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Could Higher Taxes Increase the Long-Run Demand for Capital? Theory and Evidence for Chile"

  • Alvaro Bustos
  • Eduardo Engel

    ()

    (Economic Growth Center, Yale University)

  • Alexander Galetovic

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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File URL: http://www.econ.yale.edu/growth_pdf/cdp858.pdf
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Paper provided by Economic Growth Center, Yale University in its series Working Papers with number 858.

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Length: 28 pages
Date of creation: Jul 2003
Date of revision:
Publication status: Published in Journal of Development, Vol. 73, No. 2, 2004
Handle: RePEc:egc:wpaper:858
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Web page: http://www.econ.yale.edu/

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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. Eduardo M.R.A. Engel & Alexander Galetovic & Claudio E. Raddatz, 1998. "Taxes and Income Distribution in Chile: Some Unpleasant Redistributive Arithmetic," NBER Working Papers 6828, National Bureau of Economic Research, Inc.
  3. Chang-Tai Hsieh & Jonathan A. Parker, 2007. "Taxes and Growth in a Financially Underdevelopped Country: Evidence from the Chilean Investment Boom," ECONOMIA JOURNAL OF THE LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION, ECONOMIA JOURNAL OF THE LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION.
  4. 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.
  5. 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.
  6. King, Mervyn A, 1974. "Taxation and the Cost of Capital," Review of Economic Studies, Wiley Blackwell, vol. 41(1), pages 21-35, January.
  7. 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.
  8. Lucas, Robert E, Jr, 1990. "Supply-Side Economics: An Analytical Review," Oxford Economic Papers, Oxford University Press, vol. 42(2), pages 293-316, April.
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