Regional effects of investment incentives

Abstract

The Economic Recovery Tax Act of 1981 (ERTA) offers a number of powerful investment incentives. The Accelerated Cost Recovery System provisions of the act allow firms to depreciate structures over 15 years, equipment over 5 years, and vehicles over 3 years; in addition, the act expands the investment tax credit. Hulten [7] has estimated that ERTA will lower the effective tax rate from 33 to 12%. Some critics of the act contend that it is biased against the older Frostbelt regions.2 They argue that these incentives will lead to faster capital formation in the South and West and a new wave of plant closings in the Northeast and Midwest. Proponents of the act respond that it treats all regions equally since the more generous depreciation allowances are available to all investment regardless of location. This paper examines several potentially important short-run and long-run issues in this debate. Section II of the paper looks at an industry consisting of firms located in two regions. One of the regions is declining. No investment is forthcoming in this region as capital is allowed to depreciate and then is eventually scrapped. A new tax policy that increases the present value of depreciation charges reduces the cost of using new capital but offers no benefit to the owners of old capital. I show that as a result of this new tax policy, old capital becomes less competitive and is scrapped sooner and the decline of the region that is contracting accelerates. Section III examines the impact of this change in tax policy on the industry’s long-run equilibrium. Wages are higher in one of the regions and, as a consequence, production in that region is capital intensive. I show that