Taxation and Investment: Lessons from the Microeconomic Structure

This paper addresses the role of taxes over the firm's investment decisions. We propose a framework that considers microeconomic decisions to evaluate aggregate effects of taxes over the economy's investment dynamics. We obtain strong results and policy recommendations. First, and contrary to other studies, we conclude that the tax system significatively affects the long run level of capital stock in the economy. Second, we indicate that the "first-best" policy is to tax retired profits rather than current profits. Third, when the "first-best" policy is not available, because it does not provide enough revenues, we should implement a tax system that minimize the distortion over the relative price of investment. This tax system is a mixture of zero investment subsidies (credit to investment and depreciation allowances) and positive, but small, corporate tax. We simulate the effects of those tax policies in an economy with heterogenous firms and, under a reasonable set of parameters, we find that the effect of a tax in current profits over the long run level of capital stock, may be as large as 43 per cent of capital stock, when we compare an economy with no distortions versus an economy with a 15 per cent corporate tax rate