Deficits, Interest Rates, and the User Cost of Capital: A Reconsideration of the Effects of Tax Policy on Investment

32 Pages Posted: 2 Aug 2005

See all articles by William G. Gale

William G. Gale

Brookings Institution

Peter R. Orszag

Lazard Asset Management

Date Written: July 2005

Abstract

Under traditional formulations, lower capital income tax rates reduce the user cost of capital and stimulate investment. The traditional approach, however, implictly or explicitly considers a revenue-neutral reduction in capital income taxation. We extend the traditional approach by considering a reduction in taxes that generates an increase in the budget deficit; the expanded budget deficit raises interest rates and the opportunity cost of investment. This provides a mechanism through which tax cuts can raise the cost of capital. Representative calculations show that, even with relatively modest interest rate effects, the net effect of making the Administration's recent tax cuts permanent or a 10-percent reduction in individual income tax rates would be to raise the user cost of capital. Thus, sustained tax cuts can raise the cost of capital and reduce investment.

Keywords: deficits, interest rates, user cost capital, tax policy

JEL Classification: H2

Suggested Citation

Gale, William G. and Orszag, Peter R., Deficits, Interest Rates, and the User Cost of Capital: A Reconsideration of the Effects of Tax Policy on Investment (July 2005). Available at SSRN: https://ssrn.com/abstract=774485 or http://dx.doi.org/10.2139/ssrn.774485

William G. Gale (Contact Author)

Brookings Institution ( email )

1775 Massachusetts Avenue, NW
Washington, DC 20036
United States
202-797-6148 (Phone)
202-797-6181 (Fax)

Peter R. Orszag

Lazard Asset Management ( email )

30 Rockefeller Plaza
New York, NY 10112
United States

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