Investment Ramifications of Distortionary Tax Subsidies

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.