Inflation and the Choice of Asset Life

Abstract

This paper considers the choice of capital durability by competitive firms subject to a corporate income tax. We find that, with a positive rate of inflation, a historic cost depreciation rule biases the choice of asset life toward greater durability and lowers the market valuation of a firm's capital assets. Extending the familiar one-sector monetary growth model to incorporate this behavior, we explore the general equilibrium effects that the failure to index depreciation allowances for inflation may have on the long-run characteristics of the economy, including the capital-labor ratio and the rate of return received by investors.