Long-Run Effect of Taxes, Prices, and the Interest Rate on the Capital Stock

36 Pages Posted: 17 Mar 2007

See all articles by Huntley Schaller

Huntley Schaller

Carleton University - Department of Economics

Date Written: March 13, 2007

Abstract

This paper is the first paper to break user cost into its natural pieces - the risk-adjusted market interest rate, tax variables, and the price of capital goods - and estimate the long-run effect of each on the capital stock.

Why is the separation of user cost into interest rate, tax, and capital goods price components an interesting question? Finance constraints, for example, can lead to a wedge between the market interest rate and the shadow cost of finance. As a result, the estimated elasticity of the capital stock with respect to the interest rate might be close to zero. Similar issues arise when corporate governance problems (in the sense of Jensen 1986) cause empire-building managers to put weight not only on profitability but also on the size of their firm. Finance constraints can also affect the estimated elasticity of the tax component of user cost. With perfect capital markets, the marginal tax rate influences investment decisions, but the average tax rate is also relevant when firms face potentially binding finance constraints. To obtain estimates of the long-run effect of the interest rate, taxes, and capital goods prices on the capital stock, the paper is careful to use long-run econometric techniques (specifically, DOLS estimation of the relevant cointegrating relationship).

The empirical results show that the price of capital goods has an economically and statistically significant effect on equipment capital. The estimated long-run elasticity is about -0.9, precisely estimated, and robust to variation in the econometric specification. The elasticity of equipment capital with respect to the real interest rate is close to zero (and, in most cases, precisely estimated). This result is robust to a variety of econometric specifications. The preferred estimate of the long-run elasticity of equipment capital with respect to tax variables is -0.9.

The estimated elasticities have an unusually rich set of implications - for finance constraints, corporate governance, the operation of capital markets, economic growth, and monetary policy.

Keywords: Capital stock, investment, growth, trade policy, economic development, import substitution, protectionism, monetary policy, transmission mechanism, budget deficits, savings incentives, corporate tax design

JEL Classification: E22, E44, H25

Suggested Citation

Schaller, Huntley, Long-Run Effect of Taxes, Prices, and the Interest Rate on the Capital Stock (March 13, 2007). Available at SSRN: https://ssrn.com/abstract=970352 or http://dx.doi.org/10.2139/ssrn.970352

Huntley Schaller (Contact Author)

Carleton University - Department of Economics ( email )

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