Mr. Evans, an economist in the Western Hemisphere Department, was a Research Fellow at The Brookings Institution before coming to the Fund. He holds degrees from the University of Sydney and the University of Pennsylvania.
Mr. Kenward, Senior Economist in the Asian Department, was in the Western Hemisphere Department when this paper was prepared. He worked at the Bank of Canada before coming to the Fund. He received his Ph.D. from Queen’s University, Canada.
The peak marginal tax rate had been reduced from 70 percent to 50 percent in the Economic Recovery and Tax Act of 1981.
For interest to be deductible, loans for other purposes cannot exceed the homeowner’s cash equity.
Under previous law, only 40 percent of long-term capital gains was subject to tax, which thus set the top effective rate at 20 percent.
Under the new ACRS rules, most types of manufacturing equipment are depreciated over seven years, compared with five years under previous law. Some longer-lived types of equipment are depreciated over ten years (five years previously). Cars and light trucks are depreciated over five years (three years previously). Nonresidential real property is to be depreciated over a 31.5-year period (19.0 years previously), whereas residential rental property is depreciated over 27.5 years (19.0 years previously).
This legal doctrine had generated a substantial tax incentive for corporate mergers and acquisitions. Under the rule, these activities provided a mechanism for liquidating appreciated assets without paying taxes on the gains: the repeal of the general utilities rule took effect at the end of 1986 and may help to explain the surge in mergers and acquisitions in the second half of 1986. A detailed discussion is provided in Steindel (1986).
For a discussion of the importance of the links between tax policy, international capital mobility, and competitiveness, see Summers (1986).
The TAXSIM model computes marginal tax rates and tax payments for a synthetic 1988 population of over 30,000 taxpayers; see Hausman and Poterba (1987).
;The results of the Summers model, of which the Council’s model is an extension, have been shown to vary considerably depending on the parametric assumptions; see Evans (1983).
The TRA generates a revenue bonus for state and local governments by broadening the tax base, so that the effect on the state and local government surpluses could be positive; the magnitude of any such effect would depend on the extent to which state and local governments take offsetting action by raising spending or lowering tax rates.
In 1986, gross private saving amounted to 16.1 percent of gross national product (GNP), of which 2.7 percent was household saving and 13.4 percent was business saving.
The paper by Boskin (1978) is typically cited in favor of the existence of a positive interest elasticity of household saving, whereas that by Friend and Hasbrouck (1983) is frequently cited against that proposition.
The classic reference is Hall and Jorgenson (1967). A large volume of subsequent work discusses the impact of earlier tax policy changes on U.S. business investment; see, for example, Cohen and Clark (1984) and Brayton and Clark (1985).
The Council’s 1987 Annual Report cites two sets of figures, depending on which view is taken on a controversy about the relative importance of taxes on dividends and capital gains for determining the cost of equity capital. The figures cited above are those calculated under the presumption that taxes on capital gains are very important, whereas taxes on dividends are nearly irrelevant.
Summers (1987) argues that leveling the playing field is an issue of little economic importance, and that even if all nonneutralities were eliminated— which the TRA does not achieve—the gains would total about 0.3 percent of GNP.
For elasticities of substitution in production of 0.55 for equipment and 0.16 for structures, and for an induced interest rate decline of 0.8 percentage point.
The comparisons discussed in this section are relative to a baseline that assumes no tax reform.
As with the WEFA simulations, the WUMM results were based on a version of tax reform that, although qualitatively similar to the legislation finally enacted, was different in some details.
The empirical results are an extension of earlier, unpublished work by Corker and Kenward that soon will be made available in updated form in Corker, Evans, and Kenward (1988, forthcoming).
Lucas (1976) criticized standard econometric techniques of policy evaluation, arguing that when government policy changed in a significant way private economic behavior would shift, making invalid the assumption of constant economic structure.
The standard framework for the cost of capital used in assessing the impact of taxation on investment assumes that each asset is depreciated for tax purposes only once. To the extent that a secondary market exists for a given asset category, however, it becomes possible for an asset to be depreciated for tax purposes several times. In this way the tax benefits from accelerated depreciation schedules could be much higher than normally indicated, in the case of assets for which a secondary market is well established. This argument would imply that the possible impact of the TRA on investment in business structures may be higher than indicated by a cost of capital calculation because the tax benefits that were removed by the TRA might otherwise have been used several times.
For a derivation and explanation of the formula, see Ott, Ott, and Yoo (1975). A useful guide—in particular, to the calculation of the present value of depreciation allowances—is provided in Hall and Jorgenson (1971).
A weighted average of the interest rate on ten-year BAA-rated corporate bonds, the Standard and Poor’s dividend-price ratio for common stocks, and the three-month U.S. Treasury bill rate, which is used as the proxy for the imputed cost of internally generated funds, was used. 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.
A weighted-average service life was calculated for equipment and for structures, and economic depreciation was taken to be the inverse of the estimated service lives.
From 1979, the ten-year-ahead survey of expected inflation conducted by Drexel Burnham Lambert was used; before 1979, a four-quarter moving average of the University of Michigan’s survey of one-year-ahead consumer price expectations was used. Strictly speaking, p should represent the expected rate of increase of prices of investment goods; the implicit assumption is that this is adequately captured by expectations of general price-level movements.
The specification follows the interpretation by Clark (1979) of Bischoff’s (1971) formulation of the neoclassical theory of investment. A more detailed discussion of the specification is provided in Corker, Evans, and Kenward (1988, forthcoming).
Quarterly observations for the gross capital stocks were constructed by interpolating annual end of year stocks according to the patterns of gross investment throughout the year.
If tax reform is assumed to have induced a 1 percentage point decline in before-tax nominal interest rates, then the estimated rise in the cost of capital for equipment is reduced to 22 percent and that for structures to 29 percent.
The starting point was set at 1986 because the retroactive repeal of the investment tax credit (to the start of 1986) was broadly anticipated. The terminal point of 1992 was chosen keeping in mind the long distributed lag terms in the investment equations.