A Note on Taxation and Investment

The Irrelevance of Capital Structure for the Impact of Inflation on Investment

“…Nelson did not address himself to the “interest effect” and therefore, by considering the “depreciation effect” only, concluded that inflation depresses firms' demand for investment. Jaffe [13] considered a world in which the marginal investment is entirely debt‐financed and the market‐real‐rate‐of‐interest on bonds is independent of the inflation rate (the “Fisher effect”). The focus of Jaffe's analysis was the “interest effect” and thus he limited his discussion to nondepreciating assets.…”

“…This is demonstrated by considering two alternative assumptions. First, following Jaffe [13] and Cross [4] we consider the assumption that the market real interest rate on bonds, , is independent of the inflation rate (the “Fisher effect”) and show that the cut‐off rate of return declines with inflation. Then, following Nelson, we consider the alternative assumption that the (pre‐personal‐tax) real rate of return required by stockholders, , is independent of inflation and demonstrate that, under this assumption, the cut‐off rate rises with inflation 9…”

“… ρ is the analog of , the marginal real product of a $1 of capital, in Jaffe [13] and Cross [4].…”

A Note on Inflation, Taxation and Investment Returns

“…In a recent paper in this journal, Gandolfi [1] argued that the existence of a tax on corporate profits will not alter the real rate of return on the firm's marginal investment. In a subsequent paper, Jaffe [2] exposed Gandolfi's error in ignoring the tax subsidy to debt‐financed investments. Both authors assumed that the firm's investment takes the form of a non‐depreciating machine—a special case, as Jaffe notes, among an infinite number of possible depreciation schedules.…”

The Impact of Inflation on the Aggregate Debt‐Asset Ratio

“…S tudies concerning the effect of inflation on firms' capital structure conclude that inflation enhances debt financing. Jaffe [9], Modigliani and Cohn [16], and Modigliani [15] argue that nominal interest payments consist, in part, of true interest payments and, in part, of a compensation for the reduction in the real value of the principal. The fact that firms are allowed to deduct their entire interest expense, including the portion that is a return of principal, reduces their cost of debt capital.…”