Economic Report of the President

higher interest rates and monetary stringency. The expected slowingof growth in demand reduces the incentive to add capacity.But by far the most important effect of inflation on investment isits impact on tax accounting provisions and depreciation allowances.Depreciation is a cost of earning income from fixed capital assets.This cost is the reduced value of the asset due to use, aging, and obsolescence.The depreciation allowed for tax purposes is based onthe historical cost of an asset. When inflation occurs, allowable depreciationis reduced relative to the cost of replacing the asset attoday's price. Inflation therefore raises the tax on capital and reducesthe rate of return on investment, and this problem worsens as therate of inflation increases.The inflation-induced increase in the tax on income from businessplant and equipment is partly offset by the inflation-induced reductionin the tax burden of borrowers. Firms are allowed to charge thefull value of their interest payments against income, even though aportion of these higher interest payments amounts to the repaymentof real capital to lenders. The effect on the return to investment ofthis "excess" deduction varies with the proportion of investment thatis debt-financed. It also varies with the extent to which inflation isreflected in interest rates. Since an important part of investment isnot debt-financed, it is clear that inflation's tax-increasing impact onthe value of depreciation allowances outweighs the tax-decreasingimpact of excess deductions on the return to business investment.Some have suggested that the inflation-induced distortion of taxdepreciation could be corrected by indexing the value of existingbusiness assets to allow replacement—rather than historical—cost depreciation.But indexing the value of assets would ignore the interestrate offset described in the prior paragraph. Moreover, as with all indexingschemes its administrative and accounting problems would bequite severe, and almost any simple index imaginable would introducedistortions of its own. For these and other reasons, indexing isnot an attractive means of correcting the inflation-induced distortionin depreciation allowances.TAX MEASURES TO INCREASE INVESTMENTPolicymakers have three principal measures to influence investmentthrough the tax system: changes in depreciation allowances, changesin the investment tax credit, and changes in the corporate income taxrate.Since the effect of inflation in depressing the value of depreciationis such an obvious factor in the recent decline in after-tax rates ofreturn on capital assets, the liberalization of depreciation allowancesis an attractive way to enhance investment. It not only provides anoverall incentive for investment but, if carefully designed, it can also74