2/2011 Jaan Masso, Jaanika Meriküll and Priit Vahter. Gross profit taxation versus distributed profit taxation and firm performance: Effects of Estonia's corporate income tax reform

Working Papers of Eesti Pank. No. 2/2011

This paper estimates the effect of the corporate tax reform in Estonia in the year 2000. This unique reform nullified the taxation of retained earnings and retained the corporate income tax only on distributed profits. The effect of the reform is identified by comparing the performance of Estonian firms that were affected with that of firms from Latvia and Lithuania, the two other Baltic states. We use firm-level financial data and the difference in differences and propensity score matching methods for our analysis. The results show that the corporate tax reform has resulted in increased holdings of liquid assets and lower use of debt financing. These developments have contributed positively to firms' survival during the recent global economic crisis. A positive effect on investment and labour productivity has also been found.
JEL Code: H25, H32, D22, O16
Key words: corporate income tax, capital structure, liquidity, investments, productivity, comparative economic development

* Jaan Masso is a senior research fellow at University of Tartu, Jaanika Meriküll is a researcher at Eesti Pank and Priit Vahter is a research fellow at Birmingham Business School. The research presented in the paper is largely based on the work undertaken for the project The impact of non-taxation of undistributed profits on investments and economic development ordered by the Ministry of Finance of the Republic of Estonia. In addition to that project, authors also acknowledge financial support from the Ministry of Education and Research of the Republic of Estonia target financed project No. SF0180037s08 and Estonian Science Foundation grant No. 8311. We are grateful for comments made by Indrek Seppo, Ott Toomet, Andres Võrk and the participants of seminars in Tartu, Tallinn and Riga, in particular Vyacheslav Dombrovsky. All errors are wholly the responsibility of the authors only.

Authors' e-mail addresses: Jaan.Masso [at] mtk.ut.ee, Jaanika.Merikyll [at] eestipank.ee, p.vahter [at] bham.ac.uk, Priit.Vahter [at] mtk.ut.ee

The views expressed are those of the authors and do not necessarily represent the official views of Eesti Pank.

Contents

1. Introduction
2. Data
3. Methodology
3.1. Difference in differences (DID) analysis
3.2. Propensity score matching
4. Results
4.1. The effect of the tax reform on capital structure and liquidity
4.2. Capital structure, liquidity and firm survival during the crisis
4.3. The effect of the tax reform on investment and productivity
4.4. Robustness tests
5. Conclusions
References
Appendix 1. The difference in differences estimation results of the effect of corporate income tax reform over the longer sample, Estonia, Latvia and Lithuania, 1996-2008
Appendix 2. Quality of propensity score matching of firms: average indicators in 1999. Treatment group = firms in Estonia.
Control group = firms in Latvia and Lithuania, either the whole sample or the matched firms only

Gross profit taxation versus distributed profit taxation and firm performance: effects of Estonia's corporate income tax reform, Working Papers of Eesti Pank No 2/2011 (PDF*)