Investment, Taxes and the Cost of Capital: An Euler Equation Specification Test

Abstract

Problem statement: Previous studies (primarily employing goodness-of-fit tests) have found it difficult to provide clear and direct evidence that taxes and the interest rate have a strong influence on investment. Approach: The objective of this study was to test whether the cost of capital, which includes taxes and the interest rate, affects investment. This study used the Euler equation for investment, the Generalized Method of Moments estimator and the associated test of overidentifying restrictions (J statistic). Specifications including and excluding components of the tax system were estimated and the resulting J statistics were compared. This study also examined two potential problems with measuring another component of the cost of capital (the interest rate): (1) risk; (2) finance constraints. To examine the second issue, the Euler equation is modified by parameterizing the Lagrange multiplier on the finance constraint. The models with and without finance constraints were compared using a Newey-West test. Results: Including taxes in the investment Euler equation reduced evidence of misspecification. In particular, including the investment tax credit, the corporate tax rate and interest deductibility, respectively, all lead to lower J statistics than omitting these tax considerations. Using a risky interest rate instead of the risk-free interest rate makes little difference. The Newey-West test rejected the model without finance constraints. Parametric estimated of the model with finance constraints suggest that variations in the tightness with which finance constraints bind lead to substantial variation in the effective discount rate. Taxes continue to matter in the model that incorporates finance constraints. Conclusion: The results suggested that the cost of capital (specifically, the tax system) influences investment and finance constraints are important.