How Taxes Affect Economic Behavior

By Henry J. Aaron; Joseph A. Pechman | Go to book overview
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tions regarding both the response of macroeconomic policy and the method of financing the business tax cut are necessary to obtain a reasonable estimate of the impact of the change in tax lives or of any capital- allocative policy.40. We hope that future work will be devoted to such a general equilibrium analysis.

With regard to business investment, further experimentation with measurement of the cost of capital is probably in order. Specifically, the effect of possible anticipation of the removal of the investment credit in 1969 should be modeled and, more generally, care should be given to distinguishing between temporary and permanent (in the eyes of businessmen) changes in the components of the cost of capital. Consideration of alternative proxies for the expected cost of equity funds and expected inflation might also be desirable. Finally, experimentation with more general production functions, such as the translog function, is another area for future work.41.

Appendix: The Real User Cost of Capital

In this appendix we derive a general expression for the real user cost of capital, discuss difficulties in computing expected real after-tax financing rates, and present the data underlying the computed costs of capital for equipment and structures.

Basic Framework

As is well known, the decision to invest depends on whether the present value of the expected future revenue generated by investment, net of direct operating expenses and indirect taxes, exceeds the supply price of capital. In our analysis we assume that inflation is expected to cause the supply price of capital and net revenues to rise at rate p (profit margins are constant). Further, the productivity of the investment and thus real net revenues are expected to decline at the output decay rate of d per year for a finite period N, at which point the capital good is discarded. In

See Patric H. Hendershott and Sheng-Cheng Hu, "The Relative Impacts of Various Proposals to Stimulate Business Investment,"in George M. von Fursten berg , ed., The Government and Capital Formation (Ballinger, 1980), pp. 321-36.
See, for example, Ernst R. Berndt and Laurits R. Christensen, "The Translog Function and the Substitution of Equipment, Structures, and Labor in U.S. Manufacturing, 1929-68," Journal of Econometrics, vol. 1 ( March 1973), pp. 81-113.


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