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Inflation, Tax Rules and Investment: Some Econometric Evidence

Martin Feldstein

Abstract

This paper presents econometric evidence on the effect of tax incentives on business investment in the United States in the period from 1953 through 1978. The analysis emphasizes that the interation of inflation and existing tax rules has contributed substantially to the decline of business investment since the late 1960s. Because the investment process is far too complex for any simple econometric model to be convincing, I have estimated three quite different models of investment behavior. The strength of the empirical evidence rests on the fact that all three specifications support the same conclusion. More generally, the analysis and evidence show that the theoretical models of macroeconomic equilibrium should specify explicitly the role of distortionary taxes, especially taxes on capital income. The failure to include such tax rules can have dramatic and misleading effects on the qualitative as well as the quantitative properties of macroeconomic theories.