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The Effects of Tax Rules on Nonresidential Fixed Investment: Some Preliminary Evidence from the 1980s

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  • Martin Feldstein
  • Joosung Jun

Abstract

The evidence presented in this study confirms that tax-induced changes in the profitability of investment have had a powerful effect on the share of GNP devoted to nonresidential fixed investment. More specifically, we have reestimated two models of aggregate investment initially presented in Feldstein, "Inflation, Tax Rules and Investment: Some Econometric Evidence,"(Econometrica, 1982). The present study extends the previous analysis byusing revised national income accounts, by improving the estimation of the effective tax rate and the profitability of new investments, and by extending the sample to include the years 1978 through 1984. Despite these changes, the new statistical estimates are remarkably close to the previous results. The statistical estimates are also very robust with respect to sample period, estimation method, and the presence of other variables.The first model relates the investment-GNP ratio to the real net-of-tax rate of return received by the providers of debt and equity capital to the nonfinancial corporate sector and to the rate of capacity utilization. Our estimates imply that each percentage point increase in the real net return raises the investment-GNP ratio by 0.4 percentage points. A one percent age point increase in the net return is equivalent to a ten percentage point reduction in the overall effective tax rate. Since the net nonresidential fixed investment averaged 3 percent of GNP during the past three decades, a ten percentage point tax reduction induces a 13 percent rise in the investment-GNP ratio.Our second model relates the investment-GNP ratio to the difference between the maximum potential net return that firms can support by investing in a "standard investment project" and the net cost of debt and equity capital. The statistical estimates imply that each percentage point change in this measure of the rate of return over cost raises the investment-GNP ratio by 0.3 percentage points or 10 percent of its three-decade average.The estimates imply that the 1985 tax bill passed by the House of Representatives would reduce the investment-GNP ratio by between 10 percentand 15 percent of its average value, depending on the model used to make the calculation. Such reductions would represent between one-half and three-fourths of the rise in the investment-GNP ratio since the 1981 investment incentives were adopted.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1857.

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Date of creation: Mar 1986
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Publication status: published as Feldstein, Martin (ed.) The Effects of Taxation on Capital Accumulation. Chicago: University of Chicago Press, 1987.
Handle: RePEc:nbr:nberwo:1857

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  1. Feldstein, Martin S & Rothschild, Michael, 1974. "Towards an Economic Theory of Replacement Investment," Econometrica, Econometric Society, vol. 42(3), pages 393-423, May.
  2. Mark Warshawsky, 1982. "Life Insurance Savings and the After-Tax Life Insurance Rate of Return," NBER Working Papers 1040, National Bureau of Economic Research, Inc.
  3. Feldstein, Martin, 1980. "Inflation and the Stock Market," American Economic Review, American Economic Association, vol. 70(5), pages 839-47, December.
  4. Martin Feldstein & Lawrence Summers, 1983. "Inflation and the Taxation of Capital Income in the Corporate Sector," NBER Chapters, in: Inflation, Tax Rules, and Capital Formation, pages 116-152 National Bureau of Economic Research, Inc.
  5. Fumio Hayashi, 1981. "Tobin's Marginal q and Average a : A Neoclassical Interpretation," Discussion Papers 457, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  6. Martin Feldstein, 1986. "Budget Deficits, Tax Rules, and real Interest Rates," NBER Working Papers 1970, National Bureau of Economic Research, Inc.
  7. Abel, Andrew B, 1985. "A Stochastic Model of Investment, Marginal q and the Market Value of the Firm," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 26(2), pages 305-22, June.
  8. 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.
  9. Lawrence H. Summers, 1981. "Taxation and Corporate Investment: A q-Theory Approach," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 12(1), pages 67-140.
  10. Feldstein, Martin S & Foot, David K, 1971. "The Other Half of Gross Investment: Replacement and Modernization Expenditures," The Review of Economics and Statistics, MIT Press, vol. 53(1), pages 49-58, February.
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Cited by:
  1. Gastanaga, Victor M. & Nugent, Jeffrey B. & Pashamova, Bistra, 1998. "Host Country Reforms and FDI Inflows: How Much Difference do they Make?," World Development, Elsevier, vol. 26(7), pages 1299-1314, July.
  2. Martin Feldstein & Douglas W. Elmendorf, 1989. "Budget Deficits, Tax Incentives and Inflation: A Surprising Lesson From The 1983-84 Recovery," NBER Working Papers 2819, National Bureau of Economic Research, Inc.

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