Investment Ramifications of Distortionary Tax Subsidies

41 Pages Posted: 13 Jun 2017

See all articles by James R. Hines Jr.

James R. Hines Jr.

University of Michigan; NBER

Jongsang Park

Korea Institute of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: May 26, 2017

Abstract

This paper examines the investment effects of tax subsidies for which some assets and not others are eligible. Distortionary tax subsidies concentrate investments in tax-favored assets, thereby reducing the expected pre-tax profitability of investment and reducing payoffs to bondholders in the event of default. Anticipation of asset substitution encourages lenders to require covenants in debt contracts, which only imperfectly address asset substitution and distort investment. The result is that borrowing is made more expensive, which in turn discourages investment. Borrowing rates can react so strongly that aggregate investment may rise very little, or even fall, in response to higher tax subsidies. Debt issued by U.S. firms in risk of default after the 2002 introduction of bonus depreciation for U.S. equipment investment contained many more covenants than in other periods, a pattern that reversed when bonus depreciation was discontinued after 2004; furthermore, firms at risk of default borrowed less, and were more apt to lease capital, than were other firms during the bonus depreciation period.

Keywords: investment tax subsidies, business taxation, deadweight loss, corporate borrowing

JEL Classification: H25, G31, G33

Suggested Citation

Hines, James Rodger and Park, Jongsang, Investment Ramifications of Distortionary Tax Subsidies (May 26, 2017). U of Michigan Law & Econ Research Paper. Available at SSRN: https://ssrn.com/abstract=2985021 or http://dx.doi.org/10.2139/ssrn.2985021

James Rodger Hines (Contact Author)

University of Michigan ( email )

625 South State Street
Ann Arbor, MI 48109-1215
United States

NBER

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Jongsang Park

Korea Institute of Finance

4-1 Myung-dong 1-ga
Seoul 100-021
United States

Register to save articles to
your library

Register

Paper statistics

Downloads
37
Abstract Views
387
PlumX Metrics