Uncertainty, Welfare Cost, and the 'Adaptability' of U.S. Corporate Taxes

Alternative corporate tax systems differ in their ability to adapt to changes in the rate of inflation. Absent complete indexing of depreciation allowances, a tax system may use the expected inflation rate to set accelerated depreciation allowances in a way that minimizes the welfare loss from them is allocation of capital. This welfare loss is a nonlinear function of the assumed inflation rate, however, so the welfare loss at the expected inflation rate may be quite different from the expected welfare loss. We compute these two welfare concepts for each of three alternative corporate tax schemes in the U.S. and for two different relationships between inflation and interest rates. One important finding is that the Auerbach-Jorgenson first year recovery plan is not equivalent to indexing as is often claimed, if uncertainty about inflation implies uncertainty about the real after-tax discount rate.