Why Taxes Matter: Reagan's Accelerated Cost Recovery System and the US Trade Deficit

Abstract

Accelerated depreciation and the US trade deficit Hans-Werner Sinn In 1981 the introduction of the Accelerated Cost Recovery System (ACRS) dramatically reduced the tax depreciation periods for most US corporate investment. This is likely to have caused an investment boom in the US, an increase in world interest rates, and a massive redistribution of world capital towards the US. US trade deficits are the counterpart to this capital flow. The mechanism is straightforward. Double tax agreements mean that interest income is taxed according to the residence principle, hence world financial markets tend to equate pretax rates of interest. Effectively, debt is the marginal source of investment finance, and investment will proceed until its post-tax return equals the pre-tax interest rate. With US corporations enjoying a larger tax offset on depreciation, the US capital stock will expand, interest rates will increase, and the capital stock in the rest of the world will contract. Thus the introduction of ACRS in 1981 may simultaneously explain the US investment boom, the strength of the Dollar, high world interest rates, and the US trade deficit. Conversely, current proposals to abolish or reduce ACRS can be expected to have the opposite effect.