US tax reform incorporates a significant investment tax incentive in the form of full expensing. [1]