Can Tax Rate Increases Foster Investmentunder Entry and Exit Flexibility?- Insights from an Economic Experiment

It is well-known that taxes affect risky investment decisions. Analytical studies
indicate that tax rate increases (decreases) can foster (hinder) investment if there is flexibility, in
particular when an exit option is available. We design an experiment based on an analytical
model with binomial random walk and entry and exit flexibility. Contrasting the underlying
model, we find accelerated investment, which is often considered as an increased willingness to
invest, on tax rate increases to be independent of the existence of an exit option. However, we
observe this investor reaction only for a tax increase, not for a tax decrease. This behavior is
driven possibly by tax salience and the mechanisms known from the theory of irreversible choice
under uncertainty. Our empirical evidence suggests that the at-first-sight unexpected tax reform
effects are more common than is predicted by the theoretical literature. Policy makers should
therefore carefully consider the behavioral aspects when anticipating taxpayer reactions.