Question

Consider a neo-classical investment model with depreciable capital and a corporate income 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 adjusted 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 capital 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.

assume the following:

i=ρ=.10, β = .40, δ = .20, The ITC is initially equal to k = .10 prior to its elimination. The tax depreciation (CCA) rate is increased from 20% to 50%. 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