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Investment With Uncertain Tax Policy: Does Random Tax Policy Discourage Investment?

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  • Kevin A. Hassett
  • Gilbert E. Metcalf

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Abstract

In models with irreversible investment, increasing uncertainty about prices has been shown to increase the required rate of return (hurdle rate) and delay investment (e.g., Pindyck, 1988). One serious form of uncertainty faced by firms, a form that policy makers could conceivably control, is tax uncertainty. In this paper, we show that it does not follow from past work that tax policy uncertainty increases the expected hurdle price ratio and delays investment. This is because tax uncertainty has an unusual form that distinguishes it from price uncertainty: tax rates tend to remain constant for many years, and then change in large jumps. When tax policy follows a jump process, firms' expectations of the likelihood of the jump occurring have important effects on investment. Indeed, as we show below, while price uncertainty increases the hurdle rate and slows down investment, tax uncertainty has the opposite effect.

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Bibliographic Info

Paper provided by Department of Economics, Tufts University in its series Discussion Papers Series, Department of Economics, Tufts University with number 9823.

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Date of creation: 1998
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Handle: RePEc:tuf:tuftec:9823

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  1. Dixit, Avinash, 1993. "Choosing among alternative discrete investment projects under uncertainty," Economics Letters, Elsevier, vol. 41(3), pages 265-268.
  2. Robert S. Pindyck, 1986. "Irreversible Investment, Capacity Choice, and the Value of the Firm," NBER Working Papers 1980, National Bureau of Economic Research, Inc.
  3. Bizer, David S & Judd, Kenneth L, 1989. "Taxation and Uncertainty," American Economic Review, American Economic Association, vol. 79(2), pages 331-36, May.
  4. Auerbach, A.J. & Hines, Jr.J.R., 1988. "Investment Tax Incentives And Frequent Tax Reforms," Papers 135, Princeton, Woodrow Wilson School - Public and International Affairs.
  5. Caballero, Ricardo J & Pindyck, Robert S, 1996. "Uncertainty, Investment, and Industry Evolution," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 37(3), pages 641-62, August.
  6. Ricardo J. Caballero & Eduardo M. R. A. Engel & John C. Haltiwanger, 1995. "Plant-Level Adjustment and Aggregate Investment Dynamics," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 26(2), pages 1-54.
  7. Pindyck, Robert S, 1993. "A Note on Competitive Investment under Uncertainty," American Economic Review, American Economic Association, vol. 83(1), pages 273-77, March.
  8. Metcalf, Gilbert E. & Hassett, Kevin A., 1995. "Investment under alternative return assumptions Comparing random walks and mean reversion," Journal of Economic Dynamics and Control, Elsevier, vol. 19(8), pages 1471-1488, November.
  9. Poterba, J.M., 1989. "Dividends, Capital Gains And The Corporate Veil: Evidence From Britain, Canada And The United States," Working Papers 3, John Deutsch Institute for the Study of Economic Policy.
  10. 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.
  11. Koenker, Roger & Bassett, Gilbert, Jr, 1982. "Robust Tests for Heteroscedasticity Based on Regression Quantiles," Econometrica, Econometric Society, vol. 50(1), pages 43-61, January.
  12. Jack, William & Viard, Alan D., 1996. "Production efficiency and the design of temporary investment incentives," Journal of Public Economics, Elsevier, vol. 61(1), pages 87-106, July.
  13. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 19-46, January.
  14. B. Douglas Bernheim & John B. Shoven, 1991. "National Saving and Economic Performance," NBER Books, National Bureau of Economic Research, Inc, number bern91-2, July.
  15. Koenker, Roger W & Bassett, Gilbert, Jr, 1978. "Regression Quantiles," Econometrica, Econometric Society, vol. 46(1), pages 33-50, January.
  16. Hartman, Richard, 1972. "The effects of price and cost uncertainty on investment," Journal of Economic Theory, Elsevier, vol. 5(2), pages 258-266, October.
  17. 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.
  18. Abel, Andrew B, 1983. "Optimal Investment under Uncertainty," American Economic Review, American Economic Association, vol. 73(1), pages 228-33, March.
  19. Cabalero, R.J., 1997. "Aggregaete Investment," Working papers 97-20, Massachusetts Institute of Technology (MIT), Department of Economics.
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