Taxes and the quality of capital

This paper shows that tax policy toward investment, by changing the relative prices of capital varieties even within narrow classes of equipment, can have a direct effect on the quality composition of capital goods that firms purchase. Detailed data on farming, mining, and construction machinery suggest that this impact is economically important. Finns significantly shift investment toward higher quality varieties when they receive investment subsidies (and do not do so when investment is high for other reasons). In the aggregate, all of the new investment generated by tax subsidies appears to come from firms shifting to higher quality capital goods rather than buying a larger number of their existing capital types. The paper also applies a methodology for calculating the implied deadweight loss from the quality distortion and shows that its magnitude may represent a substantial efficiency cost from capital taxation that is neglected in conventional work. (C) 2002 Elsevier B.V. All rights reserved.