Are Investment Incentives Blunted by Changes in Prices of Capital Goods?

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Recent research on business investment decisions suggests that real investment in plant and equipment is quite sensitive to changes in the user cost of capital, pointing to the possibility that long-run changes in tax policy may have a significant impact on an economy's capital stock. Indeed, many countries have at times adopted investment tax incentives to stimulate investment. The prevalence of investment incentives suggests that local policymakers believe that incentives are effective in increasing investment at a reasonable cost in terms of lost revenue for a given increment to investment. In this paper, we explore this issue by estimating the extent to which countries are price-takers in the world market for capital goods. We find that most countries -- even the United States -- likely currently face a highly elastic supply of capital goods, suggesting that the effect of investment incentives on the price of investment goods is small. Hence efforts of long-run changes in investment tax policy are likely to materialize in real investment rather than simply being dissipated in changes in capital-goods prices.

Published: International Finance, vol. 1, no. 1, pp. 106-125, 1998.

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