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.

Figure 1. Investment share on GDP

Figure 2. Income tax rates

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.

Figure 3. Investment response to tax policy shocks

References

• Madsen, J.B., Minniti, A., Venturini, F. (2023) “The Long-run Investment Effect of Taxation in OECD Countries” Economica, 90(358), 584-611.