05 Jun ry Allowing the full and immediate deductibility of capi
Question
Opinion
How to Energize a Lackluster Recovery
Allowing the full and immediate deductibility of capital
investment would spur growth and raise wages.
By
Edward P. Lazear
April 20, 2014 5:35 p.m. ET
Excerpts from article
Taxing investment reduces after-tax returns to investing. Investors care about after-tax
returns and a tax policy that lowers investment returns is especially harmful to longterm economic growth..There are many changes that would improve the
efficiency of the tax code, but cutting the tax on investment heads the list.
Mr. Lazear, chairman of the President’s Council of Economic Advisers from 2006-09, is a
professor at Stanford University’s Graduate School of Business and a Hoover Institution
fellow.
Please answer the following questions.
1. a. In this part you are to explain exactly how lowering the effective tax rate on capital (τ) will
work (in theory) its way through the economy in order to "spur growth and raise wages. In this
discussion, you need to differentiate between the short- run and long-run. In the space below,
explain, with graphical analysis, how lowering the effective tax rate on capital will influence real
economic variables in the short run (hint, its a demand side story). Draw 4 diagrams (label
them 1 through 4), with 1) a user cost ; desired capital (K*) diagram, followed by 2) a closed
economy desired saving; desired investment diagram, followed by 3) an IS LM diagram
followed by 4) an aggregate supply ; aggregate demand diagram.
Start at an initial equilibrium and label as point A in all diagrams, with all the associated market
clearing variables denoted by subscript A. For example, in your IS LM diagram, the interest
rate that clears the goods and money market is labeled as r A with the associated output at YA. Note
that YA, our initial equilibrium output, is below full employment output = Y B (we still have
slack in the economy). Now let the effective tax rate on capital fall (same as a fall in τ) and
show how all your graphs are affected. In particular, locate point B as the new short-run
equilibrium in all graphs (assume the standard; that is, let output rise to YB = full employment Y)
while holding the general price level fixed at P A = PB. Make sure you refer to each diagram
individually explaining how and why we get to point B (i.e., provide intuitive economic
reasoning starting with how a lower τ effects K* and why)!). Be sure to include a discussion of
why the real interest rate has to change the way it does – hint, the money market
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