and forward values of the wage-capital cost ratio and of the output. The equation so obtained, with modification, is shown to adequately characterize the investment behavior of the private manufacturing industry in Taiwan. The most critical variables in the investment function, we note, are one-year lagged and current wage-capital user cost ratios and the current output.
Using our empirical model, we estimated the effect on gross investment of a tax policy measure, Taiwan's investment tax credit. In the context of the Taiwan economy, the ITC is shown to have been an effective stimulus for investment. Not only has the ITC provided a potent investment stimulus but it has done so while being a net contributor to government revenue. The distinctive feature of the present analysis is the inclusion of the wage-capital cost ratio (w/c) in the model and the specification of the appropriate lag structure assigned to this variable to account for the substitution effect involving labor and capital. Previous studies of investment behavior in Taiwan that attest to the dominant influence on investment of the sales prospects and to little or no role for the relative input costs may be faulted for their failure to include the variable(s) to capture this substitution effect. As the economy continues its high-rate growth with labor shortages becoming increasingly acute, the rise in w/c accelerates. The substitution effect, given the rapid rise in real wages evident in the statistics, must have played an important role in investment decisions in Taiwan.