Private Equity and Local Public Finances

• Published date: 01 September 2023
• Author: MARCEL OLBERT,PETER H. SEVERIN
• Date: 01 September 2023
• DOI: http://doi.org/10.1111/1475-679X.12487

DOI: 10.1111/1475-679X.12487

Journal of Accounting Research

Vol. 61 No. 4 September 2023

Printed in U.S.A.

Private Equity and Local Public

Finances

MARCEL OLBERT ∗AND PETER H. SEVERIN†

Received 10 June 2021; accepted 28 April 2023

∗London Business School; †University of Mannheim

Accepted by Douglas Skinner. This paper is based on the authors’ dissertations. Wegreatly

appreciate the guidance and support of our dissertation committees: Christoph Spengel

(chair), Jannis Bischof, and Lisa De Simone for Olbert; Ernst Maug (chair) and Oliver Spalt

for Severin. We thank an anonymous reviewer and the associate editor for their thoughtful

comments. We further thank Brian Baik, Dyaran Bansraj (discussant), Nathan Born (discus-

sant), Stephen Campbell, Shuping Chen, Jonathan Cohn (discussant), Jesse Davis, Collin

Dursteler,Alex Edwards, John Gallemore, Stephen Glaeser, Sharon Katz, Mark Lang, Clemens

Lauer, Jong Hyuk (Jay) Lee, Petro Lisowsky (discussant), Paul Mason (discussant), Julian

Marenz, Filippo Mezzanotti (discussant), Stefan Obernberger,Yannik Schneider, Lakshmanan

Shivakumar, Ahmed Tahoun, Erin Towery, Florin Vasvari, Patrick Verwijmeren (discussant),

Johannes Voget, Vadym Volosovych, and Malcolm Wardlaw for valuable comments. We also

thank seminar participants at the University of Mannheim, University of North Carolina, Eras-

mus University, Paderborn University, and referees and session participants at the 2022 LBS

Private Capital Symposium, the 2021 FARS and ATAMidyear Meetings, the 2020 National Tax

Association, WHU Young Scholar, American Economic Association (poster), and the 2019

AFFI, EFMA, FMA Asia, FMA Europe, and WFA conferences. Wegratefully acknowledge travel

grants from the Julius-Paul-Stiegler-Gedaechtnis-Stiftung and the IDEUM Program at the Uni-

versity of Mannheim. This paper received the MaFAT Research Award and the Cubist Ph.D.

Award for Outstanding Research. We are grateful to London Business School’sInstitute of En-

trepreneurship and Private Capital for supporting this research. Jefferson Abraham provided

excellent research assistance and helpful comments. We thank the authors of Berg, Reisinger,

and Streitz [2021] for sharing their data and code. We thank Dr. Ralf U. Braunagel, PE Tax

Leader at PwC Germany,for sharing insights into the target firm selection process and restruc-

turings after PE buyouts in Europe. Finally,we thank Dr. Frank Streif and Martin Manhart from

the Municipal Finance Department of the City of Mannheim and Lothar Schmitt from of the

municipality Ehrenberg (Rhön)-Wüstensachsen for sharing insights into local public budget

allocations and the details of the administrative data used in this paper. An online appendix

to this paper can be downloaded at https://www.chicagobooth.edu/jar-online-supplements.

1313

© 2023 The Authors. Journal of Accounting Research published by Wiley Periodicals LLC on behalf of The

Chookaszian Accounting Research Center at the University of Chicago Booth School of Business.

This is an open access article under the terms of the Creative Commons Attribution License, which

permits use, distribution and reproduction in any medium, provided the original work is properly cited.

1314 m. olbert and p. h. severin

ABSTRACT

We study the economic impact of private equity (PE) investments on local

governments, which are important corporate stakeholders. Examining over

11,000 deals and private firm data in Europe, we document that target firms’

effective tax rates and total tax expenses decrease by 15% and 13% after

PE deals. At the same time, target firms expand their capital expenditures

and firm boundaries, but do not increase employment. Using administrative

data on the public finances of German municipalities and exploiting the geo-

graphical and time-series variation in PE deals, we document that PE activity

is negatively associated with local governments’ tax revenues and spending.

This result is likely driven by reduced tax payments of PE portfolio firms, ac-

companied by only modest positive spillovers of PE investments on regional

economic growth. Collectively, our findings suggest that corporate tax effi-

ciency serves as a cost-cutting channel in the PE sector and constrains the

finances of local governments.

JEL codes: G31, G34, H25, H26, H70

Keywords: PE; leveraged buyouts; investments; tax avoidance; public

finances

1. Introduction

As of 2022, Private equity (PE) was the largest alternative asset class with

over 4.5 trillion USD in assets under management, which are projected to

exceed 11 trillion USD by 2026 (Economist [2022], Preqin [2022]). This

growing importance begs the question of how PE firms create value. A

particular concern relates to the PE industry’s contribution to tax revenues,

which impacts the public finances of the government. For example, during

the crisis around Covid-19, critics lamented that PE-backed firms pay low

taxes in good times but are financially fragile and demand government

support during downturns (Financial Times [2020]). Further, recent

media coverage has revealed that PE firms exploit favorable corporate

tax rulings in Luxembourg and dodge taxes at the executive partner level

(The Guardian [2014], New York Times [2021b]). We examine how PE

buyouts are associated with target firms’ corporate tax payments and eco-

nomic activity as well as the corresponding changes in local governments’

public finances.

Understanding the impact of PE activity on local public finances is im-

portant because sound fiscal budgets and local government spending are

crucial for economic development and community well-being (Gyourko

and Tracy [1991], Busso, Gregory, and Kline [2013], Glaeser [2013], Corbi,

Papaioannou, and Surico [2019], Antolin-Diaz and Surico [2022]). Regula-

tors are often skeptical of the value contribution of PE firms in light of the

imposition of debt and cost-cutting on portfolio firms (Kaplan and Ström-

berg [2009], Davis et al. [2020]). PE investors likely lower their portfolio

firms’ tax payments to increase shareholder value, potentially resulting

in monetary transfers away from governments. Practitioners, in contrast,

private equity and local public finances 1315

argue that the PE industry contributes significantly to aggregate invest-

ment, employment, and tax revenue in the United States (Frontier Eco-

nomics [2013], EY and AIC [2019]), and academic studies document that

portfolio firms’ profits and investments generally increase after PE buyouts

(e.g., Boucly, Sraer, and Thesmar [2011], Cohn, Mills, and Towery [2014],

Cohn, Hotchkiss, and Towery [2022], Guo, Hotchkiss, and Song [2011]).

Thus, economic benefits might counterbalance lower corporate taxes

such that governments may not need to worry about PE portfolio firms’

tax strategies.

To comprehensively assess the impact of PE on local governments, we

examine economic outcomes at three levels.1First, we study target firm

outcomes after PE buyouts. The main tests focus on effective tax rates

(ETRs) as a common measure of tax-related performance. As lower ETRs

reflect a relatively lower amount of taxes paid for the same amount of pre-

tax income generated, the ETR outcome directly relates to the concept of

cost efficiency critical to PE firms’ value creation focus (Gompers, Kaplan,

and Mukharlyamov [2016], Sorensen and Yasuda [2023]).2Building on

Badertscher, Katz, and Rego [2013], we expect that target firms report

lower ETRs after a PE buyout. This reduction in ETRs may stem from

more focused tax management, more aggressive tax strategies, or also

operational changes that are not necessarily driven by tax considerations.

Additional tests explore these possibilities to pin down the specific mech-

anisms of firms’ tax planning. As PE buyouts may increase firms’ pre-tax

earnings and investment, the impact of PE activity on total corporate tax

payments is unclear, even if ETRs decline. To address this issue, we also

decompose the ETR into tax payments and pre-tax earnings and further

study associated changes in economic activity.

Second, we study corporate tax and investment outcomes at the aggre-

gated level to account for the direct changes in target firms’ economic

activity and potential spillovers on nonacquired firms due to competitive

interactions or supply chain relationships (Bernstein et al. [2017], Breuer

[2021], Berg, Reisinger, and Streitz [2021]). By accounting for spillovers

on other firms located in the same region, we can assess the aggregate

consequences of PE on local governments’ public finances. Spillover

1Appendix B illustrates our conceptual framework. We acknowledge that PE investments

can have effects on the broader economy, and that some of these effects are outside the scope

of our study. Examples include technological transformations of industries and consequences

of PE activity for other stakeholders such as customers and suppliers. However, our analyses

should indirectly account for these factors, as we capture the net outcomes regarding local

governments’ finances.

2When interpreting our results, we use the term “tax efficiency” instead of only referring to

the term “tax avoidance,” which is not unambiguously defined in the academic literature and

can relate to a continuum of firms’ tax strategies ranging from mild forms of tax planning such

as investing in tax-exempt bonds to aggressive sheltering activities without much economic

substance (Blouin [2014]). We use the term “aggressive tax avoidance” when we study specific

measures of aggressive forms of tax planning such as the use of tax havens.