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Hidden Stimuli to Capital Formation: Debt and the Incomplete Adjustment of Financial Returns

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  • Robert S. Chirinko
  • Stephen R. King

Abstract

There is a common belief that the disappointing economic performance in the 1970s can be attributed in good part to the interaction of tax rules, inflation, and capital formation. In this paper, we reassess the relationships between inflation, the tax code, and investment incentives because previous results are based on a number of tenuous assumptions whose impact has not been fully appreciated. We also question the appropriateness of the conventional user cost formulation, and derive an alternative measure taking explicit account of the role of debt -- acquisition,retirement, and net-of-tax interest payments -- and the equity holders' ownership of the firm. Our numerical results show that previously reported disincentives for acquiring capital goods in generaland against longer-lived capital in particular are attenuated, and in a number of cases reversed, under various sets of assumptions. Differences in results stemming from the conventional and modified user costs are highlighted, and are illustrated by a comparison of the U.S. Treasury's tax reform proposals under the two formulations.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1684.

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Date of creation: Aug 1985
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Handle: RePEc:nbr:nberwo:1684

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  1. Aivazian, Varouj A & Callen, Jeffrey L, 1979. "Investment, Market Structure, and the Cost of Capital," Journal of Finance, American Finance Association, vol. 34(1), pages 85-92, March.
  2. Kopcke, Richard W, 1981. "Inflation, Corporate Income Taxation, and the Demand for Capital Assets," Journal of Political Economy, University of Chicago Press, vol. 89(1), pages 122-31, February.
  3. Brock, William A & Turnovsky, Stephen J, 1981. "The Analysis of Macroeconomic Policies in Perfect Foresight Equilibrium," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 22(1), pages 179-209, February.
  4. Feldstein, Martin S, 1976. "Inflation, Income Taxes, and the Rate of Interest: A Theoretical Analysis," American Economic Review, American Economic Association, vol. 66(5), pages 809-20, December.
  5. Taggart, Robert A, Jr, 1980. " Taxes and Corporate Capital Structure in an Incomplete Market," Journal of Finance, American Finance Association, vol. 35(3), pages 645-59, June.
  6. DeAngelo, Harry & Masulis, Ronald W, 1980. " Leverage and Dividend Irrelevancy under Corporate and Personal Taxation," Journal of Finance, American Finance Association, vol. 35(2), pages 453-64, May.
  7. Joe Peek and James A. Wilcox., 1982. "The Postwar Stability of the Fisher Effect," Research Program in Finance Working Papers 129, University of California at Berkeley.
  8. Fama, Eugene F, 1981. "Stock Returns, Real Activity, Inflation, and Money," American Economic Review, American Economic Association, vol. 71(4), pages 545-65, September.
  9. Tanzi, Vito, 1980. "Inflationary Expectations, Economic Activity, Taxes, and Interest Rates," American Economic Review, American Economic Association, vol. 70(1), pages 12-21, March.
  10. Martin Feldstein & James M. Poterba & Louis Dicks-Mireaux, 1981. "The Effective Tax Rate and the Pretax Rate of Return," NBER Working Papers 0740, National Bureau of Economic Research, Inc.
  11. Alan J. Auerbach, 1980. "Wealth Maximization and the Cost of Capital," NBER Working Papers 0254, National Bureau of Economic Research, Inc.
  12. 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.
  13. Robert A. Taggart, Jr., 1980. "Taxes and Corporate Capital Structure in an Incomplete Market," NBER Working Papers 0594, National Bureau of Economic Research, Inc.
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