How Quickly Do Corporations Respond to Changes in Tax Law? Evidence fromthe California Manufacturer's Investment Credit

Abstract

An understanding of the timing of firm response to changes in corporate tax law is vital for accurately estimating the revenue impact of pending corporate tax legislation. Unfortunately, the literature does not contain any standard references describing the actual responses of firms to tax law changes. The recent adoption of California's Manufacturer's Investment Credit provides a unique opportunity to study how corporations adjust their tax payments in response to changes in tax law. For background, it is shown that even in the absence of law changes many corporations overpay on their estimated taxes, perhaps because of transactions costs or agency problems. Analysis of corporate tax payments indicates that taxpayers did adjust their estimated tax payments in response to the introduction of California's MIC, but that their response fell short of the response predicted by the zero transactions cost, perfect information model of the firm. Furthermore, firms whose MIC credit was large relative to their pre-MIC tax liability were less adept at adjusting to the law change than were firms for whom the MIC was relatively less important. As a result, the revenue loss to the State of California for 1995 tax year MIC credits is estimated to be spread out over four fiscal years.