Finance and Economics Discussion Series (FEDS)
November 1997
Inflation, Taxes, and the Durability of Capital
Darrel Cohen and Kevin Hassett
Abstract:
Auerbach (1979, 1981) has demonstrated that inflation can lead to large inter-asset distortions, with the negative effects of higher inflation unambiguously declining with asset life. We show that this is true only if depreciation is treated as geometric for tax purposes. When depreciation is straightline, higher inflation can have the opposite effect, discouraging investment in long-lived assets. Since our current system can be thought of as a mixture of straightline and geometric, the sign of the inter-asset distortion is indeterminate. We show that under current U.S. tax rules, the "straightline" and "geometric" effects approximately cancel for equipment, causing almost no inter-asset distortions. For structures, inflation clearly causes substitution into long-lived assets.
Full paper (102 KB Postscript)Keywords: Inflation, user cost of capital, capital durability
PDF: Full Paper
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