NBER WORKING PAPER SERIES
TAX POLICY AND HETEROGENEOUS INVESTMENT BEHAVIOR
Eric Zwick
James Mahon
Working Paper 21876
http://www.nber.org/papers/w21876
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
January 2016
This paper previously circulated with the title, “Do Financial Frictions Amplify Fiscal Policy? Evidence
from Business Investment Stimulus.” Zwick thanks Raj Chetty, David Laibson, Josh Lerner, David
Scharfstein, and Andrei Shleifer for extensive advice and support. We thank Gary Chamberlain, George
Contos, Ian Dew-Becker, Fritz Foley, Paul Goldsmith-Pinkham, Robin Greenwood, Sam Hanson,
Ron Hodge, John Kitchen, Pat Langetieg, Day Manoli, Isaac Sorkin, Larry Summers, Adi Sunderam,
Nick Turner, Tom Winberry, Danny Yagan, Moto Yogo, and seminar and conference participants
for comments, ideas, and help with data. Tom Cui and Prab Upadrashta provided excellent research
assistance. We are grateful to our colleagues in the US Treasury Office of Tax Analysis and the IRS
Office of Research, Analysis, and Statistics—especially Curtis Carlson, John Guyton, Barry Johnson,
Jay Mackie, Rosemary Marcuss, and Mark Mazur—for making this work possible. The views expressed
here are ours and do not necessarily reflect those of the US Treasury Office of Tax Analysis, nor of
the IRS Office of Research, Analysis and Statistics, nor of the National Bureau of Economic Research.
Zwick gratefully acknowledges financial support from the Harvard Business School Doctoral Office,
and the Neubauer Family Foundation and Booth School of Business at the University of Chicago.
NBER working papers are circulated for discussion and comment purposes. They have not been peer-
reviewed or been subject to the review by the NBER Board of Directors that accompanies official
NBER publications.
© 2016 by Eric Zwick and James Mahon. All rights reserved. Short sections of text, not to exceed
two paragraphs, may be quoted without explicit permission provided that full credit, including © notice,
is given to the source.
Tax Policy and Heterogeneous Investment Behavior
Eric Zwick and James Mahon
NBER Working Paper No. 21876
January 2016
JEL No. D21,D92,G31,H25,H32
ABSTRACT
We estimate the effect of temporary tax incentives on equipment investment using shifts in accelerated
depreciation. Analyzing data for over 120,000 firms, we present three findings. First, bonus depreciation
raised investment in eligible capital relative to ineligible capital by 10.4% between 2001 and 2004
and 16.9% between 2008 and 2010. Second, small firms respond 95% more than big firms. Third,
firms respond strongly when the policy generates immediate cash flows but not when cash flows only
come in the future. This heterogeneity materially affects aggregate estimates and supports models
in which financial frictions or fixed costs amplify investment responses.
Eric Zwick
Booth School of Business
University of Chicago
5807 South Woodlawn Avenue
Chicago, IL 60637
and NBER
ezwick@chicagobooth.edu
James Mahon
Deloitte LLP
james.mahon.3@gmail.com
Economists have long asked how taxes affect investment (Hall and Jorgenson, 1967). The
answer is central to the design of countercyclical fiscal policy, since policymakers often use
tax-based investment incentives to spur growth in times of economic weakness. Improving
policy design requires knowing which firms are most responsive to taxes and why they respond.
However, because comprehensive micro data has been previously unavailable, past work has
not fully explored the role of heterogeneity in how tax policy affects investment or whether
such heterogeneity is macroeconomically relevant.
1
This paper uses two episodes of investment stimulus and a difference-in-differences method-
ology to study the effect of taxes on investment and how it varies across firms. The policy we
study, “bonus” depreciation, accelerates the schedule for when firms can deduct from taxable
income the cost of investment purchases. Bonus alters the timing of deductions but not their
amount, so the economic incentive created by bonus works because future deductions are
worth less than current deductions. That is, bonus works because of discounting: firms judge
the benefits of bonus by the present discounted value of deductions over time.
2
Our first empirical finding is that bonus depreciation has a substantial effect on investment.
We find that bonus depreciation raised eligible investment by 10.4 percent on average between
2001 and 2004 and 16.9 percent between 2008 and 2010. Our estimates are consistent with
the large aggregate response House and Shapiro (2008) document for the first episode of
bonus, but well above estimates from studies of other tax reforms.
3
The first part of the paper details this finding and a litany of robustness tests. The research
design compares firms at the same point in time whose benefits from bonus differ. Our strat-
egy exploits technological differences between firms in narrowly defined industries. Firms in
industries with most of their investment in short duration categories act as the “control group”
because bonus only modestly alters their depreciation schedule. This natural experiment sep-
arates the effect of bonus from other economic shocks happening at the same time. If the
parallel trends assumption holds—if investment growth for short and long duration industries
1
Key theoretical studies include Hall and Jorgenson (1967), Tobin (1969), Hayashi (1982), Abel and Eberly
(1994), and Caballero and Engel (1999). Abel (1990) presents a unifying synthesis of the early theoretical
literature. Key empirical work includes Summers (1981), Auerbach and Hassett (1992), Cummins, Hassett and
Hubbard (1994), Goolsbee (1998), Chirinko, Fazzari and Meyer (1999), Desai and Goolsbee (2004), Cooper and
Haltiwanger (2006), House and Shapiro (2008), and Yagan (2015). Edgerton (2010) explores heterogeneity
within a sample of public companies but finds mixed results.
2
Summers (1987) states this most clearly: “It is only because of discounting that depreciation schedules affect
investment decisions. . . ”
3
Cummins, Hassett and Hubbard (1994) study many corporate tax reforms with public company data and con-
clude that tax policy has a strong effect on investment. Using similar data and a different empirical methodology,
Chirinko, Fazzari and Meyer (1999) argue that tax policy has a small effect on investment and that Cummins,
Hassett and Hubbard (1994) misinterpret their results. Hassett and Hubbard (2002) survey empirical work and
conclude that the range of estimates for the user cost elasticity has narrowed to between -0.5 and -1. Surveying
this and more recent work, Bond and Van Reenen (2007) decide “it is perhaps a little too early to agree with
Hassett and Hubbard (2002) that there is a new ‘consensus’ on the size and robustness of this effect.”
2
would have been similar absent the policy—then the experimental design is valid.
The key threat to this design is that time-varying industry shocks may coincide with bonus.
This risk is limited for four reasons. First, graphical inspection of parallel trends indicates
smooth pretrends and a clear, steady break for short and long duration firms during both the
2001 to 2004 and 2008 to 2010 bonus periods. The effects are the same size in both periods,
though different industries suffered in each recession. Second, the estimates are stable across
many specifications and after including firm-level cash flow controls, industry Q, and flexible
industry trends. Controlling for industry-level co-movement with the macroeconomy increases
our estimates, and we confirm parallel trends in past recessions when policymakers did not
introduce investment stimulus. Third, the estimates pass a placebo test: the effect of bonus on
ineligible investment is indistinguishable from zero. Last, for firms making eligible investments,
bonus take-up rates (i.e., whether firms fill in the bonus box on the tax form) are indeed higher
in long duration industries. For these reasons, spurious factors are unlikely to explain the large
effect of bonus.
In the second part of the paper, we present a set of heterogeneity tests designed to shed light
on the mechanisms underlying the large baseline response. Our second empirical finding is that
small firms are substantially more responsive to investment stimulus. We work with an analysis
sample of more than 120,000 public and private companies drawn from two million corporate
tax returns. Half the firms in our sample are smaller than the smallest firms in Compustat.
4
The largest firms in our sample, those most like the public company samples from prior work,
yield estimates in line with past studies of other tax reforms. In contrast, small and medium-
sized firms show much stronger responses. Though aggregate investment is concentrated at
the top of the firm size distribution—the top five percent of firms in our sample account for
more than sixty percent of investment—accounting for the bottom ninety-five percent of firms
materially affects our aggregate estimate. The investment-weighted elasticity is 27% higher
than the elasticity for the largest firms.
The asymmetry of the corporate tax code introduces another source of heterogeneity: firms
with tax losses must wait to realize the benefits of tax breaks. Because many firms in our sample
are in a tax loss position when a policy shock occurs, we can ask how much firms value future
tax benefits, namely, the larger deductions bonus depreciation provides them in later years.
Our third empirical finding is that firms only respond to investment incentives when the policy
immediately generates cash flows. This finding holds even though firms can carry forward
unused deductions to offset future taxes, and it cannot be explained by differences in growth
opportunities.
4
When aggregated, these small firms account for a large amount of economic activity. According to Census
tabulations in 2007 (http://www.census.gov/econ/susb/data/susb2007.html), firms with less than
$100 million in receipts (around the 80th percentile in our data) account for more than half of total employment
and one third of total receipts.
3
To confirm the importance of immediacy, we study a second component of the depreciation
schedule. Firms making small investment outlays face a permanent kink in the tax schedule,
which creates a discontinuous change in marginal investment incentives. This sharp change in
incentives induces substantial investment bunching, with many firms electing amounts within
just a few hundred dollars of the kink. And when legislation raises the kink, the bunching
pattern follows. Immediacy proves crucial in this setting, as bunching strongly depends on a
firm’s current tax status: firms just in positive tax position are far more likely to bunch than
firms on the other side of the discontinuity. For a different group of firms and a different
depreciation policy, we again find that firms ignore future tax benefits.
Our findings have implications for which models of corporate behavior are most likely to
fit the data. In the presence of financial frictions (Jensen and Meckling, 1976; Myers and Ma-
jluf, 1984; Stein, 2003), firms value future cash flows with high effective discount rates, which
amplify the perceived value of bonus incentives because the difference in today’s tax bene-
fits dwarfs the present value comparison that matters in frictionless models. Building on the
differential response by firm size, we perform a split sample analysis using alternative mark-
ers of ex ante financial constraints. In addition to small firms, non-dividend payers and firms
with low cash holdings are 1.5 to 2.6 times more responsive than their unconstrained counter-
parts. Moreover, we find that firms respond by borrowing and cutting dividends. That firms
only respond to immediate tax benefits also suggests models in which liquidity considerations
matter.
Though these facts suggest a role for financial frictions, markers of financial constraints and
tax position may also measure the likelihood of adjustment in models with non-convex adjust-
ment costs (Caballero and Engel, 1999; Cooper and Haltiwanger, 2006). In these models,
when the policy induces a firm across its adjustment threshold, investment increases sharply
because the firm does not plan to adjust every year. Thus models in which fixed costs lead firms
to differ in their relative distance from an adjustment threshold may also explain the patterns
we observe. Consistent with this idea, firms very likely or very unlikely to invest in the absence
of the policy indeed exhibit lower elasticities. Taken together, the data point toward models in
which financial frictions, fixed costs, or a mix of these factors amplify investment responses.
Our paper follows a long literature that exploits cross sectional variation to study the effect
of tax policy on investment (Cummins, Hassett and Hubbard, 1994; Goolsbee, 1998; House and
Shapiro, 2008). We depart by using a broader sample of firms than public company samples
and by using detailed micro data to present new heterogeneity analyses, which shed light on
the underlying mechanisms. Allowing for heterogeneous responses also proves necessary to
estimate an accurate aggregate elasticity. In addition, the results suggest that countercyclical
policy aimed at high elasticity subpopulations can produce larger effects, in a similar spirit to
studies documenting heterogeneous responses of consumption to policy changes (Shapiro and
4
