No. 68: Can tax rate changes accelerate investment under entry and exit flexibility? – Insights from an economic experiment

Abstract

This study investigates the conditions under which tax rate changes accelerate risky investments. While tax rate increases are often expected to harm investment, analytical studies find tax rate increases may foster investment under flexibility. We design a theory-based experiment with a binomial random walk and entry-exit flexibility. We find accelerated investment upon tax rate increases irrespective of an exit option but no corresponding response to tax cuts. This asymmetry may be due to tax salience and mechanisms from irreversible choice under uncertainty. Given this evidence of unexpected tax reform effects, tax policymakers should carefully consider behavioral aspects.