JOURNAl, OF

O~NCS
EI.ShaClER Journal of Public Economics62 (1996) 237-273

Tax reforms and investment: A cross-country

comparison

Jason G. Cummins ~*, Kevin A. Hassett h, R. Glenn Hubbard cd,

~Department of Economics. New York University 269 Mercer Street. 7th Floor. New I/ork.
NY 10003. USA
~Bourd of Governors of the Federal Reserve System. Washington. DC 20551. USA
"Graduate School of Business. Columbia University. New York. NY W027. USA
"National Bureau of Economic Research. Cambridge. MA 02138. USA

Abstract

We use firm-level panel data to explore the extent to which fixed investment
responds to tax reforms in t4 OECD countries. Previous studies have often found
that investment does not respond to changes in the marginal cost of investment. We
identify some of the factors responsible for this finding, and employ an estimation
procedure that sidesteps the most important of them. In so doing, we find evidence
of statistically and economically significant investment responses to tax changes in 12
of the 14 countries.

Keywords: Tax reform; Investment; q theory

J E L classification: E22; H25; H32

1. Introduction

Economists have long argued that s~gnificant reforms of corporate

taxation can have large effects on firms" investment decisions. At some
level, policymakers themselves have heeded this message. During the 1980s,
significant tax reforms were introduced in many developed countries (see,
for example, Jorgenson, 1992; Messere, 1993). But while extensive studies

*Corresponding author. E-mail: cummins~fasecon.econ.uyu.edu.

~M7-2727/96/$15.6'0 (~) 1996 Elsevier Science S.A. All rights reserved

P I I S0047-2727(96)01580-0
238 J.G. Cummins et al. / Journal o f Public Econot~ws 62 (1996) 237-Z73

of the effects of various tax parameters on firms" user costs of capital have
been prepared and then compared across countries (for the first such study,
see King and Fullerton, 1984; most recently, see OECD. 1991). empirical
evidence has not been overwhelmingly supportive of significant effects of tax
policy on investment (see, for example, the review in Chirinko, 1993).
Neoclassical models of investment that rely on the user cost of capital
model (see Jorgenson, 1963; and the application to tax policy in Hall and
Jorgenson, 1967) or q models (see. for example, Tobin, 1969; Hayashi,
1982; Summers. 1981) generally have little explanatory power for invest-
ment. Estimated adjustment costs are implausibly large, rendering any
inference about the effects of changes in market valuation or tax parameters
on investment difficult at best. Indeed. the user cost of capital and q
approaches usually fail to explain investment as well as simple ad hoc
accelerator models (see, for example, Clark, 1979. 1993: Bernanke et al.,
1988; Oliner et al., 1995), and measures of outpu*,, corporate cash flow, or
profitability generally improve the fit of empirical investment models
significantly, l The weight of the existing evidence appears to lean toward the
interpretation that tax variables have little effect upon firm investment.
In this paper we attempt to measure the effects of tax reforms on business
investment using an extension of the tax-adjusted q model. In so doing we
improve upon existing approaches by using tax reforms to better identify
determinants of investment decisions. In particular, we argue that tax
reforms are natural experiments for measuring the responsiveness of
investment to fundamentals affecting the net return to investing, since they
represent discrete events with a large and discernible effect on the return to
investment.
This approach builds on that in our earlier paper (Cummins et al., 1994)
in which we analyze models of business fixed investment for US firms.
There. the estimated effects of neoclassical fundamental,, on investment
were more statistically and economically significant than those generally
found in earlier studies, and the estimates implied reasonable adjustment
costs in both the tax-adjusted q and user cost of capital specifications. For
the United States. we found that following each major tax reform since
1962, the cross-section pattern of investment changed significantly. In
addition, our estimates of structural parameters were economically similar
across different specifications of the same basic structural model over a
36-year period. 2 As discussed below, we find similar patterns in our

IThe often poor empirical performanceof neoclassical models has led some researchers to
abandon the assumptionsof reversible investment and convex adjustment costs used in testing
neoclassical models in favor of approaches based on "irreversible" investment. Scc the
discussions and reviewsof studies in Dixit and Pindvck (1994) and ttubbard (1994).
"Our results have since been corroborated using plant-level data by Cabellero et a[. (1995).
 J.G. C~tmmins et al. / Journal o f Public Economits 62 (1~36) 237-273 2.~)

exploration of tax reforms outside the United States. The estimated effects
of fundamentals of the neoclassical model are economically significant and
plausible, and are relatively similar across most of the countries we study.
This suggests that the stylized fact that investment does not respond to tax
changes affecting the net return to investing is incorrect for the sample of
firms we study.
To pursue this, we employ a rich firm-level panel dataset on tax reforms
in 14 countries to study the investment decisions of over 3000 firms. We rely
on firm-level panel data instead of aggregate time-series data because they
allow us to overcome several important problems that have hampered
previous attempts to isolate tax effects. First, the time-series variation in
investment incentives is clearly not exogenous. Governments tend to
institute investment incentives when aggregate investment is perceived to be
"low' and remove them when aggregate investment is perceived to be ~high'.
Second, since corporate tax parameters are changed often, it is difficult to
judge what a firm's expected tax treatment is in any given year. Finally, if
the stock market value of the firm is noisy, it may be hard to isolate tax
effects if movements of these are dominated by noise from other sources.
We rely on a cross-sectional variation in tax parameters just following tax
reforms in order to overcome these estimation problems.
T h e paper is organized as follows. Section 2 describes the model we
estimate. Section 3 reports estimation results using standard estimation
techniques. Section 4 discusses the problems that may lead to bias in the
results reported in Section 3, and then describes our two proposed alter-
native estimation procedures. Section 5 reports the results we obtain using
these procedures. Section 6 concludes.

2. Tax-adjusted q and investment

Assuming convex adjustment costs, there are four standard ways to obtain
empirical investment models in the neoclassical approach. Each begins with
the firm maximizing its net pr,;~cnt value. The first-order conditions lead to
a Euler equation describing the period-to-period optimal path of invest-
meat. Abel and Blanchard (1986) solve the difference equation which
relates investment to its expected current and future marginal revenue
products. Alternatively. the Euler equation itself may be estimated (see, for
example, Hubbard and Kashyap, 1992; Bond and Meghir, t994). As in
Auerbach (1983), investment can be expressed in terms of current and
future values of the user cost of capital, and, under some conditions,
expressed in terms of average q. This final approach was first suggested by
Tobin (1969), with the necessary conditions supplied by Hayashi (1982). We
relate the q model of investment to the approach discussed below. Since the
240 J.G. Cummins et al. I Journal o f Public Economics 62 (1996) 237-273

investment equations we utilize are largely familiar, we refrain from

repeating derivations presented elsewhere and focus on the estimation
equations. Appendix A provides a formal derivation of the tax-adjusted q
model.
Following Hayashi (1982) and Summers (1981), who derive the relation-
ship between Tobin's q and investment in the presence of quadratic
adjustment costs, we represent the tax-adjusted q approach as follows:

l,_,/K,.,_~ = p.~ + yQ~.r + e,.,, (1)

where I and K are investment and the capital stock, respectively; i and t are
the firm and time indexes, respectively; /z is a firm-specific constant; Q is
the tax-adjusted value of Tobin's q (see the derivation in Appendix A); and
e is the error term. That is,

q, , - g , 0 - r ~ , )
Q'.' = (1 - ~',) ' (2)

where r is the corporate tax rate, p is the price of capital goods relative to
output, and F is the present value of tax savings from depreciation
allowances and other investment incentives. F~r example, with an invest-
m e n t tax credit (ITC) at rate k, F is

F~, = k i , + ~,(1 + r~ ~r~)~-'r~DEP~ ~(s - t) (3)

s=t

where r is the real rate of interest, and DEPt.s(a) is the depreciation

allowance permitted an asset of age a discounted at a nominal rate that
includes the expected inflation rate ~rc.
M a n y of the countries we study provide some sort of dividend relief. It is
a simple extension of the above model to adjust the estimation equation to
account for imputation systems (see, for example, Alworth, 1988). How-
ever, if the 'new view' (King, 1977; Auerbach, 1979; Bradford, 1981) is
correct, then dividend taxes are capitalized into the value of the firm, and
p e r m a n e n t changes are irrelevant for the investment decisions. For the
exercises we consider here, we rely on the 'new view' assumption. This
assumption simplifies the construction of the tax-adjusted q, and allows the
results across countries to be compared more easily. O f course, if this
assumption is incorrect, then we should expect to see less responsiveness of
investment to tax policy in countries with imputation systems, because the
variable we use would be more mismeasured. We return to this issue below.
 J.G. Cummins et al. / Journal of Public Economics 62 ( 1 ~ ) 237-273 24[

3. Standard approach

As a baseline, we begin by presenting estimates of the tax-adjusted q

model using standard econometric techniques employed by many previous
authors. We present this evidence for two reasons. First, results using a
comparable approach for all the countries are unavailable. It is an important
first step to identify whether the 'stylized facts', as we presented them
above, apply when a uniform method is used on data from a much larger set
of countries. To our knowledge, estimates are only available for Canada
(Schaller, 1993); Italy (Galeotti et ai., 1994); Japan (Hayashi and Inoue,
1991; Hoshi et al., 1991); Spain (Alonso-Borrego and Bentolila, 1994); the
United Kingdom (Devereax and Schiantarelli, 1990; Blundell et al., 1992_;
Devereux et al., 1994): and the United States (see the review of studies in
Cummins et al., 1994). We use finn data for Australia, Belgium, Canada,
Denmark, France, Germany, Italy, Japan, the Netherlands, Norway, Spain,
Sweden, the United Kingdom, and the United States.
Second, ue~ng these data, we analyze previous results that have implied
low responsiveness of investment to fundamentals, such as Q, and explore
whether identifiable econometric problems (e.g. weak instrumental variables
or moment restrictions) can at least in part explain the econometric
difficulties. In the next section we describe and employ two techniques that
sidestep the ma./n problems documented here.
For the estimation, we draw from the Global Vantage database and the
tax variables we have assembled, which arc both described ;n detail in
Appendix B and in Tables 1-4. To provide a complete reference for the
history of the relevant tax parameters used to construct Q during our sample
period, Tables 1-3 report the statutory marginal corporate income tax rates,
investment tax credits and deductions, and depreciation and inventory
valuation rules fer each of the countries we study (see also the description of
variable construction in Appendix B).3
Table 4 provides means and medians of some of the more important
variables in the dataset. Firm market values are reported in column 1.
Median values range from a low of $41 million (mean $99 million) for
Denmark to a high of $889 million (mean $2174 million) for Japan. These
values are calculated converting the real market value in home country
currency to US dollars using the exchange rate at the end of the firms' fiscal
year. As such, they will tend to reflect exchange rate effects so that if the
dollar is strong over the sample period then the foreign firms will appear

STable 3 details the depreciationand inventoryvaluat/on rules for the tax year 1992. For a
more completede.~criptionof the changesin theserulesover the sampleperiod,see Appendix
B.
Table t to
Statutory maximum marginal colporate income tax rates
Couotr}, 1981 1982 ,1983 , ,1984 1985 198~ 1987 1988 1999 199t1 1991 19~2
Australia ~ 0.46 0.46 0.46, 0.46 0.46 0,49 11.49 0.39 1L39 0.39 0,39 11.39
Belgium" 0,48 0.45 0.45 Q.45 (;.45 0.45 11.43 0.43 11.43 l).41 O.39 I).39 '
Canada ''a I.I.483 0.483 0.472 Q.46 0.483 0,483 0,464 0,391 I).391 O.391 0,391 11.391
Canada ¢'a 0,42 11.42 11.4f 0,411 0,42 0,42 0,391 0.371 0.361 0.350 0,340 0.340
Denmark 0,40 0,40 11.40 0.40 0.50 0.50 0.511 0.50 0.5(I 0.411 0.38 0,38
France ~ 0,50 0,5d 0,50 0,50 0.50 0,45 0,45 0.42 11.39 11.37 0.34 0~34 ~'
Germany I 0.56 0.56 0,56 0,56 0,56 0,56 0,fU 0,56 0,56 0.50 0.519 0.519
Ireland s 0,45 0.50 0.511 0,50 0.50 0,50 0,50 0,47 0.43 Q,43 0.40 11.4o
Italy' ,.h 0.363 0.413 0.413 0,464 0,464 0.4fi4 0.464 0,464 0,464 0,464 0,478 O.552 '
lapan 0.42 0.42 0,42 0.433 0.433 0,433 0,42 11.42 0,40 0,375 0,384 0.384 "x
Nether|ands 0.48 0.48 11.48 11.43 0,43 0.42 0.42 0.42 0,35 0,39 11,35 035
New Zealand 0,45 0.45 0.45 0.45 0,45 0.48 0,4,q 0.28 0.33 0.33 0,33 0.33
Norway i 0.5(~ 0.51}8 11,5118 0,508 ().50ff 0,508 0,50g 0.508 1),508 0.508 11.508 028
Spain 0.33 0.33 0.35 0.35 11,35 11.35 1),35 0,35 tL35 {).35 0.35 11,35
Sweden ~ 0.58 0.58 0,58 0.52 11.52 0.52 0.52 0,52 11.52 11.40 0,30 0.30 ~,~
Swhzerland k 0.098 I).1198 0.098 0.01J8 0.098 0,098 11.098 0.098 0.098 0.098 0.098 0,098
UK ~ 11.52 0.52 0.52 0.45 0.40 0,35 0,35 ft,35 0.35 0,34 0,33 11.33
US ~ 0.46 .0.46 ...... 0.46 , , 0.46 0.46 0.46 tl,40 0,34 0.34 11.34 0.34 11.34 ~
Notes;
"Undistributed profits were taxed al the rate of 0.50 until an imputation system came into operation in July 1987.
~'Excess profils surtax at the rate of 0.04 applied until 1982,
Additional corporate income tax levied by state and/or municipa~ government which is rebated or deductible at the federal level
'~The corporate income tax rates in the third row are the general rates. The rates in the fourth row are those for manufacturir~g and processing income.
A split-rate system, which applied a higher tax rate of 0.42 to distributed profits, was in effect from 1989 until 1992.
t Distributed profits taxed at n lower rate of 0.36~
e Corporate income tax is levied at a lower rate of 0.10 on manufacturing films,
Distributed profits were taxed at a 0.t0 lower rate until 1988. In 1989, distributed profits were taxed at a 0.05 lower rate, The split-rate system was permanently
abolished in 191~.
' Additional corporate income taxes were levied at munieipa} love} and for a lax equafizatior, fund', resulting in a combined rate of 0.23 which was mJl deductible
front the federal rate of 0,278, Effective 1992. th~ federal corporale income ~.;~xwas abolished, the municipal rate was lowered to 0.11, and the 'lax equalizalion fuud' ~I
rate was increased tO 0.17. %
Additional corpoYate income tax levied at municipal level, which was deductible al federal level, was abolished in 1985.
Federal, cantonal and municipal corporate income taxes, which are typically parti~dly deductible against o n e anolher, are levied at graduated rates based on tile
proportion of taxable profits to equity capital, Top federal rate reported.
tThe rate for 1990 was retroactively changed from 0,35.
Table 2
Rates of investment incentives"
Country 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992
Australia" 0.18 0.18 0.18 0.18 0.18 0 0 0 11 0 0 0 ""
Belgium' 11.05 0.(15 0.05 0,05 0,05 0,05 0.05 0.05 0.05 004 0.03 0
Canada a 0.07 0,07 0.07 0.07 0.117 0.07 0.115 0.03 0 0 13 0
Denmark" 0 0 0 0 0 0 0 0 0 (I 0 0
France" 0,10 0.15 0 (I 0 O 0 0 11 0 0 0
Germany 0 0 0 (I 0 0 0 0 0 0 0 0 ~"
lrehmd 0 0 0 0 I) 0 0 0 11 0 11 0
Italy 0 0 tl 0 1) (I 0 0 0 0 l) 0 '~
Japan 0 0 0 (1 11 (I 0 0 0 0 11 0 "-,
Netherlands t 0.12 0.12 0.12 11.125 0.125 0.125 0.125 0 0 0 0 0 ~-
New Zeahmd 11 0 (I 0 0 0 11 0 0 0 0 0 =::
Norway 11 0 0 0 0 0 0 1) 0 (] 0 0
Spain ~: 0.15 0.15 11.15 (1.15 0,15 (I,15 0.15 0.10 0.05 0.05 0.05 0.05
Sweden t, 0,10 0.10 0.10 11 0 0 (1 0 0 0 0 0 ~'=
Switzerla,d 0 0 (I 0 0 0 0 0 0 0 0 (I
IJK (I 0 0 0 0 0 (1 0 0 0 () 0 ~
US d 0.1 0.08 11,08 0.08 l),08 0.08 0 I) 0 0 0 0
Notes:
" All countries ill the sltmple have investmcm incentives for specilit: regions,or industries, for certain types of business lixed investment, or fi)r
research and development, which are not reported, 3"
" Investment incentive was it deduction.
• Investment incentive was a deduction. Before 1982, the incentive was an inveslnlent reserve.
d Investment incentive was an ITC. In Canada, rcginnal and some asset ITCs were retained at reduced rates after 1988. ~
• A limited investment reserve is available. See footnote h below for a description.
t Investment incentive wits an r r c (called "WI R'). In 1984, the various W l R rates were combined into one uniform rate: before 1984 the rate
reporled is that for mtmt fixed assets. Beginning in 19911, an investment deduction is awtilable at degressive rates ranging from 0.18 to 0.02 ti)r
relatively small.scale investment: no deductiolr is allowed after the cut-off tl~tal is reached. to
~ Investment incentive is an ITC. In 1985 a statutory rate for fixed assets wits instituted; before 1985 the rate reported is that for the typical .~.
iflvestmenl grant.
i, lnvestnlenl incentive was ill| investment allowance. Until 1990, all illVe~luleal reserve program wits also available, It allowed companies to
set aside and deduct, at their own discreliou, up to 50% of their pre-lax profits Ik~r future investments fit a countereyclieal fund. The benclit of
the fund was that it could he used for inunediatc depreciation of new assets acquired.
Table 3
D e p r e c i a t i o n and i n v e n t o r y valuation rules (1992)
Country Depreciation Accelerated Asset Inventory
method ~ depreciation revaluation valuation method
available" permitted (ta~ purposes) ~ .~
Equipment Structures
Auslralia DB. SL SL no no AC, FIFO, SC. SI
Belgium DB. SL DB, SL yes yes AC, FIFO, LIFO
Canada DB DB no no AC. FIFO, SI ~'
Denmark DB SL no yes AC, FIFO, LIFO
France ~ DB, SL DB. SL yes limited AC. FIFO. LIFO. SC
Germany d DB, St, DB, SL yes no AC,LIFO, SI ....
Ireland DB. SL SL no yes AC, FIFO
Italy SL SL yes limited AC, FIFO. LiFO
Japan DB, SL DB, SL yes no AC. FIFO. LIFO, SI
Netherlands DB, SL DB, SL yes yes AC. FIFO. LIFO
New Zealand DB SL no yes AC. FIFO ,~
Norway' DB DB no yes FIFO
Spain DB, SL SL yes no AC. FIFO ~.
Sweden DB, SL SL no yes FIFO ~
Switzerland DB, SL DB. SL yes no AC, FIFO
UK DB. SL SL no yes AC. FIFO
USA DB SL yes no AC. FIFO, LIFO
Notes: ~'
DB denotes Ifie decJining balance method.
SL denotes the straight llne method, t.~
A C denotes the average cost method. "~,~
FIFO denotes the first-in-first-out method.
LIFO denotes the last-in-first-out method.
SC denotes the standard cost method.
Sl denotes the specific identification method.
Statutory depreciation and inventory valuation methods are reported, or when the tax authority allows any 'appropriate' method, the methods generally used are
reported. When the authority does not specify appropriate melfiods, those generally accepted are reported.
Accelerated depreciation is for specific regions or industries, and for certain types of assets. Exact rules vary widely by country.
LIFO acceptable when used in consolidatod financial reporting.
,s As of assessment year ll)gl), LIFO was permil[ed.
As of assessment year 1992, accelerated depreciation was abolished.
Table 4
Means and medians of sample variables
Country Value Q I /K ~ Y/K OI /K CF/K RE/ K 1)/01
Australia 402.059 2.553 0.205 0.113 3,314 (I.241 0,241 0A)55 0.261 .~
( 130.1411) (1.378) (0.128) (0.098) (2,128) (0.2t8) (0.226) O.057) (0.2531
Belgium 369,1H11 1,505 t),29(t 0.243 5,976 0.248 (1,476 11.078 0.232
(54.706) (0.615) (0.223) (1t.187) (4.699) (0,192) (0.354) 0,0591 (It.IS3) ~
Canada 422,9111 2.123 0.216 0.124 3.304 0.2111 0,2tt5 !1.(t52 (), 125 g
1132.7251 (0.8981 (0.1421 (O,IL~) (1,6791 (0.144) (t1,163)
Denmark 98.585 I. 166 11.236 0.151 4.897 0.211 0,334 0,I18 (L133
(4(I,567) (1).64(1) ( O. 195 ) (0.1431 (4. I 71 ) (0.169 ) 10.2691 ().tP)2) (0. I t 4)
France 349.033 2.3tXl (),304 ().209 7,662 0,429 0,449 0.156 0.15g
( 126.673 ) ( I. 1781 10.2591 (0.186) (6,4~t) (11,330) (0,347) {),0~6 ) (0. l I H) ~.
Germany 037.884 2,219 0,324 0.254 6.099 0,238 0.388 0.051 11,213 g,.
(251.688) ((1.t.169) (0,273) ((),237) (5.050) (0.1751 (0,351) 0.032 ) (0.17./) ~-
Italy 321,14(1 1,846 (I.272 0.182 4,27(I t).321 (I.424 ILII3 11.222 _~
(109.455) (0.856) (11,204) (0,164) (3.285) (O,21h")) 10.2911 0,056) (11,1791
Japan 2174,025 5.5111 0.248 0,150 5.489 0,326 0,301 0.095 0.154
(889.983) (4.1001 (0.211 ) (l). 143) (4.417) (11,2311) ((t,252} 0.(t59 ) (0.13o) '~'
Netherlands 718.493 1.292 0.239 11.167 6.187 1),335 11.377 0.130 11,222
( 102,748,) (0,~12) ((t. 189 ) ~tl. | 50) (4,342) (0,232) ((I. ~14) 11.(~)4) (0.232) ~-,~
Norway 205.992 1.579 0.263 0.139 3,892 0.199 11.177 It.(X)9 O, I 13
(72.7(11) (1).633) ((I.1761 (g.126) (2.99(I) (0.164) ((I.1621 , t,e" 8 ) 1o.o9t)
Spain 315,376 1.645 0.148 (I, 110 3.233 0.229 0,234 t1,o52 0.217
(122.587) (0.793) (O.(Igo) IlL [ l I) ( 1.747 ) 10.140) (0.1771 (0.(t29) (0.189) _~
Sweden 328.292 0,835 tt.242 (I, 128 4.893 0.352 0.293 0,(197 o.184 ~.
(128.254) (0,273) (0.177) (11.123) (4.023) (0.247) ((1,222) 10.t149) (0.154)
UK 672.885 1,967 0.249 O. 125 5,702 0.423 0.428 (I.Igl 0,260
1123.282) (0.769) (0.171) (0.114) (4.293) (8,311 ) (0.317) (0.1201 (0,244) ,'~
US 050,524 3,222 0.251 0.171 5,583 0.342 0.339 0.1211 0,12(1
(126,444) (t,408) (0.168) (0,145) (4 015) (0,239) (0.257) (0.080) (0.033)
Noles:
Medians are in paremheses bctr , the means.
~v~lU~: is the real market value ul the firm at the ¢nd-of-ilscal-ycar converted to US dollars usir,g the end-of-fiscal-year exchange rat,:,
The ratio of investment to beginning-of-period capital stock is I/K.
The variable 8 is the rate of depreciation,
The ratio of sales to beginning-of.period capital stock is F/K,
The ratio of operating income In beginning.of-period capital stock is OI/K.
The ratio of cash flow to bcginr'ng-of-pcriod capital stock is CF/K.
The ratio of retained earnings to beginning-of.peri(xl capital stock is RE/K.
The ratio of dividends to b~ginniag-of-puriud operating income is D/OL
246 J.G. Cummins et ~d. / Journal of Public Economics 62 (1996) 237-273

larger, ceteris pafibus. This elfect is most distinct in evaluating the value of
Japanese firms.
Median values of tax-adjusted q range from a low of 0.273 (mean 0.835)
for Sweden to a high of 4.10 (mean 5.50) for Japan. Note that the
tax-adjusted q is the shadow value of capital less its acquisition cost. As
such, it is comparable to q - 1 rather than q. The magnitudes appear
reasonable, with the exception of those for Japan, in which estimated q
values are large relative to those in previous studies.~ However, few
comparisons are available to assess these numbers in countries other than
Japan, the United Kingdom, and the United States.
T h e values of the ratio of investment to beginning-of-period capital stock
median and mean are reported in column 3. The former indicate a range of
per year investment of about 8 % - 2 7 % of the capital stock; the latter of
about 1 5 % - 3 2 % ot the capital stock. The depreciation rates are reported in
column 4.
In the columns 5 - 9 of Table 4, we report information on five variables on
firm characteristics and performance. The median and mean ratios of cash
flow to the beginning-of-period capital stock are larger in most countries
than the ratio of operating income to beginning-of-period capital stock. The
ratio of retained earnings to beginning-of-period capital stock is reported in
column 8. The ratio is highest in Denmark, France, the Netherlands, the
United Kingdom, and the United States. The ratio of dividends to begin-
ning-of-period operating income is reported in the final column. Firms in
most all countries appear to pay out a larger share of their earnings than
those in the United States. This finding is somewhat deceptive, however,
since the sample of firms for the United States contains a much larger
proportion of (often smaller and younger) firms that pay no dividends.
Table 5 provides four different sets of estimates of the basic Q model
using panel data for the 14 countries in our sample. In the first row. ordinary
least squares (OLS) is used to estimate Eq. (1), after first differencing the
model to remove firm-specific fixed effects and adding year d u m m y vari-
ables. T h e second row adds the first difference of once-lagged cash flow, CF.
relative to the capital stock, K (i.e. CF,., t / K i . , _ z - C F ~ . , , / K , . , s) as a
regressor to the specification in the first row. The third row provides the
generalized method of m o m e n t s (GMM) estimates of the specification in the
first row. with the instrument set (levels of the second and third lags of Q,
I / K , and C F / K ) reported below the row. Similarly, the fourth row provides

"~Fhevalues of tax-adjusted q do not include the market value of land in the calculationof the
replacement cost of the capital stock because the Global Vantage datasct does not separately
report the book value of land for non-financialcorporations. As a result, the tax-adjusted q for
Japanese firms is larger than in comparable studies (see, for example. Hoshi and Kashyap,
1990).
T a b l e ,5
,...,
rl'ax-adjusled q m o d e l illVt/S[llll~ll| Ctluatiolls: S t a n d a r d a p p r o a c h

Coumry
A,US BI!L CAN DNK IRA (iER ITA JPN NLD NOR SPN SWE UK LISA
OLS ~"
Q,, 11,1152 11.117}t I1.11.I~1 11.124 11.1167 (I,II3! II,I)f17 11.1117 1l.I)3fi 0,1143 11.1134 ILl07 t).05S I).031) ~-.
((I.I)1151 (0.1116) (11.1)1)3) 111.0161 (O.()11S) (11.1)1),3) Ill.Ill l) (ll,ll(12) 11),007) (IL(II3 } Ill.0101 (IL(Ilgl (O,[X)3) (11,()111) :.,,.
11.11~12 I)r(197 I1.1111 I1.1~11 11.137 11.1156 11.1167 O.(158 IL1))19 11.195 0.174 11,148 11.119U I).1173 ".
1(.1157 111177 11.1143 (I,213 1(.1177 0.032 11.1178 1),(118 11.031 I).1)29 0.1138 11.112 0.1~311 11.1)34
(t),(ltl'/I (11.1117) 1(I.I)114) (11.112.]) 10,111191 (0 ()l)l~) (11.111.;.) (O,(X)2) {II.I)11S) 111.1)15) (0.1113) 111.1)23) (I).OI).l) (11.1)111) ~,
(UI-/K , r i -11. t82 11.11tl2 (I.Ilf, N 11.117t1 -11.179 (I.I)~B 0.11611 11.1112 -tl.I)tJ6 11.519 4).1!41 11.136 -11.1152 11.1)1t3
#' (0.11771 (O.IITLI) (11.11421 (l).(INfi) (11.1172) (11.1155) (11.1181 (IL(M3) (t1.11131 10,141) (1t.165) 111.162) ( 11.1134) fILl)117) ~,~
111N4 IL lotl o. 114 I1. INII It lgLJ I).(~'12 0.1178 I).(g~6 11.1172 I1,164 O. 161 11.144 I1.114 11.1188
(iMM ~
I),Ofil) IL 1113 O,1141 I)+IIM I),l)h5 I).O95 1).(151 ILI)]t/ ll.(Ibtt OJ)fi9 (I,(M4 ILI)51 11.1162 I).IMN
(I).IIIL)) ( I),O.|4 ) (11.111191 (l) IlN5) lOAM]) (l).lgil) [I).(ll N) IILI)1)8 ) (0.1144) ((1.1131 ) (11.028) (11.1!47) 111.1113) (O.(K)61
11.293 11.3114 ll.g.15 11.131 11.21)7 11.731 1.67 1.34 1.94 2.23 11.7611 1.15 I.h4 7.114
p- ~-'altl~" I).tlqN I).gIJN I}975 l).gtJlJ (I.giJt) 11.9~tI I).N92 O.IJ31 0.857 O.816 I).98(1 O.9511 II.S~/0, I).218 ~.
Q,, 0.1)34 I1.1JU6 ILIM4 II.I)~Y 11.07-1 (I. Ilg I1.1($1} 1l.ll2tl I).O-Ih 0.113~) ILI)45 O.II~tJ 11.(146 ILIM2
Ill.Ill4) 111.11411 Ill.ill l) OLI)gII) (ll.l)3fi) III.IM2 } Ill.OIq) 111.1)117) 111.11311 1(I.II331 (11.11291 111.11781 (11.11131 (ILI)1~) t~
I('/'/K l, , t 11.1)83 11.1~5 11.1115 IL164 (I.IISl~ I1.11t)O 11.1164 11.24g 11.188 11.488 11.316 I).1115 (I,233 IL177
111.2371 111.1651 111.11511) |11.1691 (O. l l l ) Ill. Ill4 ) (l}. IbY) (ll.(Ig4) II). 193) (1).203) 111.2631 (IL4131 (0.065) 111.01t) )
~1 11,51!4 1.85 1.34 11.253 O.2(~2 11.661 I.t~5 I.fitl 1.88 1.73 tl.h86 [. 18 1.115 2:;,1 !'a
p- ~.'ahle I1,~J73 ().7~3 (I.1~55 ().tllJ3 11.992 (I.I156 II.NI)11 ((.gl)9 I).758 I).7195 ((,IJS.~, II.Ngl (L~;~)2 I1.1M3 i~
IVs Q,, ~, ~; (ILK),, ~ ~; (CF/K),, :., ,
Sourct,; Aulhors' calculaliolts usillg (ilnbal Vantage data. ]'he dttpentlcnl variable is I,.,IK,, i. The ratio of cash 1low to bL,ginning-of-p¢[iod capital sll~ck is ( ' F / K
Variables are delink, d ill Ihe Itqgl. Standard e m i r s ill ¢l~cfticJ¢lll~;, in parcnlhttscs, art: ¢Oll|plllgd (fort| a hL,l¢lrt~kt2dasli¢-¢oxlsislclll colrlclalion matrix. "l'h¢ regtcssio|ls a[c
baszd on it differenced vvrsioa ~1( Eq. (I) ;is described in tile Icxl. Year dummy wmablcs are included bul not rept~rted.
248 J.G. Cummins et al. / Journal of Public Economics 62 (1996) 237-273

the G M M estimates of the specification in the second row, with the

instrument set reported below the row. The test of the overidentifying
restrictions and its p value is reported just below the third and fourth rows.
T h e test is asymptotically distributed X2o,_p), where n is the n u m b e r of
instruments and p is the n u m b e r of parameters estimated.
T h e estimates of the coefficient on Q reported in the first row are typical
of those reported in previous studies. The estimates range from a low of
0.017 for Japan to a high of 0.124 for Denmark. Most estimates range from
0.03 to 0.06. All of the estimates are statistically significant at least at the
1% level. However, the precision of the estimates is not necessarily a
confirmation of the standard model. These estimates still imply extremely
large adjustment costs. Given the sample means of ( l / K ) and ~ for
D e n m a r k in Table 4, even the largest estimate of 0.124 implies adjustment
costs of about 70% per unit of investment expenditure.
T h e second row reports an OLS specification sometimes used in the
investment literature to examine the importance of internal finance (see, for
example, Fazzari et al., 1988; and Hubbard et al., 1995). The point
estimates and standard errors on Q are similar to those in the first row,
except for Denmark, in which the coefficient is nearly twice as large. The
coefficient estimates on the first difference of once-lagged cash flow are
statistically significant only for Norway and the United States. In the other
cases, the coefficients are very imprecisely estimated. In unreported results,
we also estimated the specification in the second row, replacing the first
difference of lagged cash flow with the contemporary first difference of cash
flow. In this case, for each country except Sweden, the estimated coefficients
for this term were positive and statistically significant at least at the 5%
level.
G M M estimates are reported in the third and fourth rows. In the third
row only the coefficient on Q is estimated. Compared with those reported in
the first r o b , the coefficient estimates are larger for nine countries, and
smaller for five countries. Only for G e r m a n y is the coefficient more than
twice that reported in the first row; only for Sweden is the coefficient less
than half that reported in the first row. The standard errors are substantially
larger than those reported in the first row. The coefficient estimates for
D e n m a r k , the Netherlands, and Sweden are not significant. The test of the
overidemifying restrictions is not rejected for any country.
T h e f o u ~ h row reports results considering the addition of the cash flow
variable. The point estimates on Q are similar to those reported in the third
row. T h e significance of this coefficient is not affected by the inclusion of the
first difference of lagged cash flow, except in No'way, in which the point
estimate on cash flow is twice as large as for any other country (but nearly
identical to that reported in the second row). For all countries, the
coefficient estimate is positive; for Japan, Norway, the United Kingdom,
 J.G. Cummins et al. / Journal o f Public" Economics 62 (19c26) 237-273 249

and the United States the coefficient estimates are statistically significant,
T h e point estimates for Japan, the United Kingdom, and the United States
are similar to those reported in previous studies using similar specifications,
As with the basic Q model, overidentifying restrictions are not rejected for
any country. Two conclusions are suggested by the estithates in Table 5,
First, estimates on Q are usually statistically significant and qualitatively
similar across countries, but imply large adjustment costs. Second, invest-
m e n t displays an excess sensitivity to cash flow (at least for the generally
larger firms in our sample) in only a subset of countries.

4. Alternative approaches: Focusing on tax reforms

In this section we describe the techniques we use to estimate the effects of

tax reforms on firm investment. Generally, Eq. (1) or similar formulations
have been estimated using OLS, instrumental variables, or G M M tech-
niques, as in the previous section. However, significant m e a s u r e m e n t error
problems may bias downward the estimated coefficient on Q, leading to the
conclusion that structural variables (and their tax components) are not
statistically or economically significant. Below we provide methods that
allow us to isolate better the effects on investment of changes in Q.5
We begin by considering the specification of the Q model of investment in
Eq. (1). If, because of noise trading (see De Long et al., 1990) or other
factors that m a y cause the stock market value of the firm to reflect factors
other than fundamentals, the econometrician observes a noisy signal of the
true fundamental Q used by the firm, then the estimate of 3' may be biased
toward zero. Suppose that tax reforms offer periods in which there is
substantial exogenous cross-sectional variation in the change in Q. During
these years, an unusually large portion of the variation in the tax-adjusted Q
is observable, and the signal-to-noise ratio may be much higher. A n
estimate using the tax reform to isolate an observable variation in Q may
decrease the bias in the estimate of 7 significantly.
T o assess this argument empirically, we consider two different alternative
empirical approaches. The first modifies Eq. (1) in an attempt to increase
the signal-to-noise ratio, and the second uses G M M , but modifies the
instrument set to include contemporaneous tax variables. Both approaches
will narrow the samf~. ~eriod in order to focus on tax reforms.

~The first technique that follows was also used to study US panel data in Cummins et aL
(1994), where results across many different US lax reforms were compared. Other stud,s in
the same spirit include Cumminsand Hasseu (1992) and Auerbnch and Hassctl (1991). Both of
these focused on estimating the response of US firmsto shocks to their user costs caused by the
Tax Reform Act of 1986.
250 J_G. Cummins et al. / Journal of Public Economics (~2 (1996) 237-273

First, we consider a modified version of Eq. (1) which states that the
d e v i a t i o n of true ( l / K ) from the value linearly p r e d i c t a b l e using i n f o r m a t i o n
a v a i l a b l e at time t - 1 is
(I,.,/K .... )-P,., i(1,.,/K,.r ~ ) = ( Q t . , - P , . , _ i Q , . , ) 3 " + e , . , , (4)

w h e r e P is a p r o j e c t i o n o p e r a t o r constructed from a non-tax subset of the

firm's i n f o r m a t i o n set. M o r e c o n v e n i e n t l y ,
~ . , = V4,,, + ~,.r. (5)

w h e r e ~o m e a s u r e s the d e v i a t i o n of i n v e s t m e n t from what it w o u l d h a v e b e e n

w i t h o u t the e x o g e n o u s s h o c k to the structural variable, and tO m e a s u r e s that
shock.
If Q is noisy, t h e n it may be that e s t i m a t i o n of Eq. (5) in a m a j o r tax
r e f o r m year offers the best o p p o r t u n i t y for identifying 3'. Eq. (5) states t h a t
the s h o c k to i n v e s t m e n t will be p r o p o r t i o n a l to the shock to the structural
v a r i a b l e if firms are a w a r e of c h a n g e s that c a n n o t be p r e d i c t e d using the
b e g i n n i n g - o f - p e r i o d i n f o r m a t i o n set. D u r i n g tax reforms, a large s h a r e of
that s h o c k is a true f u n d a m e n t a l change, r a t h e r t h a n noise, and is easily
observable.
U s i n g this first a p p r o a c h , we e s t i m a t e 3, by constructing a cross-section of
o b s e r v a t i o n s of the v a r i a b l e s in Eq. (5). We use first-stage regressions to
c o n s t r u c t e s t i m a t e s of ~o, and tO,.,, and t h e n pool a cross-section of t h e s e to
e s t i m a t e 3". The v a r i a b l e s used in the first-stage regression are (I/K),_~,
( C F / K ) , _ i, a t i m e t r e n d , and a firm-specific constant. ~'
By e x p r e s s i n g v a r i a b l e s in t e r m s of t h e i r d e v i a t i o n s from conditional
e x p e c t a t i o n s , we control for i m p o r t a n t cross-sectional h e t e r o g e n e i t y . In fact,
this e s t i m a t o r can be t h o u g h t of as the familiar d i f f e r e n c e - i n - o w n - m e a n s
e s t i m a t o r , in which individual firm m e a n s are replaced by individual
• 7
c o n d i t i o n a l expectattons. If the true tax variable is o b s e r v e d , t h e n we
a m e l i o r a t e e r r o r s - i n - v a r i a b l e s p r o b l e m s . This a p p r o a c h also avoids the
crucial p r o b l e m of the e n d o g e n o u s tax policy faced by t i m e - s e r i e s m o d e l s ; if
the s u r p r i s e s are tax policy surprises, t h e n the cross-sectional v a r i a t i o n of
the tax v a r i a b l e s on the right-hand side of Eq. (5) can be t r e a t e d as
exogenous.
F i r m fixed-effects are used in the first stage, w h e r e the e s t i m a t e s exploit

"We experimented with including additional macroeconomic variables as first-stage instru-

ments. These included the price of investment goods and various interest rates. We found that
including additional variables had little effect on the results. For the reported results, we use
the parsimonious specification reported abo~.
:If v.e use only a constant term in the firsl-slage projection, then the estimator is exactly a
difference-in-own-means estimator, applied only in the year of the tax reform. The substitution
of firm-specific conditional expectations for firm means adds precision since investment is a
dynamic process, and firm means may be a poor measure of what in,'estment would have been
at lime t had there been no tax reform.
 J.G. Cummins et aL i Journal of Public Economic.~ 62 (1996) 2.77-273 251

the whole panel of data. In the second stage, we use the cross-section to
estimate the adjustment cost parameter, which is explicitly assumed identi-
cal across firms. Hence. we estimate the following model for each country-
tax-reform year:

(1,. ,/ K , . , ,) - (i,. , / K , . , _ ~ ) = pti + 7 ( 0 , . , - Q,. ,) + e,., , (6)

where the variables with caret marks are firm-specific projections using
period t - 2 information. To focus on the tax surprise we set Q equal to the
variable Q T which contains twice-lagged values of non-tax variables and
C O n l e m p o r a n e o t t s values of the tax parameters:

q,.,_,_-P,_:(1-Fi.,)
Q,., = QL., - (I - 7 , ) (7)

In the years following substantial changes in the tax code. 3' should be of
the expected sign and precisely estimated if the identifying assumptions are
correct. In periods in which there were no changes in the tax code, 3' should
be imprecisely estimated, and, to the extent that we are measuring the
structural variable with significant errors, biased toward zero. In periods in
which there were changes that were part of a previous tax reform (such as
the reduction in the US corporate tax rate from 40% in 1987 to 34% in
1988). the value of 3, depends on whether linear projection techniques
adequately describe firms" expectations following an initial tax reform. If
they do adequately capture expectations. 3' is unidentified. ~
Since the second-stage estimation is simply OLS, in order to construct this
estimator, we made the additional identifying assumption that around tax
reforms we can observe Q used by firms when formulating their investment
decisions. In principle, this includes the non-tax elements as well. To be
especially cautious about the introduction of contemporaneous values of the
non-tax components of Q. and to highlight the variation due to tax changes.
we assume that the firm's expected value for each non-tax component of Q
is equal to that variable's value at the beginning of the previous period. That
is. we construct Q, by combining the tax components for period t and the
non-tax components for period t - 2. it is this variable that we forecast in
the first stage, and this variable that we use to construct the "surprise'. Tax
information is the only information dated ahead of year t - 2 that is included
on the right-hand side of the second-stage regression. For example, the
expected interest rate in 1987 is assumed to be the year-end rate for 1985.
Violation of the assumption concerning the observability of Q would

~The identification occurs only when we encounter a period in which the firm observes a
change in Q that cannot be predicted will' the informationin it, (as. for example, duringa tax
reform). If the projection m~asures Q perfectly, then ~" wouM be unidentified given the
definilion of 0 in Eq. (5).
252 J.G. Cummins et aL / Journal of Public Economics 62 (1996) 237-273

introduce into the second-stage regression the deviation of "true" .Q from the
assumed Q. That is, because of the assumptions about the e,~n-tax part of
Q, the error term in Eq. (4) includes the term y Q N , , where QN, represents
the contemporaneous non-tax information in Q,. If positive shocks to a
firm's Q N , are closely correlated with the cross-section variation in the tax
variables, then the estimate of 3' may be upwardly biased.
The second approach we consider is based on the same basic intuition that
tax variables may allow us to measure Q more precisely around tax reforms.
If contemporaneous tar. fundamentals explain an especially large share of
the "true' variation in Q around tax reforms, then an alternative approach is
to use these as instrumental variables to overcome the measurement error
problem. In the next section we also present estimates based on this insight.
If our description of the source of the very low coefficients reported in the
previous section is correct, then both of these approaches should provide
significantly larger estimates of y.
h is important to define the tax experiments carefully. In the United
States, for example, the 'Fax Reform Act of 1986 was passed late in that
year, and it is unclear whether investment decisions made in 1986 antici-
pated these changes. To avoid such confounding timing problems we
sidestep years in which reforms occur. Using this example, we estimate a
first-stage projection equation for each firm, using data available for that
firm through 1985 and then construct forecasts for 1987, the first post-reform
year? We pay the same attention to timing for each tax change we study,
forecasting post-reform investment with ;nformation available in the year
prior to the reform, and examining effects of changes in the tax-adjusted q
on investment in the first post-reform year.

5. Estimation of the alternative models

5. I. O v e r v i e w

In Cummins et al. (1994) we presented estimation results for the United

States for each year since 1962 and focused the discussion on the results for
the years that contained major reforms, in this paper, because we examine
14 countries, we choose for each country the reform that we believe

"Pagan (1984) has shownthat the second-stageparameterestimates and their standard errors
are consistent and asymptoticallyefficient, respectively, when the second-stage regressorsare
innovations. We require numerous assumptionsto map our problem to that result, and, for
generality, we would prefer maximum likelihood. The likelihood function [or this two-stage
estimator is nnt difficult to write down. but estimation would be extremely cumbersome
because o[ the large number of nuisance parameters.
 J.G. Cummins et al. / Journal of Public Economics 62 (trY36) 237-273 253

p r o v i d e s t h e b e s t e x p e r i m e n t o f t a x r e f o r m a n d p r e s e n t results o n l y f o r t h a t
y e a r . TM
In s e v e r a l o f t h e c o u n t r i e s w e s t u d y t h e r e w e r e several c h a n g e s in t h e
c o r p o r a t e t a x c o d e d u r i n g t h e s a m p l e p e r i o d . A s will b e c l e a r b e l o w , w h e r e
w e d e s c r i b e t h e r e f o r m s we s t u d y f o r e a c h c o u n t r y , we c o n s i d e r t w o p r i m a r y
f a c t o r s w h e n c h o o s i n g t h e ' b e s t ' e x p e r i m e n t f o r e a c h c o u n t r y . First, w e
f o c u s o n l a r g e c h a n g e s in t h e t a x c o d e , b e c a u s e t h e s h o c k s to Q d r i v e n b y
t a x e s s h o u l d b e as l a r g e as possible in o r d e r to m a x i m i z e t h e p o w e r o f tile
a p p r o a c h e s . S e c o n d l y . t h e a s s u m p t i o n t h a t firms c a n o b s e r v e the c o r r e c t tax
v a r i a b l e in t h e y e a r o f the e x p e r i m e n t is likely t o be v i o l a t e d in a y e a r in
w h i c h t h e c o r p o r a t e tax c o d e is b e i n g r e v i e w e d . F o r e x a m p l e , if a c o u n t r y
l e g i s l a t e d a c h a n g e t o t h e tax c o d e in 1987 t o t a k e effect in 1988, b u t w a s
f u r t h e r r e v i e w i n g t h e c o d e f o r a n o t h e r r e f o r m , 1988 is n o t likely t o b e a
g o o d y e a r t o e x a m i n e the effects o f t h e 1987 c h a n g e s . T h e effects o f f u r t h e r
a n t i c i p a t e d c h a n g e s m i g h t s w a m p t h e effects o f p r e v i o u s c h a n g e s . )1
T a b l e 6 s u m m a r i z e s t h e e s t i m a t i o n results f o r e a c h c o u n t r y u s i n g t h e first
o f o u r a l t e r n a t i v e a p p r o a c h e s , In a d d i t i o n , w e p r o v i d e e s t i m a t e s o f t h e
m o d e l a u g m e n t e d t o i n c l u d e firms" c a s h flow, w h i c h h a s o f t e n b e e n f o u n d to
b e statistically a n d e c o n o m i c a l l y significant in m a n y p r e v i o u s studies, t-" W e
d e s c r i b e t h e s e results f o r e a c h c o u n t r y b e l o w .

5.2. Country resuhs

5.2.1. Australia
In 1988, A u s t r a l i a r e d u c e d t h e c o r p o r a t e i n c o m e tax f r o m 4 9 % t o 3 9 %
and depreciation allowances were tightened.
T h e coefficient e s t i m a t e s f o r t h e m o d e l u s i n g this c h a n g e a r e r e p o r t e d in

"'Estimates for the other years are available upon request.

l~For example, consider the user cost of capital specification from Auerbach ([983). in which
the relative price change of capital in the user cost depends on expected changes in the tax
code. This term can lead to significant fluctuations in the user cost in years prior to anticipated
changes.
t:As discussed in the previous section, to the extent that tile omitted non-tax surprise and the
included tax surprise are positively correlated, the estimated coefficient on Q may be biased
upward. For the bias to be important, there must be a strong positive cross-sectional correlation
hetwcen the tax and non-tax news, as might happen if. for example, the firms that benefit the
most from an investment tax credit experience large positive shocks to the demand for their
product. Another concern might be that the price of investment goods would rise following the
introduction of investment incentives. However. in this case. the estimated coefficient on Q
would be biased downward. We check for this type of bias in two steps. First. we include cash
flow in the second stage since this should change the point estimates if there is an omitted
variable present. Second. we report for comparison in Table 7 results from the second
alternative approach which uses contemporaneous tax instruments in the Q model. In alnmst all
cases the results of this second approach are qualitatively similar to those of our first approach.
yielding estimated effects on investment of Q much larger than those estimated in earlier
studies.
Table 6 .'..
Tax-adjusted q model investment equations: Allernative approach
Country ~
- - AUS 8EL CAN DNK FRA GER ITA JPN NLD NOR SPN SWE UK USA ~,
Year of tax reform
1988 1990 1988 1990 1990 1990 1992 1989 1989 1992 1989 1990 1991 1987 :"
im -0.113 0.055 -0.039 11.210 -0.015 0.0119 11.1116 -0.02(I 0.080 -0.799 I).1(13 -0.220 -0.152 -11.1111
(11,0751 (11.0601 (0.023) (0.1(14) (0.026) (0.020) (0.055) 111.020) (11.0751 (0,318) 10.135) (0.052) (0.0161 ((I.(/071
Q,.r 0.605 1.626 11.8111 0.867 0,756 9.938 (I.663 0.893 (I.423 1,373 1.485 0,641 0,644 0.603
(11.2311 (0.520) (11.2161 (0.458) (0,286) (0,242) (0,237) (0,219) (0.34111 (I).528) (1.378) (0.241) (11.198) (0.086)
11.1168 0.221 0.066 0.044 11.060 0.081 0.064 11.047 0.011 11.161 0.005 0.092 0.(122 0.029
in( 0.130 0.054 -0.044 -0.210 -0,010 0.006 0.104 -0.026 0.049 -0.812 -11.014 -0.226 -0.126 -0.022 ~
(0.078) (0.065) (0.023) (0.106) (11,026) (0.020) (0.055) (0,0181 10.1176) 111.294) (11,1501 (0.055) 10.11161 (0.007) t~
Q,, 0.647 1.613 0.8113 0.865 11.6511 11.879 0.644 0.819 0.296 1.376 0.888 0.644 0.490 0.528
(0.238) (0.593) 10,2101 (0.469) (0.292) (0.249) 10.2411 (0.198) (0.344) (0.487) (I.397) (0.243) (0.186) (0.085)
(CF/K),., 0,083 0.006 0.230 0.003 0.104 0.078 0.061 0.354 0,299 0.706 0.46I -11.1150 0.278 0.108 ~'
(11.1091 (0.1091 (0,064) (0,1271 (0.068) (0.077) 10.1161 (0.042) (I).1871 (0,289) (0.273) (11.163) (0,035) (0.014)
/~" 0.063 0.194 0.123 11.026 0.073 0.082 0.057 0.222 0,043 0.284 0,059 11.078 11.145 0.063 ,~
N 82 32 t85 57 95 159 101 317 49 31 31 61 436 1652 ~
Source: Authors" calculations using Global Vantage data. The dependent variable is I,.,/K,, I " The ratio of cash llow to beginning-of-period
capital stock is CF/K. The number of firms is N. Variables are delined in the text. Standard errors on coeflicients, in parentheses, are computed ~4
form a heteroskedaslie-eonsistent correlation tv.atrix. The regressions are based on Eq. (6) as dear(bed in the text,
 J,G. Cummins et al. / Journal of Public Economics 62 (19~6) 237-273 255

Table 6. The first row reports the results obtained from the estimation of a
Q model using the surprises technique in Eq. (6). The coeKficient on Q is
0.605, with a standard error of 0.231. This coefficient is very similar to the
one we obtained for the United States using Compustat data in C u m m i n s et
al. (1994). A s a check that the results are robust, the second panel of Table
6 reports how the results change if the shock to beginning-of-period cash
flow is included in the Q equation; the inclusion of cash flow does not alter
the conclusions, and the estimated coefficient on the additional term is
statistically insignificant.

5.2.2. B e l g i u m
In Belgium, there were four major tax changes in the 1980s, and we
choose to study the last one. Effective in 1990, the corporate income tax was
reduced from 43% to 41%, and 39% thereafter, and the investment
deduction was phased out.
The first row for Belgium of Table 6 reports the results for 1990. The
coefficient of 1.626 on Q is the largest of the estimates in the sample, which
tend to be less than unity, but the standard error of 0.520 is large enough so
that more reasonable values are well within a standard deviation of the point
estimate. Including cash flow does not alter the point estimate, and its
estimated coefficient is not statistically significant.

5.2.3. Canada
Canada reformed the tax treatment of corporations significantly in the
mid-1980s. In 1985, el 5% corporate income tax surcharge was introduced
until the end of 1986. Further reform was proposed to lower the corporate
income ta:~ ~md to eliminate the ITC. Effective in 1987, the corporate
income tax was reduced from 46% to 45% and the surcharge was lowered
from 5% to 3%. The major reform was adopted to take effect in 1988,
lowering the corporate income tax rate from 45%, to 38% (and from 38%, to
36% on manufacturing and processing income) and retroactively phasing-out
the ITC. This suggests that 1988 is likely to be the best post-reform year in
which to apply our alternative approach.
The estimated coefficient of I).810 on Q is large and precisely estimated.
W h e n the shock to beginning-of-period cash flow is included, the point
estimate on Q is almost unaffected, although, in this case, the coefficient on
cash flow is economically and statistically significant.

5.2.4. D e n m a r k
Effective in 1990, D e n m a r k lowered the corporate income tax from 50%
to 40%. This change generated cross-sectional variations for firms because
of the changing relative value of depreciation deductions.
The point estimate for the coefficient on Q is similar to that for other
256 J.G. Cummins et al. / Journal of Public Economics 62 (1996) 237-273

countries and the inclusion of cash flow does not affect the point estimate.
Given the relatively small sample, the standard errors are large, and the
estimated coefficient is not quite statistically significant at the 5% confidence
level.

5.2.5. France
France has enacted seven corporate tax changes since 1980. and, given the
frequent changes, it is difficult to select one year in which firms are certain
that the existing tax code would be relevant for their current decisions over
a reasonable horizon. We choose 1990, when the corporate income tax was
reduced to 37%, with a further reduction to 34% set for 1991.
For France, the point estimate of 0.756 on Q is economically and
statistically significant, and the inclusion of cash flow, which is only
marginally significant, does not change the point estimate on Q or its
statistical significance.

5.2.6. G e r m a n y
Effective in 1990, G e r m a n y reduced the corporate income tax on retained
earnings from 56% to 50%; the rate on distributed income remained 36%.
In 1991, a temporary corporate income tax surcharge of 3.75% was !evied,
but this was the result of the unification, which one could reasonably say was
unanticipated in 1990.
For Germany, the estimated coefficient on Q is, again, large and precisely
estimated and is not affected by inclusion of the shock to cash flow.

5.2. 7. ttaly
In 1992, Italy abolished the 75% deduction for local corporate income
taxes. This resulted in an increase in the corporate incomz ta;~ from 47.8%
to 52.2%.
For Italy, the estimated coefficient on Q is 0.663, and is statistically
significant. In addition, the coefficient does not change if the shock to cash
flow is included, and the estimated coefficient on this term is not statistically
significant.

5.2.8. J a p a n
In 1988, Japan changed both the tax treatment of dividends and the
corporate tax rate, The difference in the rates of corporation tax for
retained and distributed income was removed in two stages, so that by 1990
a single standard rate of 37.5% applied.
T h e estimates for 1989 are reported in Table 6. The estimated coefficient
on Q is 0.949, with a standard error of 0.191. The point estimate is not
qualitatively changed by inclusion of the shock to cash flow, although the
estimated coefficient on this term is economically and statistically significant.
 J.G. Cummins et al. / Journal of Public Economics 62 ( lq~6) 237-273 257

5.2,9. The Netherlands

The timing of the tax changes in the Netherlands is relatively convoluted.
In 1988 the corporate income tax was reduced from 42% to 359~, effective
1989. The WlR (investment tax credit) was abolished in 1988 as well,
effective in that same year.
Despite the convolution. 1989 is the year we examine in Table 6. The
point estimate on Q is almost zero and very imprecisely estimated, The
inclusion of cash flow increases the point estimate of the coefficient on Q by
an order of magnitude, but the coefficient is still statistically insignificant,
The point estimate on cash flow is relatively large, but imprecisely esti-
mated.

5.2. I0. N o r w a y
Effective in 1992, Norway reduced the corporate income tax from 50.8%
to 28%, while abolishing existing investment allowances and reducing the
maximum rates of depreciation allowed.
The results for Norway for 1992 are reported in Table 6. Both the point
estimate of 1.373 on Q and its standard error of 0.528 are relatively large.
When the shock to cash flow is included, the coefficient on Q changes very
little. The coefficient estimate for cash flow is very large (consistent with the
large estimates reported in Section 3), and statistically significant.

5.2.11. Spain
Spain reduced the investment tax credit from 15% to 10% in 1988, and
again from 10% to 5% in 1989.
The point estimate for the coefficient on Q is large, but the standard error
is roughly the same order of magnitude as the coefficient. Including cash
flow decreases the coefficient on Q by about half. Moreover, the estimate of
the coefficient on cash flow is implausibly large. These results, as with those
for the Netherlands. are distinctly weaker than those for most other
countries.

5.2.12. S w e d e n
Sweden reduced the corporate income tax from 52c~ to 40% effective
1990. and to 30% in the years thereafter. Most investment reserves and
provisions were scrapped.
Thus. we choose 1990 as the year to examine for Sweden. The estimated
coefficient on Q is positive and significant, but somewhat smaller than the
coefficients for most other countries. 13 The inclusion of cash flow does not

L~One possible explanation for the smaller coefficient is that the 19~ tax reform had a
smaller marginal effect than that implied by our equation because of binding dividend
constraints. See Auerbach et al. (1995) for a discussionof this issue.
258 J.G. Cummins et at. / Journal of Public Economics 62 (toqo) 237-273

alter the estimates of the impact of Q , and the estimated coefficient on the
cash flow is imprecisely estimated.

5.2.13. Tire United K i n g d o m

The UK corporate income tax was reduced from 34% to 33% for 1991.
This relatively small rate of change is actually twice as large as it appears
since the 34% rate in 1990 was retroactively changed from 35%.
We choose 1991 as the year to examine for the United Kingdom. As in
most other cases, the coefficient on Q is statistically significant, although
somewhat smaller than the other estimates for the sample. The inclusion of
cash flow lowers the point estimate on Q slightly, and the estimated
coefficient on cash flow is statistically significant.

5.2.14. The United States

The Tax Reform Act of 1986 in the United States reduced the corporate
income tax rate from 4 6 % to 34%, and eliminated the investment tax credit.
We choose 1987 as the year to examine for the United States. The
estimated Q coefficient of 0,603 is similar to those for most of the other
countries in the sample (with the exception of Belgium, Norway. and
Spain). The inclusion of cash flow lowers the point estimate on Q somewhat,
and the estimated coefficient on cash flow is statistically significant.

5.2.15. S u m m a r y o f results
~ ' e have presented estimation rcsults for 14 countries, and found roughly
similar point estimates for 12 of the 14. The coefficient estimate on Q was
statistically significant in every country except the Netherlands and Spain,
where the point estimates were too low and too high, respectively. In both
countries the standard errors were very large. The other estimates ranged
from lows of about 0.6 to a high of about 1.5, with every estimate within two
standard deviations of unity) a These coefficients are roughly similar to those
we reported for the United States and to those in Gilchrist and Himmelberg
(1995) who estimate the Abel and Blanchard (1986) model using US panel
data. We find evidence of residual excess sensitivity of investment to cash
flow in Canada. Japan, the United Kingdom, and the United States) ~
Using the means of I l K and 6 reported in Table 4, these estimates imply
that the adjustment costs of investment are of the order of 5 % - 1 0 % per

~l'he coefficientestimates are potentially biased upward if tax reforms are an indicator of
shifts in future fiscal regimes. Indeed. the countries with the largest coefficient estimates
(Spain. Norway, and Belgium) underwent relatively large fiscal restructuring. We thank
Michael lqaliassosfor this suggestion.
~'The findingthat excesssensitivityof investmentto cash flow is more a characteristicof UK
firms than of continental European firms is consistent with the careful study of Bond et al.
199-I-'1.
Table 7
Tax-adjusted q model: Focusing on lax variation
Country ~"
AUS BEL CAN DNK FRA GER ITA JPN NLD NOR SPN SWE UK USA
Year of tax reform
1988 19~1 1988 1990 19~ 19~) 1992 1989 1989 1992 1989 19~ 1991 1987
GMM
Q,, 0,289 f).587 0.521 0.765 0.388 0.784 I).180 0.086 0,633 0.512 0.404 0.293 0.589 0.650
10.153) (0.422) (0.127) (0,308) (0.116) (11.296) (0.120) (0.035) (0.150) (0.295) (0.233) (0.169) (0.078) (0.077)
W
IVs O'l',,; ( I /K ) ,. , 2, ,; ( C F / K ) , ~ ,., ~
ff'~ 0.516 11.213 1.47 0.820 1.58 0.520 1.36 3.45 0.257 0.289 0.458 163 1.92 7.30
p-value 0.972 0.995 0.832 0.936 0.812 0,972 O.&SI 0.486 0.992 0.991 0.977 0.803 0,750 0.120
N 75 28 173 48 83 130 90 395 44 25 26 50 403 1365 ~'
S o u r c e : Authors" calculations using Global Vantage data. The dependent variable is I , / K , , ~. Variables are deliacd in the text. The models are
estimated using GMM. Standard errors on coeflicients, in parentheses, are computed from a heteroskedastie-constant correlation matrix. The
regressions are based on a twice-differenced version of Eq. (1) as described in Ihe text and are for each country tax reform year.
260 J.G. Cummins et al. / Journal of Public Economics 62 (1996) 237-273

unit of investment expenditure, significantly smaller than those implied by

previous estimates, using more traditional estimation techniques (see, for
example, Summers, 1981). A d j u s t m e n t costs of this magnitude imply
significant responsiveness of investment to variables affecting the marginal
cost of investment.

5.3. Results using contemporaneous tax instruments

To link the results from the standard approach reported in Section 3 to

o u r alternative approach, and to check that the admittedly strong identifying
assumptions applied in this approach do not skew the results, we next report
in Table 7 estimates of a second-dlfferenced Q model using a conventional
instrumental variables (IV) estimator. The instrument set contains levels of
the second and third lags of l / K , C F / K , and the variable Q T which contains
twice-lagged values of non-tax variables in Q and contemporaneous values
of the tax parameters, l°
This approach is another method that exploits our intuition that the
cross-sectional variation in tax parameters accompanying major tax reforms
provides an opportunity to test the response of investment to changes in the
net return to investing. We estimate the specification for each tax reform
year using the modified instrument set and find results broadly similar to
those from our first alternative approach (cf. Table 6). While some of the
estimated coefficients on Q are smaller than those obtained under our first
approach, they are almost always an order of magnitude larger than those
obtained in simple OLS regressions of the firm investment rates on Q (cf.
Table 5).

6. Conclusions

We use tax reforms to isolate changes in the marginal incentives to invest

in capital, and present evidence that changes in company tax policy (and, by
extension, the user cost of capital and the net return of investing) have
economically and statistically significant impacts on investment behavior in
almost every country we studied. The adjustment costs implied by the
responsiveness we observe are tar more reasonable than have been found in
most previous work.

I~We chose to express the instruments in levels since this has been common in the previous
literature (see. for example, Blundell et al., 1992), Since we include lags of the levels of the
instruments, there is little practical difference between using levels and differences.
 J.G. Cummins et aL / Journal of Public Economics 62 (1996) 237-273 2.61

Acknowledgements

We thank Alan Auerbach, Eric Bartelsman, Roger Gordon, Michael

Haliassos, Jeffrey MacKie-Mason, Steve Nickeli, three a n o n y m o u s referees
aw:l participants at the N B E R Summer Institute, the Seminar on Interna-
tional Perspectives on the Macroeconomic and Microeconomic Implications
of Financing Constraints, and the Tram-Atlantic Public Economics Seminar
for helpful comments and suggestions, and Sam Coffin for research assis-
tance. C u m m i n s gratefully acknowledges support from the Center for
International Business Education, the Chazen Institute, a John M. Olin
Foundation grant to the Center for Law and Economic Studies at Columbia
University, and the C.V. Start Center for Applied Economics at New York
University. Hubbard is grateful for support from a John M. Olin Foundation
grant to the Center for the Study of the Economy and State at the
University of Chicago and from the Federal Reserve Bank of New York.
T h e views expressed in this paper are those of the authors, and do not
necessarily represent those of the Board of Governors of the Federal
Reserve System.

Appendix A: Derivation of the aeoelmsieal investment model

T o derive the tax-adjusted q model, we begin with an expression for the

value of the firm, which in t a m stems from the arbitrage condition
governing the valuatio:~ of shares (see Poterba and Summers, 1983, 1985). ~
T h e after-tax r e m m to ~he owners of the firm at time t reflects capital
appreciation and current dividends. In equilibrium, if the owners are to be
content ho!ding their shares, then this return must equal their required
return, p:

[0 - z,)(E,.,(E. ,., - s,.,.,) - E.,)

+ (1 - m,)O,E,. , D . . . . , ] / E . , = P , . , . (AI)

where i and t are the firm and time indexes, respectively; E~. t is the
expectations operator of firm i conditional on information available at time
t; V is the value of the firm's equity; S is the value of new shares issued; D
represents the dividends the firm pays; z is an accrual-equivalent capital
gains tax rate; m is the personal tax rate on dividends; and O is the dividend
received by the shareholder when the firm distributes one currency unit of
retained earnings.

'~For alternative derivations, see Hayashi (1985).

262 J.G. Cummins et al. / Journal of Public Economics ,52 (1996) 237-273

In the absence of any speculative bubbles, solving Eq. (A1) forward yields
the following expression for the market value of the firm's equity at time t:

V,., = E,., = - ,

where /3i. j is the time j discount factor for tint1 i; and " O , = ( l - m ~ ) O , /
(1 z~). The variable -q is the tax discr;mination parameter that determines
-

tile relative tax advantage of dividends against retained earnings. U n d e r a

classical system of corporate taxation, 0 takes the constant value of unity.
U n d e r an imputation system, 0, = (I - c , ) -~, where c is the rate of imputa-
tion.
The firm maximizes Eq. (A2) subject to five constraints. The first is the
capital stock accounting identity:
K,., = (1 - 8 , ) K .... ~ + I,.,,
where I and K are investment and the capital stock, respectively, and 6 is
the rate of economic depreciation.
The second constraint defines firm dividends (net cash flow). Cash inflows
consist of sales~ new share issues, and net borrowing, while cash outflows
consist of dividends, factor and interest payments, and investment expendi-
tures:
D,., = (1 - T,)[F(K,. ,_ ~. N,. ,) - w,,%., - C(I,. ,. K,.,_, ) - i,_, B~.,_, ]
+ s,., + 8,., - (l - ~)B,_, -P,O - r,. ,)i,. ,.

where "r is the marginal corporate tax rate; F ( K . N ) is the firm's production
function (Fx > 0. F~K < 0); C(I, K ) is the real cost of adjusting the capital
stock ( C t > O. C u > O. C K < O, CK~ < 0); N is a vector of variable factors of
production; w is a vector of real factor prices; B is the market value of
outstanding debt; i is the nominal interest rate paid on corporate bonds; ~'~
is expected inflation; p is the price of capital goods relative to the price of
output; and F is the tax benefit of investing. For example, with an
investment tax credit at rate k. F is

/~,, = k,., + ~ ( 1 + r, + 7r~) 'r~DEP,. ,(s - t),

s=t
where r is the default risk-free real interest rate, (assumed to equal 4%),
and DEP,.~(a) is the depreciation allowance permitted an asset of age a
discounted at a nominal rate that includes the expected inflation rate ~'~.
The third constraint restricts dividends to be non-negative:
1),.,>!0.

T h e fourth constraint limits share repurchases:

 J.G. Cummins et al. / Journal o f Public Economics 62 (1996) 237-273 263

The fifth constraint is a transversality condition that prevents the firm from
borrowing an infinite amount to pay out dividends:
([~T-I )
lim__ /3i i B, r = 0 . V,.

To derive the Euler equation for investment, we set the derivatives of the
firm's maximization problem equal to zero at time t:

r {,-,:,,,
-,,)lp, + (A3)
L \ '-",/
and
E,. ,{ill ,+ i( 1 - zt+ ,)(FA+- CA') + (1 - 8+)A.... ~} = A t , , (A4)

where A is the shadow value of an increase in firm i's capital stock (i.e.
marginal q) at time t. Eq. (A4) states that it is optimal to invest until the
return on a marginal unit of capital in period t + I equals the cost of capital
in period t + 1.
To derive the equation we estimate, we posit a quadratic adjustment cost
function:
,,,I li., "~ '-
C(I,. ,, K. ..... ) = -~t K~.~_l - It,) K,. ,_,, (A5)

where p. is the steady-state rate of investment and a is the adjustment cost

parameter. Using eq. (A5) and rearranging terms in eq. (A3) yields:

li. , 1 [ A , . , - p , ( l - F,. , ) ]
Ki .---'-~ =/~i + ~ -1~ , . ~ " (A6)

Eq. (A6) is not empirically implementable since a is unobsetvable. If we

assume a constant returns to scale production function and perfect competi-
tion we may equate marginal q to average Q, defined for each firm as

Q+., = (L,. ,E., + B,., - A c .)/K[_, , (A7)

where L is an indicator variable equaling unity if the firm is not paying
dividends and "q if the firm is paying dividends; A is the present value, of the
depreciation allowances on investment made before period t; and K is the
replacement value of the firm's capital stock including inventories. We
estimate:
264 J.G. Cummins et al. / Journal of Public Economics 62 (1996) 237-273

g,.,_, = ~ , + ~ ( 1 - ~ ) ' K~.,_,

(A8)

Appendix B: Data description

The dataset we use is an unbalanced panel of firms for 14 countries from

the Global Vantage industrial database covering the period from 1982 to
1992. This database contains information on approximately 7400 companies
from 36 countries. Data for most companies are available since 1982.
Comprehensive balance sheet and income statement data are provided.
Definitions are standardized to ensure intra-company data consistency
between different accounting periods, and inter-company data consistency
within and across countries. Global Vantage does not .-.1just data for
accounting differences. Instead, it provides extensive additional information
on relevant accounting standards, data definitions, and available firm-
specific disclosures to enable the user to make whatever adjustments arc
necessary. Unlike the Compustat database, Global Vantage has relatively
few firm entrants and exits, making the dataset more nearly balanced.

B . 1 . Firm-specific variables
T h e variables we used are defined as follows. To facilitate replication and
extension of our empirical results and to aid researchers in data construction
on this relatively unfamiliar dataset, we provide the data item numbers in
parentheses after each variable. Gross investment is the s u m of the change
in the net stock of tangible fixed assets (76) and depreciation (I1)) 8 A more
precise estimate of depreciation can be obtained (12), but we choose the one
above since most firms do not separately report the more precise figure. The
h,vestment variable is divided by the value of its own beginning-of-period
capital stock. Output is defined as net sales/turnover (1), and is also divided
by the value of its own beginning-of-period capital stock. Operating income
is defined exactly as such (14). Net income is defined as income before
extraordinary ,terns (32). Total income tax is defined exactly as such (23).
Cash flow is the sum of net income and depreciation. These variables arc

~Defining gross investment as the change in the gross stock of tangible fixed assets (77) is
impracticable because that data item is frequently not reported by firms, or was not required to
be reported by firms (e.g. German firms did not report the gross stock of fixed assets until
1985). There is no data item in Global Vantage comparable to the capital expenditures data
item in Compnstat.
 J.G. Cummins et al. I Journal of Public Economics 62 (1996) 237-273 265

also divided by their beginning-of-period capital stocks. The dividend

payout rate is defined as the ratio of common dividends (36) to operating
income (defined above). We choose the above definition because it limits the
number of negative observations. We defined total debt as the sum of
short-term debt (94) and long-term debt (106). When a single stock issue
exists, the equity value of the firm is defined in the standard manner
(end-of-year stock price multiplied by shares outstanding). When more than
one issue exists, the value of each is calculated in this way, and all the issues
are added. All variables are deflated by the country's GDP deflator.
Firm-specific depreciation rates are constructed using the method in Cum-
mins et al. (1994). The present value of tax savings from depreciation
allowances is constructed from the tax parameters following Salinger and
Summers (1983). Finally, G D P deflators and investment price deflators are
taken from the O E C D National Accounts.

B.2. Taxation variables

We use three data sources to construct the panel of tax parameters and to
learn about the relevant tax law. The primary source for current tax law is
the loose-leaf service of the International Bureau of Fiscal Documentation
(IBFD). The IBFD publishes guides to taxation in separate services for
Europe, Asia and the Pacific, and Canada. These are, respectively, Guide to
European Taxation, Volume H: The Taxation o f Companies in Europe;
Taxes and Investment in Asia and the Pacific, Part 1I: Countries; and Taxes
and Investment in Canada. These services do not, in general, contain the
historical detail necessary to construct a time series of changes in tax law.
For that purpose, we use the IBFD's Tax News Service, which is a weekly
periodical containing every significant tax law change. Some of the detail in
the Tax News Service is contained in the IBFD's Annual Report and in its
European Tax Handbook, Coopers & Lybrand's International Tax Sum-
maries and International Accounting Summaries and Price Waterhouse's
Corporate Taxes--A Worldwide Summar~ provide concise and accurate
yearly descriptions of countries' tax law. However, the volumes sometimes
lack sufficiert information on the timing and detail of tax changes.

B.2.1. Corporate tax rates

Table 1 in the main text reports the statutory macginal corporate income
tax rates for 18 O E C D countries, including all of those in our sample, from
1981 to 1992. Close attention must be paid to the footnotes since no single
rate completely summarizes the w/de variation in the countries' tax systems.
Corporate income tax rates vary widely and have steadily declined over the
sample period in almost every country.
266 J.G. Cttmmins et al. / Journal of Public Economics 62 (1996) 237-273

B.2.2 Investment incentives

Table 2 in the main text reports the rates of investment tax credits and
deductions. While only a few countries provide broad-based statutory
investment incentives, all countries in our sample have investment incentives
for specific regions or industries, for certain types of business fixed
investment, or for research and development which are not reported. These
special incentives tend to be extremely complex and, in many cases, cannot
be summarized because they are essentially negotiated between the taxpayer
and tax authority.

B,2.3. Depreciation and inventory valuTtion rules

Table 3 in the main text summarizes depreciation and inventory valuation
rules. Neither one of these sections of the tax code is easily summarized in a
table; background information is provided below (see Cummins et al.,
1995). Unless otherwise noted, assets may be revalued in conformity with
the relevant tax law and stock is valued at the lower of cost or market value.

B.2.4. Australia
Depreciation of assets is calculated on the cost price and the useful life of
the assets (which before 1991 was estimated by the tax authority), which the
taxpayer estimates based on the statutory definition. The tax authority
continues to publish recommended depreciation rates which the taxpayer
may elect over estimating useful life. Plant and machinery may be depre-
ciated on either a straight-line (SL) or declining-balance (DB) basis. In the
absence of a formal election for the SL method, the DB method is used.
Most assets acquired after 1992 are depreciable by reference to a six-rate
schedule, with useful lives ranging from three to more than 30 years and DB
rates ranging from 10% to 60%. SL rates are two-thirds of DB rates. Assets
may be depreciated at a lower rate at the option of the taxpayer. Assets with
an effective life of less than three years or low cost assets may be
depreciated immediately. Structures may be depreciated at 2.5% per year if
construction commenced after September 1987, 4% if construction com-
menced between August 1984 and September 1987, and 2.5% if construc-
tion commenced before August 1984. The period over which the deprecia-
tion may be claimed is 40 years for structures subject to the 2.5% rate and
25 years for structures subject to the 4% rate.
For valuation of stock, the tax authority accepts average cost (AC),
standard cost (SC), specific identification (SI), and first-in-first-out (FIFO).
Last-in-first-out (LIFO) and base-stock methods are not allowed.

B.2.5. Belgium
Depreciation of assets is calculated on the cost price and the useful life of
the assets and is allowed as of the financial year in which they were acquired
 J.G. Cummins et al. / Journal o f Public Economics 62 (1996) 237-273 267

or produced and must be applied every year. The law allows only SL and
DB methods. SL is the normal method. The depreciation periods and the
corresponding rates are normally fixed by agreement between the taxpayer
and the tax authority, although for certain assets the rates are set by
administrative ruling (e.g. commercial buildings 3%; industrial buildings
5 % ; machinery and equipment 10% or 30%; rolling stock 20%). DB is
optional, as is a combination of both methods---if in a certain year the
a m o u n t of depreciation computed by applying DB is lower than that
computed according to SL, then a company can switch to the latter method.
Accelerated depreciation (AD) is available for certain assets based on
administrative ruling (e.g. ships and scientific equipment).
T h e tax code does not contain special provisions for the valuation of
stock. The tax authority therefore requires that the stock be valued at cost
or market value, whichever is lower. As for methods, A C , SI, FIFO, and
LIFO are accepted but the base-stock method is not.

B.2.6. Canada
T h e capital cost allowance system groups depreciable assets into various
classes (similar to the method used in ~he United States). Each class is
depreciable at a specific rate, generally on a DB basis. In the year of
acquisition, only half the normal rate m a y be claimed on that asset. The
depreciation allowances are elective, allowing the taxpayer to claim any
desired amount (subject to the maximum). The following sets out some of
the more c o m m o n types of depreciable assets with the applicable DB rates:
structures 4 % , machinery and equipment 30%, and autos and computers
30%. Asset revaluation is not allowed.
Permissible inventory valuation methods include A C and FIFO. In some
circumstances, the tax authority will accept the SC method. The LIFO
m e t h o d is not accepted.

B.2. 7. Denmark
SL depreciation for business structures is permitted. For most types of
buildings the depreciation rate is 6% of cost during the first 10 years, and
2% thereafter (a lower rate of 4% and 1% is applied to service buildings.
and a higher rate of 8% and 4% to building installations). Between 1982 and
1990 the depreciable base was adjusted annually for inflation. For equip-
m e n t DB depreciation is allowed on a collective basis. The rate may be
chosen by the taxpayer but may not exceed 30%. in any year. Tax
depreciation is not allowed for accounting purposes.
T h e A C , SI, FIFO, and SC methods are considered appropriate; LIFO is
acceptable but rarely used.
268 ,LG. Cummins et al. / Journal o f Public Economics 62 (1996) 237-273

B.2 8 France
Depreciation is normally computed by the SL method. However, the law
provides for other methods~ namely DB and A D . The SL method may be
applied without restriction. The rates are computed by dividing the expendi-
ture by the estimated useful life of the asset as determined in accordance
with accepted business practice. Taxpayers may opt for a varying deprecia-
tion rate based on a different useful life estimation, but this will be accepted
only if the difference is within 20% of customary practice. T h e DB method
is allowed on a more limited scale. It m a y not be applied to assets whose
useful life is less than three years nor to many classes of assets. The rate is
computed by multiplying the rate of SL depreciation by 1.5 if the useful life
is three or four years, by 2 if the life is five or six years, and by 2.5 if the life
exceeds six years. A D in the form of an initial deduction is available for
certain assets (e.g. environmental protection equipment). Only limited asset
revaluation is permitted.
T h e FIFO and A C methods are usually used. The LIFO method is not
generally permitted except when used in consolidated financial statements.

B.2.9. Gomany
Systems of depreciation allowed by law are the SL, DB, and certain other
m e t h o d s (e.g. sum of the years" digits). A switchover from DB to SL is
permitted, but not vice versa. The rates of depreciation for buildings are set
o u t in the law and for other assets in the official r e c o m m e n d e d tables (over
90 tables) that are issued by the various tax authorities. T h e taxpayer may
deviate from them in individual cases on reasonable grounds. For business
structures, the annual SL rate is 4%. The corresponding DB rates are: 10%
for the first four years, 5% for the following three years and 2.5% for the
remaining 18 years. For fixed assets a general table applies SL rates of 10%
for machinery, 20% for office equipment, 10% for office furniture, 20% for
computers, and 20% for motor vehicles. If the assets are depreciated
according to D B , then the annual rate is limited to three times the SL rate
with an allowable m a x i m u m of 30%. A D is allowed for certain special assets
(e.g. those in development areas or private hospitals) and if justified by
excessive wear and tear. Asset revaluation is not allowed.
F r o m the assessment year 1990, LIFO is allowed. A C and SI are typical
methods; FIFO is not allowed unless it approximates actual physical flows.

B.2.1o. Italy
Depreciation of tangible assets is permitted on a SL basis. Depreciation is
determined by applying the coefficients established by the tax authority,
reduced by half for the first fiscal year. These coefficients are established for
categories of assets based on normal wear and tear in various productive
 J.G. Cummins el al. / Journal of Public Economics 62 (1996) 237-273 269

sectors (rates for structures vary from 3% to 7%, and for machinery and
equipment from 20% to 25%). A D is also allowed. In addition to normal
depreciatien, the deductible amount may be increased by 200% in the year
in which the asset is acquired and in one of the following two years.
Moreover, normal depreciation may always be increased -'n proportion to
more intense use of the asset (intensive depreciation), l'he amount of
depreciation may be less than normal depreciation, and the difference may
be spread over subsequent fiscal years. Only limited asset revaluation is
permitted.
Any system of inventory valuation is permitted provided it is not less than
if the LIFO method is used.

B.2.11. Japan
The amount depreciable on assets per year is computed on the assumption
that their salvage value is 10% of the acquisition cost. However, companies
may claim depreciation until the residual value of the asset reaches 5% (i.e.
up to 95% of acquisition costs). The statutory useful lives of assets are
prescribed by the tax authority. They range from 4 years (for motor
vehicles) to 65 years (for office buildings). Special depreciation is available
for assets subject to abnormal wear and tear and due to extraordinary
circumstances. A D is also available for designated assets and industries (e.g.
environmental protection equipment and ships). Initial-year depreciation
rates range from 8% to 30%, and further A D can follow. Asset revaluation
is not allowed.
For valuation of stock, the tax authority accepts AC, SI, LIFO, and
FIFO. The method should be applied consistently and not distort the
computation of the income of a corporation.

B . 2 . 1 2 . The Netherlands
Depreciation of assets is compulsory whether the company is profitable or
not. Assets with a low cost can be fully depreciated in the year of
acquisition. All systems of depreciation ~re permitted provided that the
system is in accordance with sound business practices and that it is
consistently applied. This means that changes in the system will not be
allowed when a change is made just for tax purposes. Depreciation is based
on historic cost price, useful life, and the salvage value of the asset. No
official guidelines for depreciation exist. In practice, the rates are agreed
between the taxpayer and the tax author;ty.
Under the sound business practice principle, many systems of inventory
vaiuation are allowed (e.g. LIFO, FIFO, or base-stock methods). The
system must be applied consistently.
270 J.G. Cumminx et al. / Journal of Pubhc Economics 62 (I996) 237-273

B.2.13. N o r w a y
T h e DB method of depreciation is mandatory. The 1992 tax reform
influenced the system of depreciation by changing the division of business
assets into a smaller number of classes ann by generally reducing the
m a x i m u m rates allowed. Depreciable assets ark divided into eight classes
(maximum rates follow in parentheses): (1) office machines (30%), (2)
goodwill (30%). (3) motor vehicles (25%), (4) equipment (20%), (5) ships
(20%), (6) aircraft (20%), (7) industrial structures (5%), and (8) commercial
~truetures (2%). Assets in classes 1-4 are written down on a collective basis;
c!asses 5 - 8 are depreciated individually. A D for ships, aircraft, and certain
strl: 'tures has been abolished as of 1992. Assets with an estimated life of less
than three years and low cost assets may be depreciated immediately.
The FIFO method must oe used for inventory valuation.

B . 2 . 1 4 . Spain
Depreciation is allowed on all tangible and intangible fixed assets on the
basis of their normal useful life. Depreciation may be calculated by the SL
method. In certain cases (e.g. industrial machinery and computers), the DB
m e t h o d is permitted. Rates for depreciation arc contained in official tables.
Examples of general m a x i m u m SL rates follow (with the m i n i m u m rate
following in parentheses): industrial structures 3% (2%), commercial struc-
tures 2% (1.33%L machinery 8% (5.6%), tools 20% (12.5%), office
furniture 10% (6.67%), computers 25% (16.7%L and motor vehicles 14%
(9.1%). Assets intensively used may be depreciated at a maximum rate
increased by 33% for each additional shift. U n d e r the DB method, the
annual depreciation rate is increased by 50% (if the useful life is less than
five years) or by 100% (if the useful life is five years or more). The tax
authorities can accept, at their discretion, special A D (or even free
depreciation) for certain assets and industries. Asset revaluation is not
permitted.
Accepted methods for inventory valuation are A C (in practice, the
generally applied method) and FIFO. The LIFO and base-stock methods are
not accepted for tax purposes.

B.2.15. Sweden
Machinery and equipment are normally depreciated by the DB method.
T h e m a x i m u m depreciation allowance is 30% of the aggregate book value of
all assets at the beginning of the tax year, plus the cost of assets acquired,
less the amount received for assets sold during the year. Should a SL
depreciation of 20% per year on all assets result in a lower book value in
any year, the annual depreciation may be increased correspondingly. If the
 J.G. Cummins et aL / Journal of Public Economics 62 (19ctti) 237-273 271

t a x p a y e r c a n p r o v e t h a t the real value of m a c h i n e r y a n d e q u i p m e n t is l o w e r

than that resulting from the above-mentioned depreciation methods, then
the d e p r e c i a t i o n m a y b e a l l o w e d in a n a m o u n t r e s u l t i n g in the value. A s s e t s
w i t h a useful life n o t e x c e e d i n g t h r e e y e a r s a n d low cost assets m a y b e
d e p r e c i a t e d i m m e d i a t e l y . F o r buildin,~s, o n l y the SL m e t h o d is p e r m i t t e d . In
g e n e r a l , d e p r e c i a t i o n is b a s e d o n cost a n d useful life. T h e r a t e s v a r y
b e t w e e n 1 . 5 % a n d 5 % p e r y e a r as a g r e e d by the t a x p a y e r a n d t h e tax
authority,
P r i o r to 1991. i n v e n t o r i e s w e r e f r e q u e n t l y c a r r i e d at a n a m o u n t l o w e r
t h a n t h e m a x i m u m a m o u n t p e r m i t t e d b y t h e l o w e r o f cost o r m a r k e t v a l , e ,
d u e t o tax incentives. In d e t e r m i n i n g i n v e n t o r y v a l u a t i o n , the F I F O m e t h o d
should be applied.

,~.2.16. The United K i n g d o m

I n d u s t r i a l s t r u c t u r e s a r e eligible for 4~7~ a n n u a l d e p r e c i a t i o n o n the SL
method. There are no allowances for commercial structures. Plant and
e q u i p m e n t ( w h i c h has a relatively wide: m e a n i n g ) is eligible f o r 25~;~" a n n u a l
d e p r e c i a t i o n o n ti~e D B o r SL m e t h o d .
F I F O . A C . o r at:y similar m e t h o d is a l l o w e d . L I F O is n o t a c c e p t a b l e .

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