Question

1. Consider a neo-classical investment model with depreciable capital and a corporate income tax system where is the corporate tax rate, α is the tax depreciation (CCA) rate, and k is the investment tax credit (ITC) rate. The share of investment financed by debt is B, the economic depreciation rate is 6, the interest rate on debt is i, the required rate of return on equity is p, and the price of a unit of output and capital are both normalized to unity. There are no adjustment costs, and capital can be instantaneously ad justed to its optimal level. Assume that Canada can be modelled as a small open economy and that for simplicity there is no inflation. The current tax system is characterized by the deduction of nominal debt interest (but not the required return to equity), the deduction of cap- ital cost allowances on a declining balance basis at the rate α, and an investment tax credit which is equal to a fraction k of the total cost of investment (a) Say Canada is considering a tax reform package with the following features: » An elimination of the ITC; . An increase in the tax depreciation (CCA) rate; . A decrease in the corporate tax rate Discuss generally how each of these changes would individually affect the incentive to invest in corporate capital. Can you tell whether or not investment will increase or decrease as a result of the total tax reform package? Why or why not? (b) Now assume the following: ii. β-40 iii, δ= .20 iv. The ITC is initially equal to k-10 prior to its elimination v. The tax depreciation (CCA) rate is increased from 20% to 50% vi. The corporate tax rate is decreased from 25% to 15% Calculate the METR before and after the tax reform package and comment on its impact on investment

Answer 1

a) An elimination of ITC i.e., investment tax credit , will help the producer to plan more investment in the future. An increase in the depreciation rate means more deduction in the tax rate. Similarly, a decrease in the corporate tax rate encourage to invest more and more, so the decision of the canada government change the investments of the individual and so it is profitable. The reduction in the corporate tax is very important to influence the rental cost of capital. Due to the government decision through the tool of taxation, the rental cost of the capital comes down and it increases the investment.

b) the marginal effective tax rate before the elimination shows that it is not encourageable to foster the investment. METR is an analytical measurement developed to understand various tax burden in various countries. Before the elimination of METR, the corporate tax rate and other tax rates were high and so it created a downward fall for investment. After the elimination ,the METR has been reduced helping the producer to invest more. The great reduction in the corporate tax added the investment decisions of the producers, thus we can conclude that the tax policies decides investment decision. The optimum rate of taxation will encourage the investment.