Personal Income Tax and Capital Investment

Martin Jacob / Robert Vossebürger - 11. Mai 2021

Tips for practitoners

The payslips of all employees who earn more than the basic tax-free amount clearly show it: personalincometax. This tax is levied on each individual’s income and thus reduces netearnings. However, the study "The Role of Personal Taxes in Corporate Investment Decisions" proves that not only individuals and their purchasing power are affected. Corporateinvestment falls by two percent when the average income tax burden rises by ten percent. This effect decreases at higher incomes.

The relationship between capital investment and labor costs

To produce, firms classically use labor and capitalinvestments in an optimal ratio. For example, a bakery can employ staff that produces and bakes the dough by hand or invest in an automated bread machine. In both cases, a comparable quantity is produced.

The decision whether to invest in a machine or to hire employees depends, among other things, on the laborcosts as compared to the cost of a machine. If labor costs increase because, for example, a higher income tax makes employees more expensive, this could trigger one of two distinct outcomes: Either the company invests more in machines and hires fewer employees so that the manual work in the production process is taken over by machines, or it invests less in machines because it cannot pay the skilled workers to operate the machines due to the high labor costs. In the second scenario, the company grows less, and its economic output decreases as compared to companies that are not affected by such a tax increase.

Another aspect suggests that investment decreases when taxes on employees increase relates to consumption. Since higher taxes also reduce the disposable income of employed persons, who are also customers of companies, consumption falls. As a result, companies produce less, sell less, and thus have less money to invest in machinery - a vicious cycle.

The overall economic burden of income tax

But why does the personal income tax, which is paid by employees as a percentage of their gross wages, increase companies' labor costs? At first glance, this seems puzzling. At second glance, however, it becomes clear that employees pass the tax on to their employers, at least in part. After all, if their net income, which is the decisive basis for their standard of living, falls, they or their unions often demand higher wages. This is one reason why collective bargaining regularly can be observed. Although it is hard to determine exactly how much income tax is passed on to companies, it is clear that part of the income tax increases are borne by companies through higher gross.

In addition, labor supply decreases when the tax burden increases. This is because income tax reduces the attractiveness to work if less net income after taxes remains in the pocket of employees. This makes leisure time more attractive than working for employees, hence the supply of labor in the economy falls and thus becomes more expensive. It is not for nothing that many workers prefer to have their overtime compensated with free time rather than paid out.

How exactly does income tax affect capital investment?

For the broad-based study, the average income tax burden in a country was combined with data from approximately 1.8 million balance sheets from unlisted small and medium-sized companies. This made it possible to quantify the impact of an income tax change on investment decisions. The results show that an increase in the average tax on personal income of one percent reduces capital investment by 0.2 percent.

Initially, this effect may seem marginal and negligible. However, a calculation in absolute figures shows that this is by no means the case: In 2020, according to the national accounts of the Federal Statistical Office, gross investment in Germany was around 678 billion euros. A one percent increase in income tax therefore reduces capital investments for companies by 1.36 billion euros. Entrepreneurial capital investments are particularly economically relevant, as they secure future corporate profits - and thus jobs and corporate tax revenue.

Income tax effects are not the same for all tax brackets

The study reveals another important feature of income tax increases: The negative effects of income tax on capital investment decrease with increasing income. Above an income of about 300,000 euros per year, there is no measurable reduction in capital investment due to a tax increase. The strongest negative investment effects arise when taxes are increased for middle- and low-income earners. One explanation for this is the high number of workers in these income brackets, who often also work with machinery or other capital goods.

From a tax policy perspective, it is interesting to note that tax increases in upper income brackets have fewer negative effects on capital investment. In the same vein, incentives for investment can be created by reducing income tax for low and middle incomes. These facts should be considered in a potential redesign of the income tax system.

Literature reference and methodology

The degree to which income tax increases reduce capital investment is illustrated by Prof. Dr. Martin Jacob and Robert Vossebürger, chairholder and doctoral student respectively, at the adidas Chair of Finance, Accounting, and Taxation at WHU – Otto Beisheim School of Management. In their study, "The Role of Personal Income Taxes in Corporate Investment Decisions," the researchers examine approximately 1.8 million company and tax data from 30 European countries from 2006 to 2018 and their influence on corporate capital investments.

• Jacob, M./Vossebürger, R. (2020): The role of personal taxes in corporate investment decisions, SSRN Working Paper.