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Inflation, taxes, and the durability of capital

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  • Darrel Cohen
  • Kevin A. Hassett

Abstract

Auerbach (1979, 1981) has demonstrated that inflation can lead to large inter-asset distortions, with the negative effects of higher inflation unambiguously declining with asset life. We show that this is true only if depreciation is treated as geometric for tax purposes. When depreciation is straightline, higher inflation can have the opposite effect, discouraging investment in long-lived assets. Since our current system can be thought of as a mixture of straightline and geometric, the sign of the inter-asset distortion is indeterminate. We show that under current U.S. tax rules, the "straightline" and "geometric" effects approximately cancel for equipment, causing almost no inter-asset distortions. For structures, inflation clearly causes substitution into long-lived assets.

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File URL: http://www.federalreserve.gov/pubs/feds/1997/199753/199753abs.html
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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 1997-53.

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Date of creation: 1997
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Handle: RePEc:fip:fedgfe:1997-53

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Related research

Keywords: Inflation (Finance) ; Taxation ; Capital;

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References

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  1. Auerbach, Alan J., 1979. "Share valuation and corporate equity policy," Journal of Public Economics, Elsevier, vol. 11(3), pages 291-305, June.
  2. Darrel Cohen & Kevin A. Hassett & R. Glenn Hubbard, 1997. "Inflation and the User Cost of Capital: Does Inflation Still Matter?," NBER Working Papers 6046, National Bureau of Economic Research, Inc.
  3. Auerbach, Alan J, 1981. "Inflation and the Tax Treatment of Firm Behavior," American Economic Review, American Economic Association, vol. 71(2), pages 419-23, May.
  4. Alan J. Auerbach, 1982. "Taxation, Corporate Financial Policy and the Cost of Capital," NBER Working Papers 1026, National Bureau of Economic Research, Inc.
  5. Auerbach, Alan J, 1979. "Inflation and the Choice of Asset Life," Journal of Political Economy, University of Chicago Press, vol. 87(3), pages 621-38, June.
  6. Martin S. Feldstein, 1997. "The Costs and Benefits of Going from Low Inflation to Price Stability," NBER Chapters, in: Reducing Inflation: Motivation and Strategy, pages 123-166 National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Hassett, Kevin A & Hubbard, R Glenn, 1998. "Are Investment Incentives Blunted by Changes in Prices of Capital Goods?," International Finance, Wiley Blackwell, vol. 1(1), pages 103-25, October.
  2. Austan Goolsbee, 1998. "Taxes and the Quality of Capital," NBER Working Papers 6731, National Bureau of Economic Research, Inc.
  3. Alexander David & Pietro Veronesi, 2009. "What Ties Return Volatilities to Price Valuations and Fundamentals?," NBER Working Papers 15563, National Bureau of Economic Research, Inc.
  4. Chang Nam & Doina Radulescu, 2007. "Effects of Corporate Tax Reforms on SMEs’ Investment Decisions under the Particular Consideration of Inflation," Small Business Economics, Springer, vol. 29(1), pages 101-118, June.

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