Tax competition — Greenfield investment versus mergers and acquisitions

Regional Science and Urban Economics 41 (2011) 476–486

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Regional Science and Urban Economics j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / r e g e c

Tax competition — Greenfield investment versus mergers and acquisitions Johannes Becker a,⁎, Clemens Fuest b a b

Institute of Public Economics I, University of Münster, Wilmergasse 6-8, 48143 Münster, Germany Oxford University Centre for Business Taxation, Saïd Business School, Park End Street, Oxford OX1 1HP, United Kingdom

a r t i c l e

i n f o

Article history: Received 9 June 2010 Received in revised form 8 March 2011 Accepted 10 March 2011 Available online 22 March 2011 JEL classifications: H25 F23

a b s t r a c t In this paper, we analyse tax competition in a model where investor firms have the choice between two types of investment, greenfield investment and mergers and acquisitions. We show that the coexistence of these two types of investment intensifies tax competition in comparison to the case where there is only greenfield investment. If a specific tax on acquisitions is available, this result changes. Then, tax competition is mitigated compared to the pure greenfield case. The existence of an acquisition tax may even lead to corporate overtaxation. © 2011 Elsevier B.V. All rights reserved.

Keywords: Corporate taxation Mergers and acquisitions Tax competition

1. Introduction The increasing mobility of capital across borders challenges national governments' ability to tax investment income. An increase in domestic taxes leads to an outflow of capital into other jurisdictions where it increases production and, thus, tax revenue. This positive fiscal externality implies that tax competition is likely to yield inefficiently low levels of public goods provision. A large theoretical and empirical literature, starting with Zodrow and Mieszkowski (1986) and Wilson (1986), has emerged which has significantly improved our understanding of this issue. An important characteristic of this literature is that it focuses almost entirely on greenfield investment. Building a new plant, however, is not the only way to realize an investment project. As an alternative, the investor may purchase an existing firm. Empirically, mergers and acquisitions (M&A) play an important role. Fig. 1 displays the total volume of all M&A transactions worldwide and in Europe (left ordinate) over time. Mergers and acquisitions come in waves with a peak of more than three trillion U.S. dollars in 2000 and falling to only one trillion in 2002. The ordinate on the right depicts the fraction of national M&A, i.e. transactions where acquirer and vendor are within the same borders, and the sum of national and intraregional M&A. In contrast to the high volatility in volumes, these fractions stay virtually constant over time.

⁎ Corresponding author. E-mail addresses: [email protected] (J. Becker), [email protected] (C. Fuest). 0166-0462/$ – see front matter © 2011 Elsevier B.V. All rights reserved. doi:10.1016/j.regsciurbeco.2011.03.005

What is the difference between greenfield investment and M&A? Greenfield projects “entail developing organizational structures, building factories and distribution systems, and hiring workers de novo”, (p. 23 in Estrin et al., 1997). In other words, the investor adds new resources to the country's stock of production facilities. Accordingly, in standard models of tax competition, investment is modelled as a redistribution of net savings across countries.1 However, as recently pointed out by Desai and Hines (2004), M&A do not imply a relocation of corporate capital but rather a change in ownership and control rights. After an M&A transaction, “[t]he new affiliate starts as a going concern, that normally possesses production facilities, sales force, and market share. The foreign investor attains control over these local assets, though they may not be structured to match the strategic needs of the investor, and the integration of the acquired firm may require considerable effort” (p. 2 in Meyer and Estrin, 1999). As will be discussed later on in this section, firms considering a new investment project often have the choice between an acquisition of an existing firm or a greenfield investment. The above quote already gives an idea of the trade-off behind this choice. The advantage of greenfield investment is that all production facilities are built up from scratch and, thus, perfectly suit the investor's needs. This has to be weighed against the advantage of an acquisition, which is that the investor may benefit from already existing and well-functioning organizational structures, specific assets of the target firm, client networks, distribution systems etc. 1 Standard references are Musgrave (1969), Feldstein and Hartman (1979), Wilson (1986), Zodrow and Mieszkowski (1986), Bond and Samuelson (1989), Bucovetsky and Wilson (1991).

J. Becker, C. Fuest / Regional Science and Urban Economics 41 (2011) 476–486

477

Fig. 1. M&A volume worldwide (data source: Thompson Financial).

It is the purpose of this paper to analyse the implications of this choice for the welfare effects of tax competition. We develop a simple theoretical framework which allows to explore how the coexistence of M&A and greenfield investment affects corporate tax competition. We assume that investor firms considering a new project firstly screen the market for existing firms which are suitable as acquisition targets. If they do not find an adequate existing firm, they build a new plant (greenfield investment). We thus consider a setting where greenfield and M&A investments are substitutes. In such a framework, taxes may distort both the decision on the overall number of projects and the choice to realize these projects as greenfield investments or on the basis of acquisitions. How would we expect mergers and acquisitions to affect tax competition? Intuitively, one could argue that acquisitions are less tax sensitive than greenfield investment because taxes are likely to be capitalized in the purchase price of immobile assets.2 This might suggest that the existence of M&A investment mitigates tax competition. However, our results do not confirm this presumption. To the contrary, in the baseline version of our model, we show that tax competition is intensified. The reason is that, due to the existence of M&A investment, greenfield investment becomes more tax sensitive. If a country increases its taxes, it does not only lose marginal greenfield investment projects, but intramarginal greenfield projects are replaced by acquisitions of existing firms. This reduces the number of ‘new’ projects in the country and, as a consequence, total tax revenue. Put differently, the introduction of M&A into the standard tax competition model generates a second fiscal externality which points in the same direction as the one known from the standard model. An interesting implication of this result is that high-tax countries are predicted to have more M&A projects than low-tax countries. But this is not to their advantage because, at the margin, greenfield projects generate more tax revenue than M&A projects. Things are different, however, if one takes into account that tax policy may discriminate between M&A and greenfield projects by levying a specific tax on acquisitions. In this case, corporate tax competition is mitigated. The reason is that investors which respond to a corporate tax rate increase by switching from greenfield investment to an acquisition now pay an extra tax – the tax on acquisitions. This tax compensates the government for the revenue lost due to the decline in greenfield investment. We demonstrate that there may even be equilibria where corporate taxes become too high 2 See the literature on property taxes and capital prices, e.g. Mieszkowski (1972) or Hamilton (1976) for a related argument.

in the sense that a coordinated increase of corporate tax rates reduces welfare. Furthermore, there is a potential for welfare enhancing coordination of the tax treatment of acquisitions. This also sheds light on attempts by the European Union to coordinate the tax treatment of cross-border M&A, although our argument applies to purely domestic M&A as well.3 To the best of our knowledge, this is the first paper to analyse tax competition in a framework where investors may choose between greenfield investment and M&A. The choice between these two entry modes itself, though, has recently received much attention in economic research.4 Given that this choice plays a key role in our model, it is useful to take a closer look at this literature. There is a number of theoretical papers which model the firm's choice between entering a market by greenfield investment or via an acquisition. Görg (2000) builds a model in which foreign entry of multinational firms is costly and changes the market structure of the host country. Depending on cost parameter constellations and competition characteristics, greenfield investment or M&A becomes the preferred mode of entry. Eicher and Kang (2005) add tariffs and transport costs and show that the optimal entry mode depends on the combination of country size and transport cost (see also Horn and Persson, 2001, and Norbäck and Persson, 2007). Müller (2007) endogenizes acquisition prices and equilibrium profits and shows that the degree of competition has a non-monotonic impact on the preferred mode of entry. Nocke and Yeaple (2007) introduce firm heterogeneity in the firms' endowment of mobile and immobile intangible goods. The authors show that, depending on the mobility degree of intangible goods, more profitable or less profitable firms have a higher propensity to enter a market via an acquisition. All these papers have in common that they search for firm specific or non-tax location specific characteristics in order to explain why firms opt for this or that mode of market entry. In contrast, our paper willingly abstracts from all these aspects in order to isolate the tax-related determinants of entry mode choice. None of these theoretical contributions provides empirical evidence to support the predictions made. An exception is the study by Nocke and Yeaple (2008), which theoretically models and

3 EC level coordination is mainly concerned about discrimination of border crossing relative to national transactions whereas our argument for coordination also applies to purely national transactions. 4 In contrast, other approaches analyse the decision margin between exports and greenfield on the one hand, see e.g. Helpman et al. (2004), and exports and M&A on the other hand, see Neary (2007).

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empirically measures the firms' decision between both types of entry. The authors use a sample of U.S. parent companies with affiliates abroad and find that the more efficient a firm and the less developed and the nearer the host country, the more probable is an entry via greenfield investment. They do not take taxes into account, though. Apart from the contribution by Nocke and Yeaple (2008), there is a number of purely empirical papers studying the choice between greenfield investment and M&A. Hennart and Park (1993) exploit a sample of Japanese investors in the United States. Greenfield is found to be the superior mode of entry if the competitive advantage is strong, if the industry growth rate is neither exceptionally high nor low and if the investment takes place in an industry different from that of the parent company.5 Floyd (2003) uses a sample of foreign investors in Poland to examine differences between cross-border acquisitions and greenfield investment with respect to employment, sales and business risk. Basile (2004) analyses a sample of foreign manufacturers with investment projects in Italian regions and shows that location determinants differ between the types of investment. He states that “the acquisition activity is lowest in regions having less manufacturing plants (the Mezzogiorno), as scarcity of procurable assets in a region limits the supply of acquisition candidates” (p. 7). These empirical studies lend support to the way we model the choice between greenfield and M&A: Firms frequently do seem to consider acquisitions and greenfield projects as alternative ways of realizing a project. Whether or not a target firm is considered as suitable depends on the cost of restructuring the existing firm in order to suit the investor's needs.6 This view finds support in case studies reported in Estrin et al. (1997). The authors document the case of the UK chemical company British Vita plc which sets out to invest in Poland in 1991. It was decided to enter the market via greenfield investment because no suitable firm was found to acquire.7 The study quotes Keith Bradshaw, divisional director for Eastern Europe, explaining why the board decided against an acquisition of a Polish firm: “in general, we found the companies were overmanned and the equipment old” (p. 171). In another case study, Estrin et al. (1997) tell about Pyramid Junger, a small German firm investing in the Czech Republic. “[T]here would have been the possibility to acquire or establish a joint venture with an existing firm. Pyramid chose in preference to establish a greenfield operation. This enabled a small-scale operation to be established without any pre-existing commitments” (p. 97). Summarizing the cases reported in Estrin et al. (1997), the authors state that there is no obvious relationship between motivation for investment and entry mode. However, the greenfield projects turned out to be more successful than acquisitions because investors underestimated the cost of restructuring the acquired firms. “The cases also suggest that the reason why Western firms chose to acquire rather than develop a greenfield site is to acquire existing brand names and, possibly, associated customer and distribution networks” (p. 218). Apart from this, the present paper is related to two strands of literature. Firstly, there is a large number of contributions dealing with capital mobility and tax competition, see footnote 1 and, for a recent survey, Fuest et al. (2005).8 As noted above, these contributions assume that investment takes the form of greenfield investment. A broad and still growing empirical literature on the impact of taxes on investment and capital flows is surveyed by Hines (1999) and Devereux (2007). The second strand of literature deals with the impact of taxes on M&A and is much smaller. In an early contribution, Devereux (1990) points out that 5

See also Ó Huallacháin and Reid (1997) who use similar data. As will become clearer below, our model takes into account this particular aspect of acquisitions by assuming that existing firms differ in their suitability as acquisition targets. 7 The study says: “The choice between acquisition and greenfield site was difficult. The company had been expanding steadily through acquisition for more than thirty years; its last greenfield site had been in Africa (…)”, see Estrin et al. (1997, p. 170). 8 See also Razin and Sadka (1994) who review the literature on tax competition in dynamic macroeconomics models. 6

tax distortions to ownership may be important if capital productivity depends on ownership. Gordon and Bovenberg (1996) as well as Fuest and Huber (2004) analyse tax policy strategies in models where firms may be sold to foreign investors. But they do not consider tax competition or tax coordination. Desai and Hines (2004) argue that U.S. taxation of foreign source income is likely to distort ownership patterns and to put U. S. firms at a disadvantage when competing for foreign acquisitions. They propose to exempt foreign source income from domestic taxation. In Becker and Fuest (2010), we analyse this argument and show that exemption is an appropriate policy choice when ownership advantage is a public good within the firm, but is dominated in welfare terms by a cross-border cash flow tax system. Haufler and Schulte (2007) consider tax incentives in a model where M&A can take place within and across borders. They show that ownership patterns are highly important for the welfare implications of tax policy choices. From an empirical point of view, a number of contributions use the U.S. tax reform in 1986 to explore the tax effects on M&A activity, see e.g. Auerbach and Slemrod (1997).9 Swenson (1994) explores the idea that effective tax increases in the U.S. may induce investors located in countries with foreign tax credit regimes to take over U.S. firms because the higher U.S. taxes may be credited against home country taxes, and finds robust evidence supporting the hypothesis. In a recent paper, Huizinga and Voget (2009) study the empirical impact of international taxation schemes on M&A activity. Among other things, they find that investors from tax credit countries are less likely to take over foreign firms than investors from countries where foreign profits are exempt from domestic taxation. The remainder of the paper is set up as follows. In Section 2, we present the model and the main results. In Section 3, we consider some extensions. Section 4 discusses some policy implications and concludes. 2. The model In this section, we describe the setup of the model and derive a benchmark result which is based on greenfield investment. Then, we introduce the opportunity for investor firms to acquire existing firms. 2.1. The setup The world consists of n identical open economies. Each country is populated by a large number of identical households which is normalized to unity. The representative household lives for two periods. The utility function of the representative domestic household of country i is given by Ui(C1, C2, G) = u(C1) + C2 + h(G),10 where C1 and C2 are consumption levels in the first and the second period and G is a public consumption good provided by the government in period 2. For notational convenience, we omit the country index unless misunderstandings may arise. The functions u(C1) and h(G) are strictly concave, with u ′ N 0, u ″ b 0 and h ′ N 0, h ″ ≤ 0. In period 1, the household has an endowment of E units of a numeraire good. This numeraire good may be transformed into the private consumption good and the public consumption good on a one to one basis. Households may borrow or lend in the international capital market at the interest rate r. There are no residence based taxes on capital income. Households are also endowed with m existing, immobile firms. We refer to these firms as target firms, as opposed to investor firms which will be introduced below. Target firms do not consider new investment opportunities, but they may be sold to investor firms.11 9 See also Scholes and Wolfson (1990) and Collins et al. (1995). Empirical evidence on non-tax aspects of M&A activity is reported in Andrade et al. (2001). 10 We use this quasilinear utility function because it eliminates income effects on savings which would complicate the analysis without adding further insights. 11 One could argue that the number or the type of existing target firms may depend on the possibility to be acquired later and on the tax treatment of such an acquisition. In so far, assuming that there is an exogenous endowment with firms is restrictive. This issue arises with all types of endowments like e.g. human capital or mobile physical capital.

J. Becker, C. Fuest / Regional Science and Urban Economics 41 (2011) 476–486

If a target firm is not sold to an investor firm, it yields an after-tax profit π(1 − τ) in period 2, where τ is the corporate tax rate. Thus, under their initial owners, all target firms are assumed to yield the same profits. However, we assume that they differ in their suitability as acquisition targets. This will be explained in greater detail below. Next to the target firms, there is a large number of investor firms12 which are also owned by the domestic household.13 For notational convenience, we normalize their number to unity. Each investor firm considers an investment project in its country of residence. Investing in projects in other countries is ruled out for reasons clarified in Section 3.3. In period 1, it randomly draws a project specific pre-tax return denoted by Δ( j) which is generated in the second period. Δ(j) is assumed to be uniformly distributed over the interval [Δ−, Δ+]. To ease notation, we normalize density to unity. The distribution function is denoted by Ω(Δ). The cost of investment in period 1 cannot be deducted from the corporate tax base in period 2. In most real world tax systems, this corresponds to pure equity financing.14 Thus, the after-tax cash flow generated by project j in period 2 is given by Δ( j)(1− τ). The following analysis proceeds in two steps. First, we assume that all projects are greenfield investment projects. In a second step, we introduce the opportunity to acquire existing firms and thus allow for greenfield and M&A investment to coexist.

Assume that all projects are carried out as greenfield investments which means that, for Δ(j) to be realized, the investor has to build production facilities from scratch. This requires the investment of one unit of the numeraire good in period 1. Thus, the market value of a given project j is given by ð1Þ

The superscript g f denotes the pure greenfield case. All projects will be realized whose return exceeds a critical value Δc where Δc is the level of Δ(j) at which the market value V g f of the project is zero: c

Δ =

1+r 1−τ

ð2Þ

Δc is, thus, an indicator of investment activity in the economy. Not surprisingly, investment is decreasing in the interest rate and the corporate tax rate. In the first period, the household finances greenfield investment of the domestic investor firm. In addition, the household may borrow (S b 0) or lend (S N 0) in the international credit market. The household's budget constraint is gf

Δþ

C1 = E−S−∫ c dΔ Δ

ð3Þ

In the second period, the household receives income from savings, profit income from ongoing firms and profit income from the investor 12

firm. The budget constraint is given by Δþ

gf

C2 = Sð1 + rÞ + mπð1−τÞ + ∫ c Δð1−τÞdΔ Δ

ð4Þ

Optimal savings of the domestic households imply15 u′ ðC1 Þ = 1 + r

ð5Þ

The budget constraint of the government is   Δþ = τ mπ + ∫ c ΔdΔ

gf

G

Δ

ð6Þ

Consider next the determination of the interest rate in the international capital market. Capital market equilibrium implies n

i

∑ S =0

i=1

ð7Þ

Eqs. (5) and (7) determine S i, ∀ i = 1, …, n, and r, for given values of τ . Straightforward comparative static analysis yields that the interest rate decreases in response to an increase in the corporate tax rate of an individual country, denoted by superscript d: i

dc

2.2. Greenfield investment


 gf ð1 + r Þ V + 1 = Δð jÞð1−τÞ

479

In this paper, we deliberately do not account for the consequences of imperfect competition and the question of how greenfield or M&A investment affect market structures and trade patterns, mainly because we want to keep our approach as close as possible to standard models of tax competition (like Zodrow and Mieszkowski, 1986, and Wilson, 1986). Nevertheless, we will discuss this issue further in Section (3.4). 13 Thus, there is no cross-border investment in the strict sense. However, in the absence of repatriation taxes, the results derived in this model carry over to the case of cross-border investment (which is shown in an appendix made available to interested readers upon request), but get more complex due to the incentive to tax profits accruing to foreign owners, as will be discussed in Section 3. 14 It is straightforward to extend our model by allowing for a partial deductibility of the cost of capital. This adds notation but does not alter the results. The proof is available from the authors on request.

dr ∂Δ 1 b0 ð8Þ = ∂τd Γ dτd   1 where Γ = ∑ ui ″ 1C i − ð1−τ i Þ b 0. The reason is that corporate taxes ð 1Þ dc ceteris paribus reduce the number of investment projects, ∂Δ N 0 (see ∂τd Eq. (2)) and thus the demand for capital. This in turn reduces the interest rate.16 2.3. Tax competition and tax coordination with greenfield investment Under tax competition, the domestic government maximizes domestic welfare W = u(C1) + C2 + h(G) subject to the constraints in Eqs. (3)–(6) and takes the tax policy of the other countries as given. Both governments can commit to their tax rate choices.17 The first order condition18 for the optimal tax policy of the domestic country is ∂r given by dW = ∂W + ∂W = 0 and can be written as dτ ∂τ ∂r ∂τ   þ   Δ dW ∂Δc c ∂W ∂r = h′ −1 mπ + ∫ c ΔdΔ −h′ τˆ Δ + =0 Δ dτ ∂τ ∂r ∂τ

ð9Þ

where τˆ = arg maxτ W. The first term on the right hand side represents the welfare effect of redistributing funds from the private to the public sector (the term in square brackets is the tax base) which is positive if the marginal utility of the public good is larger than that of the private good, h′ N 1. The second term captures the investment distortion. Essentially investment is reduced which leads to a loss in tax revenue. Thirdly, the government accounts for changes in the interest rate where the welfare effect of interest rate changes is given by c ∂W c ∂Δ = S−h′ τˆΔ ∂r ∂r

ð10Þ

c

1 = 1−τ . An increase in the tax rate leads to a rise in savings with ∂Δ ∂r income (if S N 0) or to a rise in credit cost (if S b 0), see the first term on the right hand side. Furthermore, increasing interest rates reduce investment and, thus, tax revenue (see the second term). Accounting 15

We assume that the properties of the utility function ensure that C1 never exceeds

E. 16

dr Note that if n → ∞, then Γ → − ∞ and dτ i →0. See Kehoe (1989) for an analysis of tax competition when this assumption is relaxed. 18 It can be shown that the second-order derivative has a negative sign. 17

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J. Becker, C. Fuest / Regional Science and Urban Economics 41 (2011) 476–486

for interest rate changes becomes necessary if the country is big relative to the world capital market, i.e. if n is sufficiently small. Of course, the model also captures the case of n → ∞. The government faces a trade-off between raising tax revenue for public goods provision and distorting investment. In a symmetric equilibrium, with S = 0, an underprovision of public goods relative to a first best equilibrium occurs, i.e. h′ N 1.19 As pointed out by Bayindir–Upmann and Ziad (2005), existence and uniqueness of equilibrium is usually assumed in the tax competition literature. The main reason is that demonstrating existence and uniqueness of equilibria typically requires highly restrictive assumptions on functional forms used. In this paper, we have to assume that equilibria characterized by the first order conditions exist and we cannot rule out that other equilibria may exist as well. How does a simultaneous change in all corporate tax rates, departing from the equilibrium without coordination, affect global welfare? The change in welfare of an individual country d can be formulated as d

dW =

! n−1 ∂W d ∂W d ∂r + dτˆd + ∑ ∂τd ∂r ∂τd i=1

! ∂W d ∂W d ∂r + dτˆi ∂τi ∂r ∂τi

ð11Þ

+ The optimal tax policy under tax competition implies ∂W ∂τd = 0. Furthermore, a change in the tax rate of other countries d does not affect welfare in country d directly, ∂W = 0 ∀ i ≠ d, but it ∂τi affects the interest rate in the world capital market. Using Eqs. (8), (10) and the symmetry property of the equilibrium under tax competition, the overall welfare effect can be written as d

∂W d ∂r ∂r ∂τd

d

dW =

 d i ∂W n−1 ∂r τˆ  c 2 n−1 u″   dτˆ N 0 Δ dτˆi = h′ ∑ n ∂r i = 1 ∂τi 1−τˆ u″− 1−τˆ ð12Þ

A coordinated increase in corporate tax rates reduces the world market interest rate which increases investment and, thus, tax revenue in country d. We can therefore state. Proposition 1. A coordinated increase in all corporate tax rates, departing from the equilibrium under tax competition, increases welfare. This result is well known from the literature on tax competition with greenfield investment. The undertaxation result occurs because corporate tax cuts give rise to negative fiscal externalities on other countries.20 It serves as a benchmark for the analysis of tax competition in the presence of mergers and acquisitions in the following section. 2.4. Adding mergers and acquisitions We now allow firms to choose between acquisitions and greenfield investment as possible ways to realize their project. After drawing Δ(j), the firm either builds production facilities from scratch (greenfield investment) or acquires existing production facilities from another firm (M&A). If neither type of market entry is profitable, the investor firm will opt for not investing at all. An important implication of this setting is that the level of Δ( j) does not depend on the type of market entry.21 It may be helpful to think of Δ( j) as related ∂W ∂τ

19

The
first order condition for
the optimal =   tax rate can be written as c c ∂r Δþ ðh′ −1Þ mπ + ∫ c ΔdΔ −h′ τˆ ∂Δ Δc 1 + ∂Δ = 0. Using the expressions derived ∂τ Δ
∂r ∂τ þ 
 ″ c Δ above, this simplifies to ∂W = ðh′ −1Þ mπ + ∫ c ΔdΔ − 1− n½u″ −uð1−τÞ h′ τˆ ∂Δ Δc = ∂τ ∂τ Δ

0, so that h′ N 1. 20 The concept of fiscal externalities is explained in detail in Bucovetsky and Wilson (1991). 21 Nevertheless, target firms will be allowed to differ in their suitability for the projects. But this will be reflected in their acquisition price, as will be explained further below.

to an idea for a new product, a patent or some intangible asset which needs production facilities as a complementary factor.22 The cost of investment in these production facilities may differ according to the type of market entry, though. If a project is carried out as a greenfield investment, it requires the investment of one unit of the numeraire good in period 1. If the project is carried out on the basis of an acquisition, rather than a greenfield investment, the investor firm has to acquire an existing target firm in period 1. 2.4.1. Additional assumptions An acquisition is a substitute for a greenfield investment, but we assume that it is an imperfect substitute. Existing firms with ongoing production differ in their suitability as target firms. This means, investors have the choice between heterogeneous target firms as acquisition opportunities and an elastic supply of homogeneous capital goods in the world capital market as greenfield opportunities. Thus, in a stylised way, the model captures the choice described by the empirical studies cited in the introductory section. Investor firms screen the market for suitable acquisition targets and compare the available firms to the option of making a greenfield investment. We model this as follows. If an investor firm decides to carry out a project on the basis of an acquisition of target firm g, rather than a greenfield investment, there is an output loss in period 2 denoted by k(g). An increasing k(g) means decreasing suitability as an acquisition object. The variable k(g) is assumed to be uniformly distributed over the interval [0, k+]. The density is assumed to be unity and the distribution function is denoted by Φ(k). The underlying idea is that greenfield investment allows the investor firm to set up its factory and choose a labour force exactly as it suits its interests whereas existing firms will not exactly match the investor's needs.23 What are the tax implications of an acquisition? We assume that the proceeds from selling a firm are untaxed and that the acquiring firm cannot write off the purchase price. This comes close to the usual tax treatment of a share deal, as opposed to an asset deal. We will discuss the robustness of our results with respect to this assumption in Section (3.2). In addition, there is a discriminatory tax on acquisitions which allows countries to tax greenfield investment and acquisitions investment differently. In real world tax systems, such a discrimination can be achieved by designing rules for the transfer of reserves and loss carryforwards, inter-company dividends, the depreciation of goodwill etc. We summarize this in a tax on acquisitions denoted by θ (per unit of acquisition).24 The acquisition prices are determined by demand for and supply of target firms. The demand for target firms is limited by the fact that the investor firm may always choose a greenfield investment. In other words, an investor firms acquires a target firm g only when the pay-off is higher than in case of a greenfield investment, i.e. if ðΔð jÞ−kðg ÞÞð1−τÞ−θ Δð jÞð1−τÞ −P ðkðg ÞÞ≥ −1 1+r 1+r

ð13Þ

where P(k(g)) is the acquisition price of firm g. If the above equation holds with equality, the investor firm is just indifferent between acquiring target firm g and choosing greenfield investment. Then, Pmax(k(g)) denotes the maximum price given by P

max

ðkðg ÞÞ = 1−

kðg Þð1−τÞ + θ 1+r

ð14Þ

22 One may note that, next to greenfield investment and acquisitions, many other contractual arrangements are used like e.g. joint ventures, franchising or licensing agreements. Our model is very stylised and abstracts from these types of contracts. 23 Of course, it may also occur that existing firms have unique assets which make them more suitable than a newly created firm. It would be straightforward to include this case by allowing for a negative k(g). 24 An alternative way of modelling a tax on acquisitions would be to levy an additional tax on corporate profits. However, since the tax base does not depend on the individual firm's decisions, such a tax would be largely equivalent.

J. Becker, C. Fuest / Regional Science and Urban Economics 41 (2011) 476–486

Δ ( j )(1− τ )

Note that Pmax(k(g)) does not depend on Δ( j). It decreases in k(g) and θ and increases in τ and r. Now, consider the supply of target firms. The initial owner of target firm g will sell the firm if the price is at least as high as the present value of the profit the firm will make if it is not sold.25 This requires P ðkðg ÞÞ−

πð1−τÞ ≥0 1+r

2.4.2. Equilibrium in the market for acquisitions Assume a sequential auction where the target firms are sold and the price is determined via competitive bidding among investors, starting with the most suitable target characterized by k = 0. Recall that each vendor has only one target firm and each investor can acquire at most one target firm. But in each auction, a large number of investors will bid. It follows from the preceding section (Eq. (14)) that each target firm faces a different willingness to pay by investors (as target firms differ in k), but investors all have the same reservation price for a target firm g with a given k(g). As a consequence, the acquisition price in the first auction is equal to Pmax(0), as lower prices would be outbid. Accordingly, the following target firms g are sold for a price of Pmax(k(g)).26 This continues until Pmax(kc) = Pmin where kc denotes the target firm which is just indifferent between selling and keeping the firm. Using the definitions of Pmax(kc) and Pmin, kc reads c

k =

1 + r−θ −π 1−τ

Δ ( j )(1− τ )

ð15Þ

If this equation holds with equality, the initial owner is indifferent Þ between keeping and selling the firm. Then, P min = π1ð1−τ + r denotes the minimum price the initial owner is willing to accept. Note that the minimum price neither depends on Δ( j) nor on k(g).

1+ r

Δ−

Δc Non-realized projects

25 The highest possible acquisition price is P(0) = 1 (if θ = 0). This implies that the original investment cost to create the target firm, net of output generated in previous periods, must have been lower than 1. 26 This implies that all surplus generated by the acquisition accrues to the seller of the firm which is due to the assumption that k(g) is target firm specific. This is in line with empirical studies, see e.g. Gugler et al. (2003), reporting that most surplus is captured by the seller. Note, however, that the surplus from the acquisition is not identical to the surplus from the entire investment project, including Δ(j). The reason is that the investor always has the option to realize his project on the basis of a greenfield investment. 27 An equilibrium where no greenfield investment occurs is also possible and will be briefly discussed in Section 3.1.

Overall number of projects

Δ+

Δ( j )

Greenfield projects

Acquisitions

P (k (g ))

1−

k (g )(1 − τ ) + θ 1+ r

π (1 − τ ) 1+ r

kc

ð16Þ

Thus, initial owners of all target firms characterized by a k(g) satisfying k(g) ≤ kc will sell their firms. Acquisitions will only occur if kc N 0 as k(g) ∈ [0, k+]. In the following, we will focus on equilibria where some acquisitions take place.27 Fig. 2 illustrates the model. The upper part depicts the decision on how many projects to realize, the lower part captures the decision on – given the overall number of projects – how many of them will be acquisitions and how many greenfield projects. Consider firstly the first margin. The overall number of projects is determined by + r Δc = 11−τ , see the upper part of Fig. 2. For a given r, neither the initial profit level π nor the acquisition tax θ will affect the total number of investment projects carried out in the country under consideration. Note, though, that changes in all these parameters may affect the equilibrium interest rate r. Once the overall number of projects is determined (see the bar in the middle of the figure), the question arises which fraction is realized as acquisitions. The second margin is defined by (16), see the lower part of Fig. 2. At the intersection of the acquisition price curve P(k g) and the reservation Þ c price π1ð1−τ + r the marginal acquisition takes place, characterized by k . The figure allows for some comparative statics. For instance, consider an increase in the corporate tax rate τ under the assumption that the interest rate r is given. In the upper part of the figure, the Δ( j)

481

k (g )

Fig. 2. Two decision margins.

(1 − τ)-curve shifts downwards which implies that the overall number of projects is reduced (Δc shifts to the right hand side). In the lower part of the figure, the acquisition price curve shifts upwards and the reservation price curve shifts downwards. Thus, the fraction of acquisitions is increased. Expressed differently, ∂kc 1 + r−θ N0 = ∂τ ð1−τÞ2

ð17Þ

This effect can be explained by reconsidering Eqs. (13) and (15). In both cases, greenfield investment and M&A, corporate taxes reduce the receipts of investment. In contrast to the greenfield case, though, where the capital cost is determined at the world market and therefore only indirectly affected by national tax policies, the marginal acquisition price is also reduced by corporate taxation. In other words, higher corporate taxes are capitalized in the purchase price for existing (immobile) firms. Thus, higher corporate taxes make acquisitions more attractive relative to greenfield investment.28 In comparison, the effects of an increase in the acquisition tax rate θ are much simpler. For a given interest rate r, only the acquisition price curve shifts downwards which implies that the fraction of acquisitions is reduced. An increase in the interest rate also leads to more acquisitions and less greenfield investment. The reason is that a higher interest rate means that new capital becomes more expensive. This increases the incentives to use ‘old’ capital. 28 In Swenson (1994), higher taxes also lead to more acquisitions, but for a different reason: Foreign investors from tax credit countries are shielded from higher taxes through tax credits in their country of residence, so that a tax increase in the host country gives them a comparative ownership advantage (or reduces their comparative disadvantage) relative to owners residing in the host country.

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J. Becker, C. Fuest / Regional Science and Urban Economics 41 (2011) 476–486

acquisition taxes and the output losses due to k. The public sector budget constraint now becomes

2.5. Investment behaviour The value of the firm is now given by (1 + r)(V g f + 1) = Δ(j)(1 − τ) in the case of greenfield investment, see Eq. (1), and  ma  ð1 + r Þ V + P ðkðg ÞÞ = ðΔð jÞ−kðgÞÞð1−τÞ−θ

ð19Þ

Thus, whether the firm chooses greenfield investment or M&A, the cut-off level Δc is given by c

Δ =

1+r 1−τ

  kc Δþ kc m−∫ dk π + ∫ c ΔdΔ + ∫ ðθ−τkÞdk Δ

0

ð23Þ

0

ð18Þ

in the case of M&A. For an acquisition, the firm has to pay the acquisition price P(k(g)). In period 2, the cash flow is reduced by the tax on acquisitions θ and the after-tax output loss (1 − τ)k(g). Using the equilibrium acquisition price of target firm g, P ðkðg ÞÞ = 1 + r−kðg Þð1−τÞ−θ , the firm value equation boils down to 1 + r  ma  ð1 + r Þ V + 1 = Δð jÞð1−τÞ

G=τ

ð20Þ

Thus, the marginal project is a greenfield project in the sense that the overall number of investment projects realized in the country under consideration is determined by the cost of greenfield investment. The mix between greenfield projects and acquisitions depends on the availability of suitable target firms. More formally, the number of acquisitions is determined by Eq. (16). The remaining projects are realized as greenfield investments.

Each additional acquisition increases tax revenue by the acquisition tax θ and reduces it through the output loss k and by decreasing the number of ongoing firms, so that tax revenue declines through the latter two channels by τ(π + kc), at the margin. 2.7. Capital market equilibrium Given the functions k ci = k ci (r, τi, θi) and Δci = Δci (r, τi), i = 1…n, implied by Eqs. (16) and (20), capital market equilibrium is determined by the first order conditions for optimal savings ui′ = 1 + r, i = 1…n , and the credit market equilibrium condition ∑ i S i = 0. These n + 1 equations determine optimal savings Si, i = 1…n, and the interest rate r, for given values of the tax instruments τi and θi, i = 1…n. Thus, the interest rate in the international capital market can be expressed as a function r = r(τ1 … τn, θ1 … θn). Standard comparative static analysis yields ∂r = ∂τi

 c ∂ki ∂Δci 1 b0 + ∂τi ∂τi Γ c

∂r ∂k 1 N0 = ∂θi Γ ∂θi where Γ = ∑ni = 1

2.6. Budget constraints

ð24Þ

ð25Þ


1 2 − ð1−τ Þi ui″



b 0. Eq. (24) shows that, as expected,

an increase in the tax rate τi reduces the interest rate. The reason is c

Consider next the budget constraints of the representative household and the government. The budget constraint of the domestic household in period 1 can be written as  þ c Δ k C1 = E−S− ∫ c dΔ−∫ dk Δ

0

ð21Þ

Period 1 consumption is the difference between the endowment and capital market investment S and greenfield investment (term in round brackets). Expenditures for acquisitions are not net expenditures as they are compensated by income of the same size (domestic investors buy from domestic sellers). Compared to the pure greenfield case, the household can reduce the expenditure for investment in period 1 by using ‘old’ rather than ‘new’ capital, i.e. by increasing the number of acquisitions.29 The second period budget constraint is given by C2 = Sð1 + rÞ +

 kc m−∫ dk πð1−τÞ 0

Δþ

kc

Δ

0

ð22Þ

+ ∫ c Δð1−τÞdΔ−∫ ðθ + ð1−τÞkÞdk Here, the existence of acquisitions affects consumption opportunities as follows. The second term on the right hand side of Eq. (22) reflects that the household's income from ongoing firms is now smaller because some of them have been acquired by the investor firm. The third and the fourth term represent the profits from new investment (based either on acquisitions or greenfield projects) net of

29

One should note that, by considering a representative household model and by excluding taxation at the shareholder level, we abstract from a number of tax obstacles like e.g. lock in effects that may arise when the initial owners consider whether or not to sell their firms and reinvest their capital.

i N 0, and that corporate taxes increase the number of acquisitions, ∂k ∂τ

reduce the overall number of projects,

∂Δci ∂τi

i

N 0. Both effects reduce the

demand of capital which then reduces the interest rate. An increase in θi, in contrast, increases the interest rate because it reduces the number of acquisitions while the overall number of projects carried out in country i remains constant. As a result, capital demand for greenfield investment in country i increases, and this drives up the interest rate.30 2.8. Tax competition Again, we assume that countries set their tax policy to maximize the welfare of the representative domestic household and take the tax policy of the other countries as given. In the presence of acquisitions, the first order condition31 for the optimal corporate tax rate is given ∂r by dW = ∂W + ∂W = 0 or dτ ∂τ ∂r ∂τ h
 i dW kc Δþ = ðh′−1Þ mπ−∫ − ðπ + kÞdk + ∫ c ΔdΔ k Δ dτ 
c  ∂kc  ∂W ∂r c ∂Δ c + τˆΔ + =0 −h′ τˆ π + k −θˆ ∂τ ∂τ ∂r ∂τ

ð26Þ

where τˆ = arg maxτ W and θˆ = arg maxθ W, as defined below. How does the coexistence of greenfield investment and acquisitions affect the optimal tax policy? An increase in the corporate tax raises revenue, as reflected by the first term on the right hand side of Eq. (26), and changes the corporate tax base, as the second term indicates. In contrast to the case of pure greenfield investment, there is a second margin which affects the tax base. An increase in the 30 Note that our model also comprises the special case of a single closed economy (n = 1). 31 Again, it can be shown that - under plausible assumptions - the second order derivative has a negative sign. The same is true for the first order condition with respect to θ.

J. Becker, C. Fuest / Regional Science and Urban Economics 41 (2011) 476–486

corporate tax induces firms to replace greenfield investment by acquisitions.
For a given interest rate, the effect on tax revenue is c equal to − τˆðπ + kc Þ−θˆ ∂k . Finally, tax policy affects the interest ∂τ ∂r rate itself. This is captured by the term ∂W with ∂r ∂τ 
c  ∂kc  ∂W c c ∂Δ + τˆΔ = S−h′ τˆ π + k −θˆ ∂r ∂r ∂r

ð27Þ ˆ

ˆ + r Þ−θ = S−h′ 2τð11−τ . As in the greenfield which can be simplified to ∂W ∂r ð ˆÞ2 model, accounting for interest rate changes in response to variations in τ is only necessary if the country is big relative to the world market, i.e. if n is sufficiently small. What is the difference between this expression and the one from the pure greenfield case? Next to the effect on interest income (reflected by S), a rise in r lowers the total number of projects realized in the domestic country. This is reflected by an increase in the cutoff level Δc. In addition, the number of acquisitions increases (kc rises), which affects tax revenue as discussed above. How are taxes on acquisitions set in a tax competition equilibrium? The first order condition for the optimal tax on acquisitions is ∂r given by dW = ∂W + ∂W = 0 or dθ ∂θ ∂r ∂θ


 ∂kc  dW ∂W ∂r k c = ðh′−1Þ∫ dk−h′ τˆ π + k −θˆ + =0 0 dθ ∂θ ∂r ∂θ c

ð28Þ

The optimal acquisition tax reflects the tradeoff between the desire to raise revenue (the first term on the right hand side of Eq. (28)) and the costs of distorting acquisitions and of driving up the interest rate (the second and the third term, respectively).32 r−θˆ Using Eq. (27) and kc = 1 + 1−τ −π, Eq. (28) can be rewritten as 
   kc dW  h′ ∂r ∂r ˆ−τˆð1 +rÞ 1− ˆ = h′ −1 ∫ dk− θ + τ ð 1 +r Þ = 0: 0 dθ ∂θ ∂θ ð1−τÞ2

ð29Þ The optimal level of θ is given by: 0 1 ∂r   B1−2 ∂θC 1−τˆ 2 h′ −1 kc C θˆ =  ∫ dk + τˆð1 + rÞB @ 0 h′ ∂r ∂r A 1− 1− ∂θ ∂θ 

ð30Þ

dr Since dθ b0; 5 for all n and u″, the right hand side of Eq. (30) is unambiguously positive. It thus turns out that the acquisition tax which emerges under tax competition is positive. However, it is ambiguous whether or not the tax system as a whole discriminates acquisitions relative to greenfield investment (as mentioned above, neutrality requires θˆ = τˆð1 + r Þ). If the number of countries n is large, ∂r though, which implies that ∂θ converges to zero, Eq. (30) shows that ˆθ N τˆð1 + r Þ. Why do small countries levy higher taxes on acquisitions? A large country would take into account that taxing acquisitions will drive up the interest rate because some intramarginal investors are induced to switch from acquisitions to greenfield investment. The higher interest rate implies that some marginal greenfield projects are cancelled, which gives rise to a tax revenue loss. Small countries neglect the impact of the acquisition tax on the interest rate. We summarize these results in

483

policy yields a level of θ which distorts the choice of market entry in favour of greenfield investment. 2.9. Tax coordination Is there scope for welfare enhancing tax coordination? Consider first a coordinated change in τ, departing from the equilibrium under tax competition and holding constant the acquisition tax θ. The effect on the welfare of an individual country d is given by d

dW =

! d d n−1 ∂W ∂W ∂r + dτˆd + ∑ ∂τd ∂r ∂τd i=1

Given that

∂W d ∂τd

∂W d ∂r ∂r ∂τd d using ∂W ∂τi

+

! d d ∂W ∂W ∂r + dτˆi ∂τi ∂r ∂τi

ð31Þ

= 0 holds in the equilibrium under tax

competition, and = 0 ∀ i and the symmetry property Si = 0 ∀ i, the welfare effect can be expressed as d

dW =

∂W d n−1 ∂r dτˆ ∑ ∂r i = 1 ∂τi i

ð32Þ

∂r b0 ∀ i, see Eq. (24), the sign of dWd depends on the sign of With ∂τ i as given in Eq. (27). As foreign tax rate increases reduce the world market interest rate, two types of externalities arise. Firstly, lower c interest rates increase the overall number of projects (∂Δ N 0, see ∂r Eq. (27)). This may be referred to as the standard externality. Secondly, lower interest rates reduce the number of acquisitions, as ∂kc N 0, which may increase or decrease tax revenue, depending on ∂r whether τ(π + kc) − θ is positive or negative. Thus, corporate tax rate changes have an externality on the other country's welfare by affecting the choice of market entry. If θ = 0, Eq. (16) implies that tax revenue increases as acquisitions are replaced by greenfield investment. In this case, a positive fiscal externality of corporate tax rate increases arises, which reinforces the standard externality. This implies that the possibility of replacing greenfield investment by acquisitions (and vice versa) unambiguously intensifies tax competition if there is no acquisition tax. In contrast, if there is such a tax, the situation is different because the sign of the fiscal externality caused by the existence of acquisitions becomes ambiguous. Eq. (32) can be written as ∂W d , ∂r




 θˆ−2τˆð1 + r Þ n−1 ∂r dW = h′ ∑ dτˆi ð1−τÞ2 i = 1 ∂τi d

ð33Þ

Thus, it depends on the sign of θˆ−2τˆð1 + r Þ whether corporate tax rate changes have positive or negative externalities in sum. We summarize this in Proposition 3

Proposition 2. Optimal tax policy in the absence of coordination implies that countries levy a positive corporate tax rate τ and a positive tax on acquisitions θ. If the number of countries (n) is large, the optimal tax

i) In the absence of a tax on acquisitions, θ = 0, the possibility of replacing acquisitions by greenfield investment gives rise to a negative fiscal externality of corporate tax cuts, due to the effect on entry mode. Tax competition is intensified, compared to the pure greenfield case. A coordinated increase of the corporate tax rate, departing from the uncoordinated equilibrium, increases welfare. ii) In the presence of an acquisition tax, a coordinated increase of corporate tax rates, departing from the equilibrium without coordination, is welfare enhancing if θˆ b 2τˆ ð1 + r Þ and reduces welfare if θˆ N 2τˆð1 + r Þ. If θˆ = 2τˆ ð1 + rÞ, the different fiscal externalities compensate each other and a coordinated corporate tax rate change does not affect welfare.

32 These considerations would also apply to a one country/closed economy framework (n = 1). In this case, tax policy faces a trade-off between, on the one hand, distorting savings through the corporate income tax and, on the other hand distorting the decision to use old or new capital for the realization of investment projects.

Proposition 3.ii) implies that the question of whether corporate tax rates are too high or too low under tax competition depends on the level of the acquisition tax. As pointed out in the preceding section, θˆ is unambiguously positive in the tax competition

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J. Becker, C. Fuest / Regional Science and Urban Economics 41 (2011) 476–486

equilibrium, but whether it exceeds 2τˆð1 + r Þ is, in general, ambiguous. Given that the standard model with only greenfield investment unambiguously leads to undertaxation, the question arises whether a negative welfare effect of a coordinated corporate income tax increase is possible. The appendix provides an example showing that parameter ranges exist where θˆ− 2τˆð1 + r Þ N 0 holds in the equilibrium under tax competition. We may thus state:

3.1. The model in the absence of greenfield investment

Proposition 4. The opportunity to levy a tax on acquisitions mitigates tax competition. In the presence of an acquisition tax, a coordinated increase in corporate tax rates may reduce welfare.

Þ P ðkðg ÞÞ = 0. Initial owners are still ready to sell if P ðkðgÞÞ≥ π1ð1−τ + r , as c in (15). The cut-off level k which determines the equilibrium number of acquisitions is thus given by:

The result in Proposition 4 shows that taking into account the existence of M&A investment in the analysis of tax competition is important because one of the benchmark results in the theory of corporate tax competition – the finding that tax competition leads to an undertaxation of corporate profits, is called into question. The economic explanation for this result is the following. A tax cut in country i drives up the interest rate r. This will reduce the level of greenfield investment in all other countries. Since the taxes on the marginal greenfield investment are positive, tax revenue and, hence, welfare in these countries declines. But at the same time, the higher interest rate leads to an increase in the number of acquisitions. If the tax on acquisitions is sufficiently high, this has a positive impact on overall tax revenue. The second fiscal externality may dominate the first, so that the sum of the fiscal externalities of corporate tax cuts may in fact be positive in our model. Is there scope for welfare enhancing tax coordination of acquisition taxes? The welfare effect of a coordinated tax change, departing from the equilibrium under tax competition and holding constant the corporate tax τ, is given by

d

dW =

∂W n−1 ∂r dθˆ ∑ ∂r i = 1 ∂θi i

ð34Þ

Using Eqs. (27) and (25), this can be expressed as:


 ! ˆ−2τˆð1 + r Þ  θ n−1 u″ d ′   dθˆ dW = h   n 2u″− 1−τˆ 1−τˆ 2

ð35Þ

We may therefore state Proposition 5. Departing from the equilibrium under tax competition, a coordinated reduction in the tax on acquisitions increases (reduces) welfare if θˆ b 2τˆð1 + r Þ (θˆ N 2τˆð1 + r Þ). The welfare effects of tax coordination of both τ and θ depend on whether θˆ is larger or smaller than 2τˆð1 + r Þ. This is not surprising because in our model fiscal externalities are transmitted through the interest rate in the international capital market. If θˆ b2τˆð1 + r Þ, tax changes which drive up the interest rate give rise to negative fiscal externalities and vice versa. 3. Extensions In this section, we consider three extensions of our model. In Section 3.1, we briefly consider our model assuming that there is no greenfield investment. Section 3.2 shows that our results also hold under different assumptions on the tax treatment of acquisitions. Section 3.3 discusses the implications of cross-border acquisitions. In Section 3.4, we provide a brief discussion of imperfect competition in output markets and its importance for the analysis of mergers and acquisitions in this paper.

A crucial assumption in our model is that firms decide between two modes of entry: greenfield investment and M&A. How do the model results change if the project returns Δ can only be realized on the basis of an acquisition? In the absence of greenfield investment, investors will acquire firms until the surplus of the marginal ÞÞð1−τÞ−θ transaction equals zero, i.e. Eq. (13) becomes ðΔðjÞ−k1ðg+ − r

c

k = Δ−π−

θ 1−τ

ð36Þ

Thus, in the absence of a tax on acquisitions, corporate taxes do not affect investment. This result is in line with the intuition presented in the introductory section that M&A might mitigate tax competition. The reason is that corporate taxes affect both the purchase price (equal to the present value of the initial owner's after-tax profits) and the receipts after acquisition. At the margin, these two are equal and are equally reduced by corporate taxation. This finding is also in line with the results of the literature on the capitalization of taxes in land prices (see Mieszkowski, 1972, or Hamilton, 1976). It is straightforward to show that, in the uncoordinated equilibrium, the specific tax on acquisitions θ is equal to zero, that public goods provision is efficient (h′ = 1) and coordination yields no welfare gains. 3.2. Taxation of capital gains and deductibility of acquisition expenditures An important but certainly restrictive assumption we have made is that the revenue from selling the firm, which accrues to the initial owners, is not subject to tax, and the investor firm cannot deduct the purchase price. The tax consequences of acquisitions are important because they are relevant for a key effect in our model: the finding that a higher corporate income tax induces firms to replace greenfield investment by acquisitions. The question is how robust this result is. An alternative approach would be to assume that the vendor has to pay tax on the revenue from selling the firm while the acquiring firm may deduct the purchase price. This would be a simple way of modelling the usual tax treatment of an asset deal, as opposed to a share deal. In this case, the investor firm will be indifferent between acquiring any firm g and making a greenfield investment if ðΔðjÞ−kðg ÞÞð1−τÞ−θ Δð jÞð1−τÞ −P ðkðg ÞÞð1−τÞ = −1: 1+r 1+r

ð37Þ

The initial owners will sell their firm if P ðkðg ÞÞð1−τÞ−

πð1−τÞ ≥0 1+r

ð38Þ

This implies that all target firms characterized by a level of k satisfying k ≤ kc will sell their firms, where kc is given by c

k =

1 + r−θ −π 1−τ

ð39Þ

which is identical to the expression in Eq. (16). The reason is that, compared to the baseline version of our model, the tax disadvantage of the vendor is exactly equivalent to the tax advantage of the buyer. It is straightforward to show that our results are robust with respect to different ways of treating acquisitions for tax purposes, provided that the vendor and the seller are treated symmetrically. Situations where this is not the case are captured by our parameter θ.

J. Becker, C. Fuest / Regional Science and Urban Economics 41 (2011) 476–486

3.3. Cross-border M&A investment So far, our analysis has been restricted to national acquisitions. What happens if we allow for cross-border acquisitions in our model? The simplest way of introducing cross-border acquisitions is to assume that the investor firms from one country also untertake greenfield investments and acquisitions in other countries. Since the location of the headquarter of the investor firms does not play any economic role in our model, this would be equivalent to assuming that investor firms which untertake projects in country i are owned by residents of some other country j. This would change our results only in so far that the desire to tax profits accruing to foreign residents would be added as an additional motive to tax corporate profits. It is well known that this may lead to corporate overtaxation under tax competition, see Huizinga and Nielsen (1997). Of course, cross-border acquisitions would also raise issues like double taxation agreements or profit shifting. Adding these elements to the model would not change the key insights provided by the analysis, though.33 3.4. Imperfect competition among firms Another limitation of our analysis is that we abstract from what is widely seen as an important factor for mergers and acquisitions: the existence of imperfect competition among firms. We have deliberately done so in order to keep our model as close as possible to the standard model of (harmful) tax competition. An alternative approach to analyse the role of M&A investment for tax competition would be to start with a model of oligopolistic competition and add intergovernmental fiscal competition to it. Several additional issues would arise in this case. Firstly, M&A investment may change the number of firms in the market. If one firm which is active in the market acquires another active firm, consumers may be negatively affected by increasing prices. However, if the merger paradox applies, mergers will only arise if they give rise to synergies, which has further implications for both consumers and the government. It is even possible that prices decline, due to lower marginal costs of the newly created firm. Of course, greenfield investment may also change the number of firms in a market. In general, effects of investment on the intensity of competition in markets for private goods are not only an issue for tax policy but also for competition policy and merger control. Moreover, if the desire to reduce competition is a factor driving M&A investment, greenfield investment would not be considered as a substitute. Possibly, a framework without greenfield investment would be appropriate. There is no doubt that these issues are worth to be investigated in models of fiscal competition. But doing so would divert attention from the focus of this paper. In addition, the effects arising in our model are also likely to be relevant in models which do account for imperfect competition among firms. 4. Discussion and concluding remarks This paper departs from the observation that the literature on international tax competition has neglected the role of mergers and acquisitions. It mainly focuses on greenfield investment although the former type of investment is empirically at least as important as the latter. We therefore suggest a simple framework which introduces mergers and acquisitions into a standard tax competition model. Investor firms choose between acquiring existing firms or realizing greenfield projects. We show that, if we abstract from the possibility of levying a specific tax on acquisitions, the introduction of M&A investment intensifies tax competition because it gives rise to an additional negative fiscal externality of corporate tax cuts. Interestingly, an increase in corporate taxes raises the number of acquisitions 33

This is shown in an appendix which is available to interested readers upon request.

485

in a country but reduces the total number of investment projects. Therefore, a tax increase does not only affect the quantity of investment but also its composition and, hence, its quality in terms of welfare.34 If an acquisition tax is available, uncoordinated policies lead to a positive tax in our model. Whether the tax system as a whole discriminates acquisitions relative to greenfield investment in a tax competition equilibrium is ambiguous. If the number of countries is large, a systematic discrimination of acquisitions relative to greenfield investment emerges. The existence of the acquisition tax implies that the fiscal externalities of corporate tax rate changes are different. If acquisition taxes are sufficiently high in the uncoordinated equilibrium, the fiscal externality which arises due to the existence of M&A investment becomes positive. As a result, corporate tax competition is mitigated, and it may even be that overtaxation occurs. In other words, from the viewpoint of an individual country there are strong incentives to levy a tax on acquisitions. In fact, there is a lot of anecdotal evidence that governments are concerned about acquisitions of larger firms, in particular, the acquisitions of ‘national champions’ by foreign investors, and they frequently oppose these acquisitions and try to prevent them, typically with instruments other than taxes.35 Whether the tax system discriminates or encourages acquisitions in general depends on a number of tax rules including depreciation rules for goodwill, the deductibility of expenses for acquisitions, the tax treatment of capital gains and others. These differ across countries, but there is no doubt that tax policy does allow governments to favour or crowd back M&A investment through the tax system. To what extent this happens is an interesting question for empirical tax research. In terms of policy implications, our analysis draws attention to the fact that corporate tax coordination which focuses on the (tax inclusive) cost of capital for greenfield investment is incomplete. The tax treatment of acquisitions is an important factor as well. Clearly, it has to be taken into account that our model only highlights a rather specific aspect of mergers and acquisitions: the possibility of replacing a greenfield investment by an acquisition. There are many other factors driving mergers and acquisitions investment, and these factors are likely to be relevant for the workings of tax competition as well. This is a promising agenda for future research. Acknowledgements We thank the Editor, Yves Zenou, and two anonymous Referees as well as Steve Bond, Harry Huizinga, Peter Neary, Andreas Wagener and participants at research workshops in Oxford, Tilburg and Vienna for their very helpful comments. The usual disclaimer applies. We gratefully acknowledge financial support from the Deutsche Forschungsgemeinschaft (DFG), Grant No. FU 442/3-1 and from the ESRC (Grant 'Business, Tax and Welfare', No RES -06025-0033). Appendix A. An example for corporate overtaxation due to the existence of M&A In this appendix, we show that the tax competition equilibrium may indeed imply θ N 2τ(1 + r), so that corporate overtaxation (i.e. a positive welfare effect of corporate tax rate reductions) emerges. We do so by providing a simple example which makes the following

34 The idea that taxation may affect not only the quantity of investment but also its composition and, hence, its quality, is developed in greater detail in Becker et al. (2010). 35 It should be noted, though, that at least within the European Union discriminating openly against foreign acquirers would be incompatible with European law.

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∂r assumptions. The number of countries n is large, so that ∂τ converges i to zero. The representative household's utility function takes the quadratic form

uðC1 Þ + C2 = ða−bC1 ÞC1 + C2

ð40Þ

where a and b are positive parameters. Assume further that h′ = α N 0 and h″= 0. Δ and k are uniformly distributed, with Δ− = 0. π is normalized to zero. With the budget constraints given by Eqs. (21) and (22), optimal period 1 consumption is given by C1 = a−ð12b+ rÞ which implies savings of Δþ

kc

Δ

0

a−ð1 + r Þ 2b

S = E−∫ c dΔ + ∫ dk−

ð41Þ

Due to symmetry, S = 0 holds in equilibrium. Therefore, Eq. (41) þ c m and the determines r. The total number of projects is given by Δ Δ−Δ þ c

c2

kc

k kdk total number of acquisitions is kkþ m. Note further that 2k þ m = ∫

and ðΔ

þ

þ

−Δ ÞðΔ + Δ Þ m 2Δþ c

c

Δ

þ

= ∫ c ΔdΔ.

0

Δ

Eqs. (26), (28) and (41) determine the equilibrium values of τ, θ and r. Starting with the optimality condition for θ, we can solve for θ and replace it in (41). Then, the resulting expression for r is replaced in Eq. (26). Assuming parameter values for α, m, E, k+, Δ+, a and b, τ can be determined iteratively. If α = 1.25, m = 20, E = 10, k+ = 1, Δ+ = 3, a = 10 and b = 0.5 , the equilibrium values are τˆ = 0:35;

θˆ = 0:97;

r = 0:19

ð42Þ

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