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Inflation and the User Cost of Capital: Does Inflation Still Matter?

In: The Costs and Benefits of Price Stability

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  • Darrel Cohen
  • Kevin Hassett
  • R. Glenn Hubbard

Abstract

In the late 1970s, many economists argued that the deleterious effects of inflation on the user cost of capital for U.S. firms were large. Since that time, the tax code has changed, the level of inflation has dropped significantly, and the of investment has evolved considerably. In this paper, we demonstrate that the net effect of these changes has--under reasonable assumptions--not relegated inflation to the sidelines. Indeed, we conclude that: (1) inflation, even at its relatively low current rates, continues to increase the user cost of capital significantly; (2) the marginal gain in investment in response to a percentage-point reduction in inflation is larger for lower levels of inflation; (3) the beneficial effects for steady-state consumption of lowering inflation even further than has been achieved to date would likely be significant; and (4) inflation has only a small impact on intratemporal distortion in the allocation of capital within the domestic business sector. We also show that the magnitude of the inflation effect on the user cost of capital is likely much smaller in open economies.

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This chapter was published in:

  • Martin Feldstein, 1999. "The Costs and Benefits of Price Stability," NBER Books, National Bureau of Economic Research, Inc, number feld99-1.
    This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 7774.

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    1. Jason Cummins & R. Glenn Hubbard, 1995. "The Tax Sensitivity of Foreign Direct Investment: Evidence from Firm-Level Panel Data," NBER Chapters, in: The Effects of Taxation on Multinational Corporations, pages 123-152 National Bureau of Economic Research, Inc.
    2. Darby, Michael R, 1975. "The Financial and Tax Effects of Monetary Policy on Interest Rates," Economic Inquiry, Western Economic Association International, vol. 13(2), pages 266-76, June.
    3. Rosanne Altshuler & T. Scott Newlon & William Randolph, 1996. "Do Repatriation Taxes Matter? Evidence from the Tax Returns of U.S. Multinationals," Departmental Working Papers 199405, Rutgers University, Department of Economics.
    4. Kevin A. Hassett & R. Glenn Hubbard, 1996. "Tax Policy and Investment," NBER Working Papers 5683, National Bureau of Economic Research, Inc.
    5. Hartman, David G, 1979. "Taxation and the Effects of Inflation on the Real Capital Stock in an Open Economy," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 20(2), pages 417-25, June.
    6. Levi, Maurice D, 1977. "Taxation and "Abnormal" International Capital Flows," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 85(3), pages 635-46, June.
    7. David F. Bradford, 1979. "The Incidence and Allocation Effects of a Tax on Corporate Distributions," NBER Working Papers 0349, National Bureau of Economic Research, Inc.
    8. Martin Feldstein & James R. Hines Jr. & R. Glenn Hubbard, 1995. "Taxing Multinational Corporations," NBER Books, National Bureau of Economic Research, Inc, number feld95-1.
    9. Martin Feldstein & Jerry Green & Eytan Sheshinski, 1983. "Inflation and Taxes in a Growing Economy with Debt and Equity Finance," NBER Chapters, in: Inflation, Tax Rules, and Capital Formation, pages 44-60 National Bureau of Economic Research, Inc.
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    13. Don Fullerton & Diane Lim Rogers, 1997. "Neglected Effects on the Uses Side: Even a Uniform Tax Would Change Relative Goods Prices," NBER Working Papers 5937, National Bureau of Economic Research, Inc.
    14. Bayoumi, Tamim & Gagnon, Joseph, 1996. "Taxation and inflation: A new explanation for capital flows," Journal of Monetary Economics, Elsevier, vol. 38(2), pages 303-330, October.
    15. Hines, J.R.J. & Hubbard, R.G., 1989. "Coming Home To America - Devidend Repatriations By U.S. Multinationals," Papers 146, Princeton, Woodrow Wilson School - Public and International Affairs.
    16. Auerbach, Alan J, 1989. "Tax Reform and Adjustment Costs: The Impact on Investment and Market Value," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 30(4), pages 939-62, November.
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    18. Jason G. Cummins & Kevin A. Hassett & R. Glenn Hubbard, 1994. "A Reconsideration of Investment Behavior Using Tax Reforms as Natural Experiments," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 25(2), pages 1-74.
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    20. Frederic S. Mishkin, 1991. "Is the Fisher Effect for Real? A Reexamination of the Relationship Between Inflation and Interest Rates," NBER Working Papers 3632, National Bureau of Economic Research, Inc.
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    Citations

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    Cited by:
    1. Eugenio Gaiotti & Andrea Generale, 2002. "Does Monetary Policy Have Asymmetric Effects? A Look at the Investment Decisions of Italian Firms," Giornale degli Economisti, GDE (Giornale degli Economisti e Annali di Economia), Bocconi University, GDE (Giornale degli Economisti e Annali di Economia), Bocconi University, vol. 61(1), pages 29-59, June.
    2. Brazell, David W. & Mackie, James B. III, 2000. "Depreciation Lives and Methods: Current Issues in the U.S. Capital Cost Recovery System," National Tax Journal, National Tax Association, vol. 53(n. 3), pages 531-62, September.
    3. Mackie, James B. III, 2002. "Unfinished Business of the 1986 Tax Reform Act: An Effective Tax Rate Analysis of Current Issues in theTaxation of Capital Income," National Tax Journal, National Tax Association, vol. 55(N. 2), pages 293-337, June.
    4. Gavin, William T. & Kydland, Finn E. & Pakko, Michael R., 2007. "Monetary policy, taxes, and the business cycle," Journal of Monetary Economics, Elsevier, vol. 54(6), pages 1587-1611, September.
    5. Darrel Cohen & Kevin A. Hassett, 1997. "Inflation, taxes, and the durability of capital," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 1997-53, Board of Governors of the Federal Reserve System (U.S.).
    6. Rochelle M. Edge & Jeremy B. Rudd, 2002. "Taxation and the Taylor principle," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2002-51, Board of Governors of the Federal Reserve System (U.S.).
    7. Pierre Fortin & George A. Akerlof & William T. Dickens & George L. Perry, 2002. "Inflation and Unemployment in the U.S. and Canada: A Common Framework," Cahiers de recherche du Département des sciences économiques, UQAM 20-16, Université du Québec à Montréal, Département des sciences économiques.
    8. Kenji Moriyama, 2008. "Investigating Inflation Dynamics in Sudan," IMF Working Papers 08/189, International Monetary Fund.
    9. Ciżkowicz, Piotr & Rzońca, Andrzej, 2013. "Does inflation harm corporate investment? Empirical evidence from OECD countries," Economics - The Open-Access, Open-Assessment E-Journal, Kiel Institute for the World Economy, vol. 7(16), pages 1-38.
    10. O'Reilly, B., 1998. "The Benefits of Low Inflation: Taking Shock "A nickel ain't worth a dime any more" [Yogi Berra]," Technical Reports, Bank of Canada 83, Bank of Canada.
    11. Eduardo Walker, 2002. "The Chilean Experience in Completing Markets with Financial Indexation," Central Banking, Analysis, and Economic Policies Book Series, in: Fernando Lefort & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Serie (ed.), Indexation, Inflation and Monetary Policy, edition 1, volume 2, chapter 9, pages 259-294 Central Bank of Chile.
    12. Ciżkowicz, Piotr & Rzońca, Andrzej, 2010. "Inflation and corporate investment in selected OECD countries in the years 1960-2005 – an empirical analysis," MPRA Paper 29846, University Library of Munich, Germany.

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