Depreciation Deductions Research Articles

Tax Concessions and Investment Behaviour

The Government of Pakistan, like many other developing countries, has opted for tax holidays as an important fiscal measure to encourage rapid industrialisation in the backward areas. This concession is also supplemented by several other economic and non-economic measures including import duty, and depreciation allowances. Mintz (1990) discusses the efficacy of tax holidays in the presence of accelerated depreciation allowances concludes that tax holidays which are designed to increase capital formation may end up penalising capital formation. Mintz’s (1990) conclusion is based on the assumption that if the assets are long-lived, and the income tax system allows deductibility of accelerated depreciation but cannot be deferred, then the tax holidays, by preventing depreciation deduction in the early period may actually penalise investment during the tax holiday period. If on the other hand the depreciation allowance is deferred till the end of tax holiday period, the tax system is genuinely generous and provides a real incentive for capital formation.

The Corporate Use Of Debt Substitutes in Canada: A Test of Competing Versions Of the Substitution Hypothesis

AbstractThis study provides an empirical examination of three competing versions of the substitution hypothesis presented in the literature by Dammon and Senbet, De Angelo and Masulis, and Dotan and Ravid. This hypothesis postulates an inverse relationship between the amount of investment and debt‐related tax shields used by a firm. Proxies for both of these tax shields, which are superior to ones used in previous studies, were used to test the hypothesis both cross‐sectionally and across time at the individual firm level, using Canadian data. In general, our results do not support the De Angelo and Masulis or the Dotan and Ravid versions of the hypothesis. However, our cross‐sectional results are supportive of the Dammon and Senbet version, for a subsample of firms that use the same production technology, i. e., are all in the same industry. Time series tests of stability in the variables reveal a relationship more in line with Miller's “neutral mutation” argument than with the substitution hypothesis. These results suggest that while in aggregate firms exhibit stability in their use of both tax shields, relatively few individual firms do. Likewise, the time series test of the substitution hypothesis for individual firms reveals that the hypothesis holds for relatively few firms. This result also lends support to the Dammon and Senbet version of the hypothesis.RésuméCet article examine empiriquement trois versions de l'hypothèse de substitution suggérées par Dammon et Senbet, De Angelo et Masulis, et Dotan et Ravid. Cette hypothèse postule l'existence d'une relation inverse entre, d'une part, le montant des investissements réalisés par une firme et, d'autre part, les avantages fiscaux reliés aux titres de dette. Cette hypothèse est testée sur un échantillon d'entreprises canadiennes à l'aide de variables‐témoin supérieures à celles qui ont étéutilisées auparavant. En général, nos résultats ne supportent pas les versions de l'hypothèse proposées par De Angelo et Masulis et par Dotan et Ravid. Cependant, en ce qui a trait aux entreprises faisant partie de la měme industrie, nos résultats de coupe par section appuient la version élaborée par Dammon et Senbet. Nos tests de stabilitétemporelle des variables révèlent une relation analogue à l'argument de “mutation neutre” énoncépar Miller. Egalement, nos tests démontrent qu'au niveau de l'entreprise, l'hypothèse de substitution n'est maintenue que dans quelques cas. Ce résultat appuie aussi la version de l'hypothèse de substitution avancée par Dammon et Senbet.

A COMPREHENSIVE LEASE/PURCHASE MODEL

ABSTRACT This study presents comprehensive formal expressions for the net advantage of leasing over buying, Δ, in the presence of all of the following parameters of the leasing issue: intertemporal changes in tax rates, loan repayment schedule, financial leverage, scrap value and inflation. The leasing model derived in this study implies the following results. When the tax rate to the lessor (Tr ) is higher than that to the lessee (Te,), Δ increases with the present value of both depreciation and interest deductions. Interestingly, Δ can.also be positive even if Te > T Tr. The existence of positive salvage value increases Δ even higher, independently of the depreciation and loan repayment schedules. The financial leverage has a positive impact on Δ, while the impact of inflation on Δ depends on both the depreciation and loan repayment schedule as well as on the inflation level itself. A discount-rate asymmetry also has an impact on Δ. Specifically, Δ is positive (negative) as the discount rate of the less...

Corporate Leverage and Nondebt Tax Shields: Evidence on Crowding‐Out

AbstractA negative relationship between corporate leverage and tax shields has been predicted because a large nondebt tax shield reduces the expected value of interest tax savings and lessens the advantage of debt financing. Previous studies, however, have provided inconclusive and contradictory evidence on whether nondebt tax shields crowd‐out debt financing. The analysis herein relies on unique constructs of discounted depreciation tax shields and presents evidence that crowding‐out does not occur. Furthermore, it is shown that contradictory inferences may result from analysis of annual tax depreciation deductions instead of discounted tax shields. The findings suggest that firms with substantial cash flow from depreciation exploit their higher debt capacity by maintaining a capital structure with significantly more debt than otherwise.

Effects of Management Buyouts on Corporate Interest and Depreciation Tax Deductions

THIS article reports depreciation and interest tax deductions associated with 83 management buyouts completed during 1982-86 and discusses how both the magnitudes of these deductions and the tax savings to be gained from them are affected by the tax environment and economic circumstances of the buyout. Our discussion of the effects of the tax environment includes estimates of the impact on buyout-related deductions of two major pieces of tax legislation: the Economic Recovery Tax Act (ERTA) of 1981 and the Tax Reform Act (TRA) of 1986. These estimates provide evidence on the sensitivity of buyout-related tax subsidies to specific features of the code. Presumably, these sensitivities will help determine trends in future tax-driven restructurings. One focus of our analysis of the tax environment is the alleged tax incentives ERTA provided for acquisitions. Specifically, a transfer of assets enabled both a step-up in the tax basis of assets (also available prior to 1981) and the application of Accelerated Cost Recovery System (ACRS) depreciation to the new basis. Scholes and Wolfson' document

Capital Structure Decisions in Real Estate Investment

This study examines the financing decisions of real estate investors and the choice of capital structure when acquiring income‐producing properties. Drawing from the literature in finance and real estate, we develop a capital structure model for real estate investment and derive six hypotheses regarding the relationship of the overall loan‐to‐value ratio chosen by an investor to selected characteristics of the investment. The hypotheses are then tested using financing data from a sample of apartment and commercial transactions over a fifteen‐year period in a specific real estate market. The empirical findings strongly support the importance of depreciation deductions, financial distress costs, capital constraints, tax rates, and interest rates as determinants of the capital structure of real estate investors.

Corporate Tax Holidays and Investment

Governments of developing countries commonly adopt tax holidays to encourage investment. This article evaluates the incentives provided by company income tax holidays and explains the importance of the timing of depreciation allowances in determining the effective tax rates and the cost of capital to firms considering additional investment during the holiday. If an asset is long-lived and depreciation allowances for tax purposes are accelerated, the tax holiday, by preventing depreciation deductions during the periods of peak profits, may actually penalize a company for investing during the holiday. The closer the investment to the end of the holiday period, the more severe the penalty. If, instead, depreciation allowances may be deferred until after the holiday, this program of incentives is quite generous to the firm. How these sharply contrasting results may emerge is illustrated through estimation of effective tax rates and user costs of capital under tax holiday systems in Bangladesh, Cote D'Ivoire, Malaysia, Morocco, and Thailand.

Tax Neutrality and Intangible Capital

The Tax Reform Act of 1986 (TRA) attempts to "level the playing field" between equipment and other tangible assets by repealing the investment tax credit that was available only for equipment. This change may not increase economic efficiency, however, if there exist substantial amounts of intangible capital. Advertising along with research and development (R & D) are viewed as investments in goodwill and production expertise. As forms of intangible capital, they receive the significant tax advantage of immediate expensing rather than delayed depreciation deductions. This chapter finds that 1. Effective tax rates are mismeasured when this investment is ignored. 2. The United States in 1983 had about $165 billion of advertising capital and $305 billion of R & D capital, which together make up 11 percent of the total capital stock. 3. The inclusion of this intangible capital with a zero effective tax reduces by one-third the gain in efficiency from prior law obtained by repealing the investment tax credit for equipment. 4. With more of this untaxed intangible capital, repeal of the investment tax credit can actually reduce overall efficiency. 5. The TRA always increases this measure of production efficiency because it lowers the taxation of other tangible assets at the same time that it repeals the investment tax credit.

Measuring the Impact of the Safe Harbor Lease Law on Security Prices

As part of the Economic Recovery Tax Act of 1981 Congress enacted a lease law that allowed firms to sell tax depreciation deductions and investment tax credits to other firms. The law was repealed a year later in the Tax Equity and Fiscal Responsibility Act of 1982 because of charges of ineffectiveness and excessive cost to the Treasury. Prior research has investigated the allocation of tax benefits in safe harbor leases by examining the amounts that firms were willing to pay for the tax benefits.1 In this study, I extend this line of research by (1) examining the attributes of firms entering into the leases; (2) evaluating the effects of the enactment and repeal of the law on the security prices of these firms; and (3) evaluating the effects of announcements of specific lease transactions on the share prices of both lessees (sellers of tax benefits) and lessors (buyers of tax benefits). My results indicate that the law encouraged firms in financial stress to effect asset restructurings. At least 60% of NYSE firms (68) reporting tax losses and over $50 million of capital expenditures in 1980 disclosed

THE INFLUENCE OF TAX LEGISLATION ON FINANCIAL ACCOUNTING: A STUDY OF THE TIMBER INDUSTRY, 1905–1925

The purpose of this paper is to examine the financial accounting records of a Mississippi timber company and its subsidiaries in light of the dynamic tax environment of the period 1905 to 1925. The financial accounting records and correspondence with the Commissioner of Internal Revenue indicate deficiencies in the following areas: asset valuation, a lack of a cost accounting system to adequately value inventories, and the depletion and depreciation deduction. The demands of the new tax laws were often in conflict with the accounting practices of this period of time forcing changes in accounting practice.

Monetary Uncertainty and Investment in an Optimizing, Rational Expectations Model with Income Taxes and Government Debt

THE EFFECT OF MONETARY GROWTH on an economy's investment has long been of interest to economists, and monetary growth models provide a convenient tool for the analysis of this question. The standard optimizing growth model postulates that money is injected into the private sector through transfer payments which typically either are of lump sum form or are proportional to wealth, income, or money holdings. (See, for example, Brock (1974), Calvo (1979), Fischer (1979), and Gertler and Grinols (1982).) In these models monetary changes are tied directly to changes in subsidy or tax rates, and greater expected money growth generally either has no effect on investment or increases it through a Tobin (1965) effect. In this paper we analyze the effects that a stochastic monetary policy has on investment in an economy with individual optimization, rational expectations, and a government which makes expenditures and finances them through borrowing, money creation, and proportional income taxes. With such a formulation, money can be injected into the private sector through government purchases and open market operations as well as through transfers, and the link between money growth and subsidy or tax rates is weakened or nonexistent. We assume that the nominal income tax rates are constant over time. Given tax rates and (stochastic) government consumption, the stochastic monetary growth rule followed by the government induces a stochastic government debt policy. The effects that changes in the stochastic monetary growth rate have on investment depend on the nature of the depreciation deduction and on the relationship between the coefficient of relative risk aversion and the tax rate on production income. When depreciation deductions are based on historical costs, an equilibrium is unique so long as the coefficient of relative risk aversion is greater than the tax rate applicable to production income. In this case an increase in the mean rate of money growth decreases equilibrium investment while a mean preserving spread in the money growth rate increases investment. Given Friend and Blume's (1975) finding that the coefficient of relative risk aversion is substantially greater than one, this seems to be the empirically relevant case. If the coefficient of relative risk aversion is less than the tax rate on production income, multiple equilibria are possible, and the effects on investment of changes in the stochastic money growth rate are generally indeterminate. When depreciation deductions are based on replacement costs, investment is independent of the stochastic money growth rate. The paper is organized as follows. Section 2 develops the optimization problem of the representative individual when depreciation deductions are based on historical costs. Section 3 describes the behavior of the government and develops the rational expectations equilibrium for this economy. Section 4 examines the effects on investment of changes in the stochastic money growth rate. Section 5 briefly reconsiders the model when depreciation deductions are based on replacement costs.

A RESPECIFIED TAX‐ADJUSTED FISHER RELATION

How much will a 1% increase in expected inflation increase nominal interest rates? Irving Fisher's famous equation implies that nominal interest rates will rise in proportion to an increase in expected inflation. Darby and Feldstein, correcting the Fisher equation for taxation, predict a nominal interest rate increase of [1/(1 ‐ T)]% where T is the marginal tax rate: i.e., if T =3, then a 1 % increase in expected inflation should cause a 1.4 % rise in interest rates.Empirical evidence, however, suggests that the rise in interest rates is much smaller than the Darby/Feldstein prediction. Estimates are around 9, varying mostly between 5 and 1.15, which is much closer to Fisher's original prediction. It is important to know the size of the interest rate response to inflation expectations in a world in which inflation and interest rates are volatile and in which tax laws are designed to influence savings and investment through interest rates.In this paper we attempt to close the gap between theorized and estimated effects of inflation by incorporating into the Fisher equation two important aspects of the U.S. tax code: historic cost depreciation and the lower tax rate on capital gains. Our model shows that the effect of expected inflation on interest rates is dampened by the lower benefits from depreciation deductions arid the capital gains tax.Our corrected Fisher equation predicts a 1.12 % nominal interest rate increase, rather than the 1.4 % increase implied by the Darby/Feldstein model. The, our model closes about 56 % of the gap between theory and empirical evidence. The remainder could be closed by additional refinements in the model or better empirical modeling.

Financial Leasing under Inflation

* In last decade, there has been a relatively rapid growth in leasing as a method of financing. Anderson [1] estimated that during period ending in 1980, approximately twenty percent of new acquisitions of capital goods in U.S. were financed by leases. Lewellen, Long, and McConnell [13] have demonstrated that in a perfect market competitive market equilibrium lease payments will be determined such that the lease or buy choice will be a matter of indifference (p. 790). They conclude that there may exist market imperfections such as tax rate differentials between lessors and lessees, differences in realizable depreciation deductions and salvage values, and different borrowing possibilities, which may lead to exploitable opportunities by lessors and lessees. While these and many other factors may contribute to a cost difference between leasing and purchasing an asset, income tax differentials among firms were emphasized by Myers, Dill and Bautista (MDB) [15] as major market imperfection stipulating lease financing. Miller and Upton [14] suggested that other tax asymmetries, such as inability of some firms to exploit investment tax subsidies, are important in explaining existence of leasing. However, in light of recent growth in leasing industry, it seems that there may be other factors that accentuate tax-related effects and further

Equitable Renewable Energy Tax Credits for Industry

Without tax credits, the federal tax treatment of industrial investments in conservation and solar technologies (CSTs) places them at a disadvantage with respect to conventional fuels. The costs of conventional fuel use lie mainly in the cost of the fuel itself and can be deducted from the tax base of the industrial investor at the time of the expense. However the costs of energy supplied or saved by CSTs occur primarily in the form of initial investment costs, for which the tax deductions must be spread out over several years according to a depreciation schedule. The time value of money reduces the worth of these depreciation deductions below their face value and below the value of comparable conventional fuel costs deductions. There are two obvious ways to correct this inequality: (i) allow total depreciation of CST investments in the first year (1), or (ii) grant a tax credit to CST investors. This paper addresses the issue of the size of the tax credit necessary to compensate for the delay in depreciation deductions.

Distortions Imposed by Inflation on Historical-Cost Depreciation

The use of historical-cost depreciation in periods of persistent inflation decreases the present value of depreciation deductions, thus understating the true economic cost of capital and increasing the real after-tax rate of return required by potential investors. Efforts to correct these problems by adopting depreciation methods that allow for artificially short recovery periods or accelerated rates do not provide an adequate solution. Distortions imposed by inflation on historical-cost depreciation can be adequately corrected by indexing the historical-cost basis.

Accelerated depreciation and the efficacy of temporary fiscal policy: Implications for an inflationary economy

The effect on investment of temporary tax rate changes depends on the age profile of depreciation deductions. If the depreciation allowance schedule is accelerated, then temporary cuts in the corporate tax rate could reduce investment. Inflation causes the age profile of real depreciation deductions to become accelerated and thus could make temporary tax cuts have a contractionary effect on investment. Two currently proposed reforms are shown to exacerbate this effect. Under each of these proposals, temporary tax cuts are likely to have opposite effects on investment in short-lived and long-lived capital, thereby complicating the conduct of countercyclical fiscal policy.

Taxes, Inflation, and the Durability of Capital

The choice of capital durability is affected by the rate of inflation because nominal depreciation deductions are based on historical cost rather than replacement cost. This paper analyzes a model with competitive firms and demonstrates that an increase in the rate of inflation will lead to an increase in the durability of capital, if the ratio of the nominal discount rate to the rate of depreciation exceeds a critical value. However, if this ratio is less than the crucial value, this effect is reversed. The effect of costs of adjustments on the crucial value is analyzed.

ADJUSTING DEPRECIATION IN AN INFLATIONARY ECONOMY: INDEXING VERSUS ACCELERATION

With the existing historic method of depreciation, higher inflation rates reduce the real value of future depreciation deductions and therefore raise the real net cost of investment. The calculations in this paper show that this rise in the net cost can be quite substantial at recent inflation rates; e.g., the real net cost of an equipment investment with a 13 year tax life is raised 21 percent by an 8 percent expected inflation rate if the firm uses a 4 percent real discount rate. The effects of inflation on the net cost of investment can be completely eliminated by indexing depreciation. A more accelerated depreciation schedule can also lower the net cost of investment and make that net cost less sensitive to the rate of inflation. The current paper examines a particular acceleration proposal and finds that, for moderate rates of inflation and real discount rates, the acceleration proposal and full indexation are quite similar. For low rates of inflation, high discount rates, or very long-lived investments, the acceleration proposal causes greater reductions in net cost than would result from complete indexing. Conversely, for high rates of inflation, low discount rates, or very short-lived investments, the acceleration method fails to offset the adverse effects of inflation. Since the acceleration and indexation methods have quite similar effects under existing economic conditions, the choice between them requires balancing the administrative simplicity and other possible advantages of acceleration against the automatic protection that indexation offers against the risk of significant changes from the recent inflation rates and discount rates.

Depreciation and interest deductions and the effect of the corporation income tax on investment

In this paper, we examine the effect of the corporation income tax on the investment decision of the firm particularly with respect to the role of interest and depreciation deductions in determining the neutrality of the tax. We demonstrate the need for introducing a constraint on corporate borrowing before a meaningful analysis of the firm's behaviour under certainty is possible. The effect of a given tax and deduction scheme on the firm's investment decision is found to depend on the form of this constraint. We then relate our results to that of earlier authors and indicate some problems with their analyses.

Investment Neutrality of Business Income Taxes

I. Introduction, 245.—II. The model, 247.—III. The model with full investment write-off, 248.—IV. Depreciation deductions depend on the capital stock, 251.—V. Depreciation deductions depend on the time profile of past investments, 256.—VI. Concluding comments, 258.