Tax Elasticity Estimates for Capital Stocks in Canada

IMF Working Papers, May 29, 2020

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Estimates the long-run, tax-adjusted, user cost elasticity of capital (UCE) in a small open economy.
Exploits three sources of variation in Canadian tax policy: across provinces, industries, and years.
Identification benefits from reductions in the federal corporate income tax rate during the early 2000s for service industries but not for manufacturing, which already benefited from a preferential tax rate.

Primary econometric approach: error correction model (ECM) to capture the long-run relationship between the capital stock and the user cost of capital.
Supplementary approach: distributed lag model in first differences (DLM).

Baseline UCE for machinery and equipment (M&E) with the ECM: -1.312.
Corresponding semi-elasticity of the stock of M&E with respect to the METR: about -0.2.
- Example implication: a 5 percentage point reduction in the METR, say from 15 to 10 percent, would in the long run generate an increase of 1.0 percent in the stock of M&E.
UCE for non-residential construction is statistically insignificantly different from zero.

Canadian data reduce endogeneity concerns stemming from tax policy effects on the interest rate or the price of capital equipment, aiding credible UCE estimation.
The estimated elasticity for M&E implies that changes in marginal effective tax rates (METRs) have economically meaningful but quantitatively moderate long-run effects on the capital stock of machinery and equipment.
The absence of a statistically significant UCE for non-residential construction suggests heterogeneous responsiveness of capital categories to tax-adjusted user costs.

Corporate income tax; Financial institutions; Financial services; Marginal effective tax rate; Real interest rates; Stocks; Tax allowances; Tax policy; Taxes.
Keywords include: Capital Taxation, Corporate income tax, cost of capital, depreciation rate, differenced GDP terms, elasticities decrease, Global, investment tax credit, machinery and equipment, Marginal effective tax rate, Metr data, open economy, provincial sales tax, rate of return, Real interest rates, Stocks, Tax allowances, UCE estimate, user cost of capital, User Cost of Capital Elasticity, WP.

Tax Elasticity Estimates for Capital Stocks in Canada, By Jean-François Wen, Fatih Yilmaz, Danea Trejo, May 29, 2020.