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Mr. Corker is an economist in the Asian Department and Mr. Kenward is a senior economist in the Asian Department; when the initial research for this paper was conducted, both were in the Western Hemisphere Department. Mr. Evans is an economist in the Western Hemisphere Department. The authors are grateful to P.B. Clark, E. Hernández-Catá, and Y. Horiguchi for helpful comments on earlier drafts. Mrs. F. Pham provided capable research assistance.
The paper deals with data up to and including the second quarter of-1987.
Real GNP reached a trough in the third quarter of 1982, before rising slightly in the fourth quarter of that year.
The recession trough for real GNP was earlier than that for business fixed investment.
The episodes beginning in 1961 and 1975 are the only postwar upswings of comparable length to the present expansion and were therefore chosen for comparison.
The implicit deflator for high technology equipment fell by 23 percent from the first quarter of 1983 to the second quarter of 1987, compared with a 1 percent decline for the deflator for total business fixed investment and a 14 percent rise for the GNP deflator for the same period.
Details regarding estimates of average service lives are provided in Fixed Reproducible Tangible Wealth in the United States, 1925-79 (Washington, D.C., U.S. Government Printing Office, 1982) and Musgrave (1976).
The assumption that the production function is of the Cobb-Douglas type (that is, that the elasticity of substitution between capital and labor in production is unitary) is critical and generates a specification that is potentially susceptible to large effects of tax policy and the cost of capital on investment.
For a derivation and detailed explanation of this formula, see Ott, Ott, and Yoo, 1975. It should be noted that if there are no taxes (u = τ = k = 0), the formula reduces to C = q(i + δ - ṗe).
A weighted average of the ten-year BAA corporate bond rate, the Standard and Poor’s dividend/price ratio for common stocks and the three-month Treasury bill rate, which is used as the alternative cost of internally generated funds. Both the BAA bond rate and the Treasury bill rate are entered on an after-corporate tax basis. The weights are the respective proportions of total credit market debt owed by private business, an estimate of total business equity, and corporate cash flow, in the sum of these items.
From 1979 onward, the ten-year ahead survey of expected inflation conducted by Drexel Burnham Lambert Inc. Prior to 1979, a four-quarter moving average of the University of Michigan’s survey of one-year ahead consumer price expectations. A regression of the ten-year ahead survey on the moving average of the Michigan survey over the period 1979-84 had yielded a regression coefficient of unity.
The maximum rate on capital gains.
The restrictions were not rejected at the 5 percent level by the appropriate F-test for both the structures and equipment equations.
Lucas (1976) criticized standard econometric techniques of policy evaluation, arguing that when government policy changes in a fundamental way--when there is a”regime change” in his terminology--private economic behavior would shift in response, invalidating the assumption of constant economic structure.
The use of the gross capital stock implies that economic depreciation follows a straight line rule. Using the net capital stock instead would imply exponential depreciation. The series for the quarterly capital stocks were constructed by a two stage process. First, given an assumed initial value, the actual quarterly gross investment flows, and depreciation rates, an initial quarterly capital stock series was constructed. The final quarterly series was then constructed by interpolating the available annual end-of-year capital stock series according to the pattern of the initially constructed series.
Presumably the previous extension of tax preferences under ERTA had a negative investment efficiency effect, by making the playing field less level.
The measures affecting business fixed investment contained in the Deficit Reduction Act (DEFRA) of 1984 were relatively minor.
The provisions and possible implications of TRA are discussed in detail in Evans and Kenward (1988).
In 1987, the rate was 40 percent.
Figures for the present value of depreciation allowances are in dollars, while those for the cost of capital are in percent. Figures presented exclude relative price effects.
Historical values that would have prevailed in the absence of changes in tax policy.
In the simulations, it was assumed that the retroactivity of ERTA to the beginning of 1981 was not anticipated by investors; the simulation was carried out as though there had been no change in legislation affecting the first three quarters of 1981. However, the retroactive abolition of the ITC under TRA, effective from the beginning of 1986, is assumed to have been fully anticipated--as it was widely forecast, in the financial press. The other provisions of TRA were assumed to take effect from 1986:4.
In all simulations the capital stock was treated endogenously and assumed to accumulate in line with simulated investment.
One major channel through which changes in inflation may influence after-tax profitability is with respect to inventories. When inflation increases, businesses become increasingly subject to taxation of artificial inventory profits, reducing profitability. If inventory accumulation and investment in fixed assets are both integral elements of the production process, then such taxation of artificial profits may curb not only the incentive to purchase inventory but also to accumulate fixed assets. However, in the standard formulation, as used in this paper, the incentives underlying accumulation of fixed capital are distinct from those affecting inventories, with the result that the mechanism just outlined is not present.
It should be noted that since a unitary elasticity of substitution in production between labor and capital was assumed, the specification was potentially favorable to the existence of large tax policy effects.