Uncertainty and Investment Options

This paper develops a simple model in which uncertainty about future tax policy leads to a temporary reduction in investment. The basic idea is that policy uncertainty creates uncertainty about the profitability of investment. If the uncertainty is likely to be resolved in the not-too-distant future, firms rationally delay committing resources to irreversible projects, reducing current investment. When the uncertainty is resolved, investment recovers, generating a temporary boom. The size of the boom depends on the realization of the fiscal uncertainty, with lower realizations of the tax rate producing larger booms.