NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Investment Ramifications of Distortionary Tax Subsidies

James R. Hines Jr.

NBER Working Paper No. 6615
Issued in June 1998
NBER Program(s):   PE

This paper examines the investment effects of tax subsidies for which some assets and not others are eligible. Distortionary tax subsidies encourage firms to concentrate investments in tax-favored assets profitability of investment and reducing payoffs to bondholders in the event of default. Anticipation of asset substitution makes borrowing more expensive, which in turn discourages investment. Borrowing rates react so strongly that aggregate investment may rise very little, or even fall, in response to higher tax credits. Observed positive corporate bond market reactions to events surrounding passage of the U.S. Tax Reform Act of 1986 are consistent with the model's implications.

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Document Object Identifier (DOI): 10.3386/w6615

Forthcoming: Investment Ramifications of Distortionary Tax Subsidies, James R. Hines Jr., Jongsang Park. in Trans-Atlantic Public Economics Seminar, Devereux and Gordon. 2014

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