Question

How will investment spending be effected when greater level of taxes are placed on business earnings?

Answer 1

Evidence shows that there is inverse relationship between level of taxation on business earnings and investment spending. That is, invest spending decreases when greater level of taxes are placed on business earnings.

One key reason that capital is so sensitive to taxation is because capital is highly mobile. For example, it is relatively easy for a company to move its operations or choose to locate its next investment in a lower-tax jurisdiction, but it is more difficult for a worker to move his or her family to get a lower tax bill. This means capital is very responsive to tax changes; lowering the corporate income tax rate reduces the amount of economic harm it causes.

When firms think about making an investment in a new capital good, like a piece of equipment, they add up all the costs of doing so, including taxes, and weigh those costs against the expected revenue the capital will generate. The higher the tax, the higher the cost of capital, the less capital that can be created and employed.So, a higher corporate income tax rate reduces the long-run capital stock and reduces the long-run size of the economy. Conversely, lowering the corporate income tax incentivizes new investment, leading to an increase of the capital stock.