Deficits, Interest Rates, and the User Cost of Capital: A Reconsideration of the Effects of Tax Policy on Investment

Under traditional formulations, lower capital income tax rates reduce the user cost of capital and stimulate investment. The traditional approach, however, implicitly or explicitly considers a revenue–neutral reduction in capital income taxation. We extend the traditional approach by considering a reduction in taxes that generates an increase in the budget deficit; the expanded budget deficit may raise interest rates and the opportunity cost of investment. This provides a mechanism through which tax cuts can raise the cost of capital. Representative calculations show that, even with relatively modest interest rate effects, the net effect of making the Administration’s recent tax cuts permanent or a 10 percent reduction in individual income tax rates would be to raise the user cost of capital. Thus, sustained tax cuts can raise the cost of capital and reduce investment.