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Investment ramifications of distortionary tax subsidies

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  • Hines, James R.
  • Park, Jongsang

Abstract

This paper examines the investment effects of tax subsidies for which some assets and not others are eligible. Distortionary tax subsidies concentrate investments in tax-favored assets, thereby reducing the expected pre-tax profitability of investment and reducing payoffs to bondholders in the event of default. Anticipation of asset substitution encourages lenders to require covenants in debt contracts, which only imperfectly address asset substitution and distort investment. The result is that borrowing is made more expensive, which in turn discourages investment. Borrowing rates can react so strongly that aggregate investment may rise very little, or even fall, in response to higher tax subsidies. Debt issued by U.S. firms in risk of default after the 2002 introduction of bonus depreciation for U.S. equipment investment contained many more covenants than in other periods, a pattern that reversed when bonus depreciation was discontinued after 2004; furthermore, firms at risk of default borrowed less, and were more apt to lease capital, than were other firms during the bonus depreciation period.

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  • Hines, James R. & Park, Jongsang, 2019. "Investment ramifications of distortionary tax subsidies," Journal of Public Economics, Elsevier, vol. 172(C), pages 36-51.
    • Handle: RePEc:eee:pubeco:v:172:y:2019:i:c:p:36-51
    DOI: 10.1016/j.jpubeco.2018.11.002
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    More about this item

    Keywords

    Investment tax subsidies; Corporate borrowing; Deadweight loss; Debt overhang; Bonus depreciation;
    All these keywords.

    JEL classification:

    • H25 - Public Economics - - Taxation, Subsidies, and Revenue - - - Business Taxes and Subsidies
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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