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Determinants of Business Fixed Investment: Evidence from German Firm-Level Data

Thiess Buettner and Anja Hoenig


This paper employs a novel firm-level dataset that combines financial accounts of German firms with data from a business survey to shed new light on the demand for capital. The empirical analysis employs firm-specific indicators in order to explore the effects of sales, the cost of capital and indicators of the business climate, which are used by the ifo Institute to provide a leading indicator for the German economy. The empirical results support a robust significant effect of a firm’s cost of capital on the stock of capital with an elasticity not significantly different from –1. Controlling for sales, a good rather than normal business situation is found to be associated with about 8 % higher investment.

JEL Classification: H25; E220; E320


For comments on an earlier draft we are indebted to two anonymous referees, Martin Falk, Simon Loretz, Joachim Winter, and participants at conferences and seminars in Uppsala, Munich, and Mannheim. All errors remain the authors’ sole responsibility.


6.1 Corporate tax parameters in Germany

During the period 1994–2007 corporations were subject to various income taxes, namely the corporate income tax (τc), the business tax on income and capital (τGSt), and the “solidarity surcharge”, τSS. To calculate the statutory tax rate τ for equation (5), we include all three components and account for their interaction. The local business tax rate varies at the level of municipalities, whereas the corporate tax and the solidarity surcharge are the same for all firms and do only vary over time. [16]

Table 8 displays the tax parameters for the cost of capital calculations. Besides the headline rates on retained earnings (and distributed profits until 2000 shown in brackets), we report the solidarity surcharge and the average business tax in our sample for each year. The latter is calculated as an unweighted average of the business tax rates of all municipalities in period t.

Table 8:

Parameters used for tax indicators.

YearCorporate tax rate retained (distributed) profits in % (τc)Solidarity surcharge in % (τSS)Business tax in %, average (τGSt)
199445.0 (30.0)015.94
199545.0 (30.0)7.515.95
199645.0 (30.0)7.516.17
199745.0 (30.0)7.516.30
199845.0 (30.0)5.516.41
199940.0 (30.0)5.516.45
200040.0 (30.0)5.516.17

Table 9:

Records per firm.

Number of yearsNumber of firmsPercentage

Source: Number of firms with no missing values in the number of years indicated.

Tax rates on corporate income declined substantially during the period 1994–2007. Moreover, there was a major change in the tax law with the full imputation and split rate system being replaced in 2001 by the so-called half-income system (Tax Relief Act 2001). This implied the replacement of two corporate tax rates – one on retained earnings (τc,RE which varied between 45 % and 40 %) and one on distributed profits (τc,D, of 30%) – by a lower, uniform tax rate of τc=25%. [17]

6.2 Cost of capital and the firms’ capital and asset structures

6.2.1 Cost of capital and the firm’s capital structure

To account for the fact that firms not only use internal funds, but also external funds in the form of debt, we assume that each firm has a specific target value for the share of debt. This target value will presumably be based on incentive considerations, since debt payments constitute a business expense that shields revenues from taxes. Let us denote the target level with λ. Then, if deviating from this target value is costly, optimal investment finance will weight the tax-advantage from using more debt against the cost associated with distorting the capital structure (e. g., Huizinga et al. 2008). For simplicity, one might assume that the cost of deviating from the optimal mix of financing with debt and retained earnings is very high. With this assumption, an investment project will be financed usually with a ratio of debt to capital that is consistent with each firm’s target level λ. If the cost of deviating from the preferred capital structure is less than prohibitive, the actual share of debt used to finance the investment is determined by a function Λλ,Θ that is increasing in the firm’s preferred debt-to-capital ratio λ as well as in the cost advantage of using debt, denoted with Θ (derived below). Obviously, this function will be time-varying since each firm’s target level and cost advantage of debt will change over time.

Then, with a share Λ of investment being financed with debt and only a share 1Λ being financed with retained earnings, the cost of capital will differ from the base case analyzed before. Following Devereux (2004), the derivation of the cost of capital with debt finance is the same, except that we consider an increase in revenues during the investment period and a respective decline in the subsequent period as debt is being repaid. Thus, with a share of debt finance Λ, we need to take account of an increase in revenues equal to Λ1τφ, with 1τφ being the effective price of a unit of investment. In the second period, debt obligations are served and repaid. Hence, profits are reduced by 1+1τr1τφΛ. Taking these additional effects into account, we can thus specify the cost of capital cocΛ for a given share of debt finance as


where Θ is the difference between the cost of capital using retained earnings and debt finance. This term simply captures the reduction in the cost of capital which arises from the deductibility of interest payments.

6.2.2 Cost of capital and the firm’s asset structure

To further determine the cost of capital for a specific firm, we calculate tax-depreciation allowances for each firm by considering firms’ asset structures. [18] Taking two types of assets into account, namely industrial buildings (IB) and plant/machinery (M) as part of a firm’s fixed assets, we construct weights Ω for each firm, with ΩIB=IBIB+M, ΩM=MIB+M and ΩIB+ΩM=1 (for simplification, the time indices are neglected here). According to these asset shares we calculate firm-specific depreciation rates δ, firm-specific rates of capital allowances ψ and net present values of allowances, A. Specifically, the firm-specific depreciation and capital allowance rates, as well as the net present values of allowances, are calculated according to δ=δIBΩIB+δMΩM, ψ=ψIBΩIB+ψMΩM and A=AIBΩIB+AMΩM.


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Received: 2015-3-6
Revised: 2016-2-13
Accepted: 2016-4-27
Published Online: 2016-8-27
Published in Print: 2016-10-1

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