The long shadow of taxation on investment
National governments face the challenge of identifying viable strategies to restore a
sustained path of economic development in response to the slowdown in productivity
growth. Higher rates of GDP per capita growth are crucial for improving living standards
through higher wages, broader occupational opportunities, and technological advances. To
this aim, tax policies have historically been regarded as powerful fiscal instruments;
however, their effects on economic growth are neither simple nor immediate.
Economic growth responds to taxation slowly, indirectly, and often invisibly, operating
through decisions that accumulate over decades rather than quarters. Household savings
and firm investment decision are inter-related, and are increasingly complicated by the
different nature of investment project pursued.
When corporate income taxation is raised, investment falls, as return from investment is
lower. Taxes cut or tax discounts contrarily raises investments. What matters for long-run
prosperity is not the volatility of investment over the business cycle, but the cumulative
effect of policy on the economy’s capacity to generate new ideas, skills, and technologies.
Following the Schumpeterian tradition of the economic growth theory, taxes should
influence growth primarily through their long-run effects on innovation and human capital
accumulation.
In joint work with Jakob Madsen and Antonio Minniti, we use historical data from 21 OECD
countries to document the relationship between tax policy and key growth-enhancing
factors, including investment in tangible assets as well as intangible assets such as
research and development (R&D) and tertiary education.
Figure 1 reports the unweighted mean of investment shares on GDP from 1890 to 2019,
where total investment is defined as the sum of investment in structures, equipment, and
R&D. While investment in equipment has remained relatively stable since World War II,
investment in structures has declined markedly. In contrast, both R&D investment and
tertiary enrolment rates have increased by approximately a factor of five over the past few
decades.
Figure 2 illustrates the evolution over the same period of the average tax rate, measured
as the ratio of total tax revenues to GDP. The figure shows that corporate income tax
revenues averaged below 5 percent from the mid-1940s, while personal income tax
revenues increased from around 5 percent to 15 percent of GDP. Over the same period,
top marginal income tax rates declined substantially, falling from approximately 60 percent
in the mid-1960s to around 40 percent in recent decades.
The work illustrates that, historically, physical investment, particularly in machinery and
equipment, responds relatively quickly to changes in corporate taxation but exhibits limited
long-run effects. Changes in firms’ investment behaviour affect GDP growth primarily in the
short run by expanding final demand, whereas the long-run growth impact, driven by
increases in productive capacity, is modest. Empirically, approximately half of the
adjustment to a tax change occurs within five years.
Investment in education responds even more slowly to tax changes, particularly those
affecting personal income taxation. Higher personal income taxes reduce tertiary
enrolment by lowering the expected returns to education. However, these effects
materialise over a decade or more, as cohorts adjust schooling decisions and gradually
enter the labour force.
R&D investment stands apart from other investment types. Although it is among the
slowest to respond to tax shocks, the increase is substantial. Tax cuts in corporate income
translate into persistently higher R&D investment rates, with effects showing up beyond a
decade. This reflects the distinctive nature of R&D activities, which are risky, cumulative,
and deeply embedded in organisational routines. Firms do not initiate or terminate
innovation programmes abruptly.
Taken together, this evidence reframes the tax policy debate. Tax changes are often
viewed primarily as short-run fiscal stimuli affecting aggregate demand, while their long-
run consequences, and the offsetting effects arising from the broader tax policy mix, are
frequently overlooked. Policies that appear benign in the short run may gradually erode the
economy’s innovation base. Conversely, policies that seem ineffective after a few years
may, in fact, be laying the foundations for future growth.
References
- Madsen, J.B., Minniti, A., Venturini, F. (2023) “The Long-run Investment Effect of Taxation
in OECD Countries” Economica, 90(358), 584-611.
Francesco Venturini
