Do Tax Incentives Affect Internal Capital Market Efficiency? Evidence from the Addback Statutes

Abstract

Addback statutes significantly reduce firms’ tax-motivated income shifting via the internal capital market (ICM). Leveraging a quasi-natural experimental setting, we find that addback statutes increase firms’ ICM and investment efficiency. This effect is robust to a stacked difference-in-differences estimation method. Moreover, addback statutes reduce overinvestment but not underinvestment. The effect of addback statutes is more pronounced when firms have more dispersed state tax rates among subsidiaries, have lower information transparency, and draw less Internal Revenue Service attention. Using establishment-level data from the National Establishment Time Series, we show that establishments in adopting states are less likely to receive internal capital subsidies. The reduction is more pronounced in establishments with higher state tax rates, higher credit ratings, and lower sales growth. Additional tests show that the effects of addback statutes on ICM and investment efficiency are less pronounced when firms have lower investment opportunity diversity and higher financial constraints. In the long run, the adoption of addback statutes has a positive effect on firm performance.

Keywords: Addback Statutes, Internal Capital Market Efficiency, Investment Efficiency, Tax Incentives