The Neoclassical Theory of Firm Investment and Taxes: A Reassessment

Economists have widely varying opinions of how corporate taxation affects aggregate investment, output, and wages. This disagreement reflects a 60-year history of misapplication of the neoclassical theory of investment to interpret empirical work and guide policy analysis. In this article I reconsider the accumulated evidence relating tax policy to firm investment through the lens of the neoclassical theory. Empirical work suggests a range for the firm-level, short-run semi-elasticity of the investment-to-capital ratio to the user cost of -0.25 to -0.75. The mid-point of this range translates into values for the elasticity of firm revenue to capital of between 0.22 and 0.35. The implied general equilibrium, long-run elasticity of capital to the user cost can differ substantially from leading policy models. The elasticity of the wage to the user cost ranges from -0.3 to -0.7, or from -0.1 to -0.2 for changes to the user cost in the C-corporate sector alone. In the relatively low-tax regime in the U.S. in 2024, the neoclassical contribution to higher output from higher capital cannot rationalize more than modest dynamic tax revenue offsets from further reductions in corporate taxation.