Do tax incentives affect investment quality?

This paper examines the effect of tax incentives in the form of bonus depreciation on investment quality. Using the expiration of tax incentives via bonus depreciation in eastern Germany and a representative panel of West German establishments, we show that bonus depreciation signifi-cantly lowers investment quality. The average quality of investments, measured by the respon-siveness of future revenue and other proxies for cash flow to current investment, reduces by 15.2-23.8% in the short run and 31.8-41.4% in the long run. Our research suggests that this adverse effect of tax subsidies is greater for jurisdictions with higher tax rates, in times of high unemployment, and for large or low-productivity establishments. Overall, while increasing in-vestment quantity, as shown by prior literature, tax incentives such as bonus depreciation sub-stantially reduce the quality of investments.

Automated summary

This paper examines the impact of tax incentives in the form of bonus depreciation on investment quality. Through analyzing the expiration of tax incentives in eastern Germany and a representative panel of West German establishments, we find that bonus depreciation significantly reduces investment quality. In the short run, the average quality of investments, measured by the responsiveness of future revenue and other proxies for cash flow to current investment, decreases by 15.2-23.8%, while in the long run, it decreases by 31.8-41.4%. Our research suggests that this negative effect of tax subsidies is more pronounced in regions with higher tax rates, during periods of high unemployment, and for large or low-productivity establishments. Overall, while prior literature has shown that tax incentives increase investment quantity, tax incentives such as bonus depreciation substantially reduce the quality of investments.