Cascades of tax policy through production networks: Evidence from Japan

Public policies can have direct effects on firms, but also propagate through production networks. This column studies the spillover effects through supply chains of a bonus depreciation tax policy in Japan. Beyond the direct effects, it finds strong positive effects on upstream firms, but not on downstream firms. Furthermore, it shows that large suppliers are able to benefit the most, likely due to market power. The results suggest policymakers need to consider supply chain spillover effects when formulating tax policy.

The Covid-19 pandemic and rising geopolitical risks have highlighted the significance of supply chains. Consequently, there is a pressing need for policymakers to consider the spillover effects of public policies propagated through supply chains. One such area is tax policy. The effectiveness of tax policies targeting firms is evaluated conventionally based on the effects on the firms that are directly affected by the tax policies. However, the indirect effects through the supply chains of the directly affected firms can also be of first-order importance.

One commonly practiced stimulative tax policy is a tax incentive for investment through bonus/accelerated depreciation. This policy has again recently been implemented by many countries to recover from Covid-19. The effects of this policy on the directly affected firms are rigorously examined by Zwick and Mahon (2017). Using the tax administrative data in the US, they find that a bonus depreciation tax policy significantly increases investment activities of firms (especially for small firms). However, no study has yet examined the spillovers of this policy through production networks, so my recent study, Koizumi (2024), addresses that gap. This study investigates a bonus depreciation tax policy introduced in 1998 that has continued since then in Japan, which targeted small and medium-sized enterprises (SMEs). My study exploits a unique proprietary dataset provided by Teikoku Data Bank (TDB) that covers sales information from approximately half a million firms and reports the presence of firm-to-firm transactions for these firms in the period 1993-2003. Using the policy shock and the unique dataset, the study provides two noteworthy findings: (1) while significant upstream propagation was found, no discernible effects were detected on downstream firms, and (2) targeting SMEs may, paradoxically, primarily benefit large firms through the supply chain.

Before delving into the details of the findings, let us review how bonus depreciation works to stimulate investment. Bonus depreciation allows companies to realise tax savings based on the nature and amount of equipment purchased. For instance, when a company invests in durable equipment like machinery or vehicles, the conventional accounting approach involves recording the cost as ‘depreciation’ over time. Bonus depreciation allows SMEs to deduct an additional percentage value of capital expenditures in the first year of an asset’s tax life. Note that this policy does not increase the total depreciation amounts and thus simply accelerates deductions from further in the future. However, it frees up funds for companies with liquidity constraints, enabling them to diversify investments or expand production.

To read the full text:
https://www.rieti.go.jp/en/columns/v01_0211.html

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