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Finance and Economics Discussion Series
The Finance and Economics Discussion Series logo links to FEDS home page 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.

Keywords: Inflation, user cost of capital, capital durability

Full paper (47 KB PDF) | Full paper (102 KB Postscript)

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Last update: January 15, 1998