Abstract
Problem statement: Previous studies (primarily employing goodness-of-fit tests) have found it difficult to provide clear and direct evidence that taxes and the interest rate have a strong influence on investment. Approach: The objective of this study was to test whether the cost of capital, which includes taxes and the interest rate, affects investment. This study used the Euler equation for investment, the Generalized Method of Moments estimator and the associated test of overidentifying restrictions (J statistic). Specifications including and excluding components of the tax system were estimated and the resulting J statistics were compared. This study also examined two potential problems with measuring another component of the cost of capital (the interest rate): (1) risk; (2) finance constraints. To examine the second issue, the Euler equation is modified by parameterizing the Lagrange multiplier on the finance constraint. The models with and without finance constraints were compared using a Newey-West test. Results: Including taxes in the investment Euler equation reduced evidence of misspecification. In particular, including the investment tax credit, the corporate tax rate and interest deductibility, respectively, all lead to lower J statistics than omitting these tax considerations. Using a risky interest rate instead of the risk-free interest rate makes little difference. The Newey-West test rejected the model without finance constraints. Parametric estimated of the model with finance constraints suggest that variations in the tightness with which finance constraints bind lead to substantial variation in the effective discount rate. Taxes continue to matter in the model that incorporates finance constraints. Conclusion: The results suggested that the cost of capital (specifically, the tax system) influences investment and finance constraints are important.
Highlights
Economists frequently emphasize the role of prices in determining the allocation of goods
The objective of this study is to determine whether the cost of capital affects investment
The evidence presented in the section entitled “Results” shows that including taxes in the investment Euler equation reduces evidence of misspecification
Summary
Economists frequently emphasize the role of prices in determining the allocation of goods. When the neoclassical model includes long distributed lags, it tends to fit the data well, suggesting that the cost of capital influences investment. This interpretation has been criticized, because in the neoclassical model, tax variables enter together with output. Since investment is strongly correlated with output, there is some concern that entering the cost of capital in combination with output exaggerates the role of interest rates and taxes. This concern is reinforced by the fact that the accelerator model which allows no role for the cost of capital, tends to fit just about as well (Pindyck, 1991). On the basis of tests using the neoclassical approach, it has been difficult to persuade skeptics that the interest rate and taxes have a strong influence on investment
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