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Developing a Cost of Capital Module for Computable General Equilibrium Modelling

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  • Winston, Ashley

Abstract

Computable general equilibrium (CGE) models are ideal tools for policy analysis. However, work conducted by the Centre of Policy Studies on recent reforms to business taxation policy in Australia has highlighted the limitations of CGE models in this specific area. This paper outlines the ongoing development of a more detailed and theoretically rigorous cost of capital module for a CGE model. Following King and Benge, we develop a model in which the firm maximises the value of its shareholder equity, taking account of: various company and personal income tax regimes; various capital-gains taxes regimes (including a treatment of realisation-based capital-gains taxation); depreciation allowances; investment allowances; and the costs of issuing various securities. The model is developed in two stages: Firstly, we develop an expression for the value of the firm to its shareholders. This approach assumes a given level of before-tax profit and seeks to determine how changes in various tax rates and allowances might impact on the firm’s value and, thus, the rate of return available to those holding its equity. With the before-tax income streams fixed, movements in the value of the firm and the after-tax income flows tell us something about this rate of return. As well as gaining some insights into the effect of policy changes on the value of equity, we can readily infer from this the effect of policy adjustments on the willingness of investors to provide funds as stakeholders. Secondly, we construct and solve a constrained optimisation problem for all of the firm’s choice variables, using the expression for the value of the firm as the objective function. We develop a set of expressions to constrain the firm’s ability to maximise the after-tax return on equity to its shareholders, and solve for the cost of capital and, thus, the level of investment, for an optimising firm. This approach enables us to generate a time path for investment and the outcomes of the firm’s other choice variables (that is, a complete solution to the “producer problem”). In this framework, we can see how taxation can influence both the choices the firm makes and the outcomes it can expect given those choices. By embedding this in a dynamic CGE model like MONASH, we can simulate the effects of tax changes on the user-cost of capital and thus on investment.

Suggested Citation

  • Winston, Ashley, 2002. "Developing a Cost of Capital Module for Computable General Equilibrium Modelling," Conference papers 331042, Purdue University, Center for Global Trade Analysis, Global Trade Analysis Project.
    • Handle: RePEc:ags:pugtwp:331042
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