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Tax Policy and Irreversible Investment

  • Sumru Altug
  • Fanny S. Demers
  • Michel Demers

We examine the impact of tax policy uncertainty on the irreversible investment decisions of a monopolistically competitive firm. We consider the impact of tax policy in terms of the investment tax credit (ITC) as well as the stochastic tax wedge which determines the after-tax costs of investing. We show that (i) temporary tax incentives have a greater stimulative impact on investment; (ii) greater policy volatility results in greater variability of investment; (iii) a stochastically larger future tax policy lowers current investment; and (iv) greater variability of tax policy around a constant mean leads to lower investment. We examine changes in the average levels of investment and its variability over short- and long-run horizons. We consider a general 3-state process, a log-normal process, and a Poisson process. We carry out an extensive sensitivity analysis that allows us to examine the impact of changes in real interest rates, and changes in the elasticity of demand facing firms.

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Paper provided by Centre for Dynamic Macroeconomic Analysis in its series CDMA Working Paper Series with number 200404.

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Date of creation: 15 Nov 2004
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Handle: RePEc:san:cdmawp:0404
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