The right kind of help? Tax incentives for staying small

Some countries in Europe support smaller firms through tax incentives in an effort to stimulate job creation and startups, or alleviate specific distortions, such as financial constraints or high regulatory or tax compliance costs. For example, over the period 2000 to 2010, small firms benefited from lower corporate income tax rates in Belgium, France, Hungary, the Netherlands, Spain, and the United Kingdom (OECD, 2015). In addition to fiscal costs, tax incentives that discriminate by firm size without specifically targetting research and development investment can create disincentives for firms to invest and grow, negatively affecting firm productivity and growth (International Monetary Fund (IMF), 2016a and 2017; Almunia, 2014). They could also hamper market selection as investors would be satisfied with lower gross return on their investment due to the tax preference. This implies that resources would be diverted towards less productive firms and their aggregate share would be larger in equilibrium, lowering in turn the efficiency of resource allocation and reducing incentives to invest in innovation (Aghion 2005, and Bobbio, 2016). This paper analyzes empirically the relationship between size-related corporate income tax incentives and firm productivity and growth, controlling for other policy and firm-level factors, including product market regulation, financial constraints and innovation. Using panel data econometric approaches on firm level data from four European economies over the period 2001 to 2013 (Belgium, France, Spain and the United Kingdom), we find evidence that size-related tax incentives that do not specifically target research and development investment can weigh on firm productivity and growth. These results suggest that when designing size-based tax incentives, it is important to address their potential disincentive effects, including by making them temporary and targeting young and innovative firms, and research and development investment explicitly.

Keywords: size-based taxation, productivity, growth, structural reforms