Investment Tax Incentives and Frequent Tax Reforms

Alan J. Auerbach
James R. Hines Jr., University of Michigan Law School

Reproduced with permission.


In the uncertain business of planning for U.S. corporate investment, one of the few reliable forecasts one can make is that the tax law will change before any new investment outlives its usefulness. While the Tax Reform Act of 1986 mandates an unusually dramatic reform in the structure of business taxation and the incentive to invest, the simple fact that Congress chose to alter in 1986 the tax treatment of new investments is hardly surprising. Earlier in the 1980's, Congress changed investment incentives with new tax legislation in 1981, 1982, 1984, and 1985, and over the period 1953-85 made such changes in 16 different years. The willingness, indeed, eagerness, of the U.S. government to amend the rate at which it taxes new investments seems likely to have substantial consequences for investor incentives. By far the bulk of an investor's return comes in years subsequent to the year in which new plant and equipment is put in place. Tax reforms affect investor returns not only by changing the amount of money owed the government, but also by encouraging or discouraging competing future investment and thereby changing levels of before-tax future earnings. For example, the knowledge that Congress plans to introduce a large investment tax credit in two years seems likely to depress investment this year and next, since the investment wave two years hence will be expected to drive down the return to any capital already in place when it starts. Despite the frequency of tax changes and their potential importance to investors, almost all of the analysis of tax-based investment incentives follows the seminal work of Dale Jorgenson (1963) in assuming investors never anticipate any tax changes. Re­cent examples include Auerbach (1983) and Mervyn King and Don Fullerton (1984). The U.S. Treasury Department in its tax reform proposal (1984) analyzed investment incentives in each year of its phased-in reform package under the assumption that investors never anticipate the sequence of tax changes that is explicitly part of the reform. In this paper, we depart from this approach by analyzing the historical pattern of U.S. corporate investment incentives over the period 1953-86, incorporating the feature of investor awareness that next year's tax code may not be the same as this year's.