Self-Constructed Assets and Efficient Tax Timing

A well-known baseline result in the theory of public finance says that firm investment decisions are not distorted by income taxation when taxable income is reduced by net economic depreciation and net interest costs. This paper extends this result to the commonly encountered situation in which firms use capital to produce other capital that they, in turn, use to produce final output — as when a firm uses a truck to construct a plant, or a laboratory to generate intellectual property. In theory, the immediate deduction of net economic depreciation and net interest costs is still sufficient for the no-distortion result — provided, that is, that net economic depreciation is suitably (and somewhat unnaturally) redefined. The required definition of net economic depreciation renders the no-distortion result especially problematic in the case of nested capital. Given informational constraints facing the tax authority, the no-distortion result is arguably inapplicable outside the steady state of the firm’s optimal investment path, which, in the case of nested capital, converges only asymptotically. In addition to establishing these results, the paper provides three interpretations of the non-distortive regime, and relates it to current law regarding interest capitalization and “depreciation cascading.”