CoPS/IMPACT Working Paper Number OP-96

Title: Developing a Cost of Capital Module for Computable General Equilibrium Modelling

Authors: Ashley Winston


This paper outlines two potential approaches to incorporating business taxation and allowances into a model of a firm to determine the effect of tax policy changes on the firm's behaviour. Following Auerbach, King and Benge, we first develop a model in which the firm maximises the value of its shareholder equity, taking account of: company and personal income taxes; capital-gains taxes (including a treatment of realisation-based capital-gains tax); depreciation allowances; investment allowances; and interest rates on debt linked to financial leverage. This approach takes the revenue streams and income payments generated by the firm as given. The second approach involves deriving a function for the user-cost of capital to the firm in an optimising framework in which the expression for the value of the firm is the objective function, and then solve for all of the firm's choice variables. In this way, the model determines the firm's optimal investment policy and the resulting levels of revenues and income streams to shareholders. By embedding this in a dynamic CGE model, we can simulate the effects of tax changes on the user-cost of capital and thus on investment. Our ultimate aim is to enable an analysis of the effects of reforms to business taxation (such as the recent Ralph proposals) using a large-scale dynamic CGE model.

This is a revised version of a paper prepared for the PhD Conference in Economics and Business held at The University of Western Australia, Perth, Australia, November 7-9 2001.

JEL Classification: C68, D92, G12, G31, G32, H25.

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