The Effect of Succession Taxes on Family Firm Investment: Evidence from a Natural Experiment

• DOI: http://doi.org/10.1111/jofi.12224
• Date: 01 April 2015
• Published date: 01 April 2015

THE JOURNAL OF FINANCE •VOL. LXX, NO. 2 •APRIL 2015

The Effect of Succession Taxes on Family Firm

Investment: Evidence from a Natural Experiment

MARGARITA TSOUTSOURA∗

ABSTRACT

This paper provides causal evidence on the impact of succession taxes on firm in-

vestment decisions and transfer of control. Using a 2002 policy change in Greece

that substantially reduced the tax on intrafamily transfers of businesses, I show that

succession taxes lead to a more than 40% decline in investment around family succes-

sions, slow sales growth, and a depletion of cash reserves. Furthermore, succession

taxes strongly affect the decision to sell or retain the firm within the family.I conclude

by discussing implications of my findings for firms in the United States and Europe.

DEMOGRAPHIC TRENDS IN both the United States and Europe make firm suc-

cession planning increasingly important for privately held family businesses.1

Each year, an estimated 690,000 firms providing 2.8 million jobs change hands

in the (European union/EU; European Commission (2006)).

Succession taxes, which are incurred during such transfers and are some-

times referred to as transfer taxes, have been at the center of debate. On the

one hand, there are concerns that taxing successions can discourage firm in-

vestment and growth, and may even force entrepreneurs to sell their firms

in order to meet their tax liability. On the other hand, abundant empirical

evidence suggests that inherited firms underperform (Perez-Gonzalez (2006),

Villalonga and Amit (2006), Bennedsen et al. (2007)), which implies that suc-

cession taxes might be too low, that is, provide incentives to keep poorly man-

aged firms within the family (Bloom (2006)). Underlying both these arguments

is a belief that succession taxes may affect firm boundaries and investment.

∗Margarita Tsoutsoura is with Chicago Booth. I thank the members of my committee, Patrick

Bolton, Charles Calomiris, Daniel Paravisini, and Daniel Wolfenzon, as well as Francisco

P´

erez-Gonz´

alez for their encouragement and support. I also thank Amit Seru for helpful com-

ments. This work also benefited greatly from the comments of participants of the finance seminars

at Boston College, Columbia University, Cornell University, Duke, Harvard Business School, IN-

SEAD, MIT, Northwestern University, NYU, Rice University, SSE, the University of Florida, the

University of North Carolina, the University of Pennsylvania, the University of Virginia, Wash-

ington University in St. Louis, and Yale University, as well as participants at the WFA 2010,

London Business School Transatlantic Conference, and Thammasat International Conference. I

acknowledge financial support by CIBER and the Kauffman Foundation. All errors are my own.

1Prior research shows that founders or their families control the majority of firms around the

world (Faccio and Lang (2002)). Even among public firms, families control 45% of listed interna-

tional firms (La Porta, Lopez-de-Silanes, and Shleifer (1999)) and at least one-third of large U.S.

public firms (Anderson and Reeb (2003)).

DOI: 10.1111/jofi.12224

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650 The Journal of Finance R

However, systematic empirical evidence that establishes this link is missing.

In this paper, I aim to fill this gap by establishing and quantifying the effect of

succession taxes on entrepreneurs’ succession decisions, investment decisions,

and financial policies.

The challenge in empirically identifying a causal effect of succession taxes on

firm policies is threefold. First, one needs to isolate the effect of succession taxes

from other possible factors that might affect firm policies around successions

(e.g., the ability of the new owner or aggregate trends). Second, endogeneity

of the decision to transfer the company to family members must be addressed.

Finally, an exogenous source of variation in the tax environment is required.

To overcome these challenges, I exploit a 2002 tax reform in Greece that

reduced succession tax rates for transfers of limited liability companies to fam-

ily members from 20% to less than 2.4%.2I begin by constructing a unique

database that contains information on all transfers of limited liability firms

in Greece for the years 1999 to 2005. Although limited liability firms are pri-

vate, they are required to publish their ownership changes as well as their

financial statements. I then supplement these data by matching them to hand-

collected data on the gender of each entrepreneur’s first-born child and on each

entrepreneur’s personal income from other sources.

In the quasi-experimental setting provided by the tax policy change, I em-

ploy two methodologies to measure the effect of the policy change on invest-

ment. First I apply difference-in-difference-in-differences (DDD) to analyze the

change in investment around successions in response to the tax policy change.

I compare firms that undergo a family succession (the treated group) to firms

transferred to unrelated entrepreneurs (the control group) both before and

after the policy change. This method controls for aggregate trends and other

succession-induced changes in investment. Furthermore, by comparing the two

groups before and after the tax reform, the analysis disentangles the effect of

the identity of the new owner (family or unrelated) from the effect of the suc-

cession tax.

A major concern with the DDD approach is that the family versus unrelated

succession decision is unlikely to be independent of firm characteristics related

to investment opportunities. Toaddress this concern, I use the gender of the de-

parting entrepreneur’s first-born child as an instrument for family succession,

as in Bennedsen et al. (2007)). The gender of the departing entrepreneur’s first-

born child is a plausible instrument for family successions because it affects the

probability of a family succession and is unlikely to be correlated with a firm’s

investment opportunities. As before, I compare firms that undergo a family suc-

cession to firms transferred to unrelated entrepreneurs both before and after

the policy change, but I use the instrument to randomly assign firms into the

two groups. Thus, the identification exploits two sources of variation: the tax

reform provides time-series variation with respect to the transfer tax, whereas

the instrument provides exogenous cross-sectional variation with respect to

the succession decision. This method allows for causal inference because, as

2The tax rate remained unchanged at 20% for unrelated transfers.

Effect of Succession Taxes on Family Firm Investment 651

before, it disentangles the effect of the new owner’s identity from the effect of

the succession tax, while also addressing concerns regarding endogeneity of

the succession decision.

Both the DDD and the instrumental variable (IV) estimates reveal a

negative effect of transfer taxes on postsuccession investment for firms trans-

ferred within the family.In the presence of higher succession taxes, investment

drops from 17.6% of property, plant, and equipment (PPE) three years before

succession to 9.7% of PPE two years after. This impact of succession taxes

on investment is economically large: the implied decline in investment ratio

(0.079) is approximately 40% of the pretransition level of investment. For these

firms, successions are also associated with a decrease in cash reserves, a de-

cline in profitability, and slower sales growth. Note that, to the extent that

entrepreneurs can plan ahead for the succession and the related tax liability,

the estimates I report in the paper likely underestimate the true effect of suc-

cession taxes. Nevertheless, I obtain similar results when limiting attention

to death-related successions—instances in which succession planning is less

likely.

I also find a strong relation between succession taxes and the decision to sell

or keep the firm within the family.After the reduction in inheritance taxes, fam-

ily successions increase from 45.2% of all transfers before the reform to 73.9%,

a more than 63% increase. This evidence shows that succession taxes signifi-

cantly influence the allocation of firm ownership and thus firm boundaries. This

finding has potentially important implications, given existing evidence in the

literature that inherited family firms underperform. In particular, to the extent

that lower succession taxes provide incentives to allocate assets to low-ability

heirs, tax policy that changes such taxes could impact aggregate productivity

and economic growth (Morck, Stangeland, and Yeung (2000), Bloom (2006),

Bennedsen et al. (2007), Bloom and Van Reenen (2007)).

The final part of the analysis investigates whether the effect of succession

taxes on investment varies with observed firm characteristics. I find that the

results continue to hold for both large and small firms in my sample. However,

when I run the analysis separately for low versus high asset tangibility, I find

that the observed effects are stronger for family firms with low asset tangibility.

The effects are also stronger for firms owned by entrepreneurs with relatively

low income from other sources, and as a result may have no alternative sources

of financing apart from costly external finance. This evidence is consistent

with financial constraints exacerbating the effects of succession taxes on firm

investment. However, care should be taken in interpreting the results, as these

patterns may also be consistent with other plausible channels.

This paper connects to several strands of the literature. First, it contributes

to the literature on family firms. Understanding what factors affect firm poli-

cies around successions is important because the way in which firm control

is passed from one generation to the next can critically affect the develop-

ment and growth of the firm. The literature so far highlights three factors that

can affect intergenerational transfers of family firms: nepotism (Burkart, Pa-

nunzi, and Shleifer (2003), Caselli and Gennaioli (2005), Perez-Gonzalez (2006),