Do tax policies stimulate investment in physical and research and development capital?

Tax policy instruments are often used to stimulate private investment in developing countries. But researchers have not explored how well such policies have met stated policy objectives. To evaluate the cost-effectiveness of tax incentives for industrial and technological development, the authors specify a dynamic production structure model with endogenous capacity utilization. Taxes and incentives are part of the user cost of capital, and thereby affect producer decisions about choice of inputs, technology, and capital accumulation. Empirical estimates of this model allow one to infer both the impact of investment incentives and their implications for revenues foregone by the government. The model results yield an objective, empirically derived cost-benefit ratio that is superior to standard cost-benefit analysis and King-Fullerton type marginal effective tax rate analysis. The authors apply this model empirically for Pakistan. The results suggest that the investment tax credit has not been effective at stimulating investments in Pakistan. The private investment stimulated has been less than the government revenues foregone. Allowing full expensing for research and development expenditures, on the other hand, has been cost effective.