General equilibrium effects of investment incentives in Mexico

Abstract

Mexico has experimented with a number of tax instruments designed to promote private capital formation. Among such initiatives are general and industry specific tax credits, employment tax credits, and corporate tax reductions. This paper examines the relative efficacy of such instruments using a dynamic computable general equilibrium model. Model simulations with Mexican data are carried out using three equal yield investment incentive scenarios. We find that a corporate tax reduction has the most stimulative impact on investment. The results emphasize the importance of using an open economy model. Unlike, for example, investment tax credits, tax rate reductions increase the demand for all capital rather than new capital alone. Hence the public increases its holdings of domestic debt, causing the price of domestic bonds to rise, real interest rates to fall, and domestic investment to increase.