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Could higher taxes increase the long-run demand for capital? Theory and evidence for Chile

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  • Bustos, Alvaro
  • Engel, Eduardo M. R. A.
  • Galetovic, Alexander

Abstract

Is a tax increase always detrimental for capital formation? This paper estimates a long-run demand for capital in Chile, and studies the responsiveness of firms’ desired capital stock to variations in tax rates. We combine the neoclassical model with a cointegration argument to obtain a long-run demand for capital that is valid for a general adjustment-cost structure. On theoretical grounds alone, there is no a priori reason why higher taxes should reduce the desired capital stock. Higher taxes reduce returns but simultaneously increase depreciation and interest payment allowances. When the sum of increased allowances is large enough, a higher corporate tax rate may reduce the cost of capital. We show that this result continues holding when the corporate veil is lifted and firms consider the income tax paid by its stockholders. The model is estimated with a panel of Chilean corporations with annual data between 1985 and 1995. The results we obtain suggest that changes in the corporate tax rate have almost no effect on the long run demand for capital: in 10 of the 11 years in our sample an increase in the corporate tax rate leads to a negligible increase in the desired capital stock. We also find that firms ignore the marginal rates their stockholders pay when they make investment decisions,i.e. there is a corporate veil.

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Article provided by Elsevier in its journal Journal of Development Economics.

Volume (Year): 73 (2004)
Issue (Month): 2 (April)
Pages: 675-697

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Handle: RePEc:eee:deveco:v:73:y:2004:i:2:p:675-697
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Find related papers by JEL classification:
  • H32 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - Firm
  • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory

References listed on IDEAS
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  1. Alan J. Auerbach, 1983. "Corporate Taxation in the United States," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 14(2), pages 451-514.
  2. Jorgenson, D.W., 1992. "Tax Reform and the Cost of Capital : An International Comparison," Harvard Institute of Economic Research Working Papers 1621, Harvard - Institute of Economic Research.
  3. Giuseppe Bertola & Ricardo J. Caballero, 1990. "Kinked Adjustment Costs and Aggregate Dynamics," NBER Chapters, in: NBER Macroeconomics Annual 1990, Volume 5, pages 237-296 National Bureau of Economic Research, Inc.
  4. Engel, Eduardo M. R. A. & Galetovic, Alexander & Raddatz, Claudio E., 1999. "Taxes and income distribution in Chile: some unpleasant redistributive arithmetic," Journal of Development Economics, Elsevier, vol. 59(1), pages 155-192, June.
  5. Lucas, Robert E, Jr, 1990. "Supply-Side Economics: An Analytical Review," Oxford Economic Papers, Oxford University Press, vol. 42(2), pages 293-316, April.
  6. Chang-Tai Hsieh & Jonathan A. Parker, 2007. "Taxes and Growth in a Financially Underdevelopped Country: Evidence from the Chilean Investment Boom," JOURNAL OF LACEA ECONOMIA, LACEA - LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION.
  7. King, Mervyn A, 1974. "Taxation and the Cost of Capital," Review of Economic Studies, Wiley Blackwell, vol. 41(1), pages 21-35, January.
  8. Caballero, Ricardo J, 1994. "Small Sample Bias and Adjustment Costs," The Review of Economics and Statistics, MIT Press, vol. 76(1), pages 52-58, February.
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Cited by:

  1. Rodrigo Cerda & Felipe Larrain, 2010. "Corporate taxes and the demand for labor and capital in developing countries," Small Business Economics, Springer, vol. 34(2), pages 187-201, February.
  2. Rodrigo A. Cerda & Diego Saravia, 2009. "Corporate Tax, Firm Destruction and Capital Stock Accumulation: Evidence From Chilean Plants, 1979-2004," Working Papers Central Bank of Chile 521, Central Bank of Chile.
  3. Rodrigo Cerda & Felipe Larraín, 2005. "Inversión Privada e Impuestos Corporativos: Evidencia para Chile," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 42(126), pages 257-281.
  4. Carlos Garcia & Jorge Restrepo, 2007. "How Effective is Government Spending in a Small Open Economy with Distortionary Taxes," ILADES-Georgetown University Working Papers inv188, Ilades-Georgetown University, Universidad Alberto Hurtado/School of Economics and Bussines.
  5. Panousi, Vasia, 2009. "Capital Taxation with Entrepreneurial Risk," MPRA Paper 24237, University Library of Munich, Germany.
  6. Cai, Jing & Harrison, Ann, 2011. "The value-added tax reform puzzle," Policy Research Working Paper Series 5788, The World Bank.
  7. Yongzheng Liu & Jorge Martinez-Vazquez, 2010. "The Growth-Inequality Tradeo in the Design of Tax Structure: Evidence from a Large Panel of Countries," International Center for Public Policy Working Paper Series, at AYSPS, GSU paper1320, International Center for Public Policy, Andrew Young School of Policy Studies, Georgia State University.
  8. Jose De Gregorio, 2004. "Economic Growth in Chile: Evidence, Sources and Prospects," Working Papers Central Bank of Chile 298, Central Bank of Chile.

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