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Galindo_Melendez[1] - Corporate Tax Stimulus and Investment...

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Corporate Tax Stimulus and Investment in Colombia Arturo J. Galindo Marcela Meléndez 1 March, 2010 Abstract We use a yearly dataset of plant level investment in Colombian firms during the period 1997 to 2007, to assess the impact of a tax incentive for firms that invest in fixed assets implemented in 2004. We find that there is a positive and statistically significant correlation between the boom observed in investment and the adoption of the tax policy. However the correlation vanishes when we control for year specific effects. This result is robust to changes in the empirical specification, changes in estimation techniques, the inclusion of additional controls, and changes in the data set among others. Overall we conclude that the analyzed tax stimulus was ineffective to promote investment in Colombia. Key words: Taxes, Investment, Colombia JEL Codes: E22, H2, O54 1 We thank Alberto Chong for comments on a previous version and Andrés Salamanca and Carolina Ydrovo for superb research assistance. Galindo works in the Research Department of the Inter- American Development Bank. Meléndez works at ECON ESTUDIO, Bogotá, Colombia. This document reflects exclusively the views of the authors and not of the IDB or its Board of Directors. Contact information: Galindo: [email protected] ; Meléndez: [email protected] .
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2 1. Introduction Many public finance economists have studied the relationship between corporate income taxes, investment and growth, and have found evidence suggesting that through their impact on the user cost of capital, taxes may have adverse effects on economic activity 2 . While, this result is robust to different estimation techniques, there is much less consensus on its magnitude 3 . Taxing the income of firms may be particularly harmful in economies where firms face financial constraints. By definition, for a constrained firm the return to its marginal investment is higher than the after tax real interest rate. By reducing the corporate tax rate, the incentives to invest are increased by raising the return to the highly potential productive investment and allowing the firm to use more of its internal funds to invest. The greater the reliance on internal funds, the greater should be the expected impact on investment of reducing corporate tax rates. With this in mind, several countries in Latin America that have usually faced low investment rates, have implemented tax stimuli to promote investment and long term economic growth. Chile, Colombia and Mexico among others, are countries that have explicitly adopted policies in this direction. The purpose of this paper is to explore the effectiveness of a policy of such type adopted recently in Colombia. In 2003 a 30% deduction of investment expenditure from taxable income was introduced. After this policy was introduced, investment boomed. Its real growth rate, that averaged 8% during the first half of the decade, augmented to an average of 16% between 2004 and 2007. While, at least to our knowledge, no formal evaluation has been done to the
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