Question

1. Consider a neo-classical investment model with depreciable capital and a corporate incorne tax system where u 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 β, the economic depreciation rate is δ, the interest rate on debt is i, the required rate of return on equity is ρ, 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 a, 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 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. With an ITC of k (rf+8-)(1-k-z) (1 METR = (rg-rnyrg

Answer 1

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