Investment Incentives and the Discounting of Depreciation Allowances

The importance of depreciation and investment tax credit provisions in determining the level and composition of investment is widely rec-ognized. Economists have long understood that the present value of depreciation tax shields along with the investment tax credit determines the effective purchase price of new capital goods, which in turn de-termines the cost of capital. Measures of the cost of capital are widely used in evaluating the likely effect of proposed tax reforms on the total level of investment and in assessing the distortions across capital goods caused by tax rules. The cost of capital depends on the present value of depreciation allowances permitted by the tax system. This raises the question of what discount rate should be used in calculating this present value and determining the cost of capital. The choice of a discount rate is of considerable importance in assessing investment incentives. For ex-ample, the much-discussed adverse effect of inflation in conjunctio