Consider the user cost of capital in the presence of taxes, starting with equation (17.5). Suppose the price of capital, pk, is constant, so there is no capital-gain term. What is new, however, is an investment tax credit: rather than costing pk, a unit of capital costs (1 − ITC)pk· That is, the government subsidizes the purchase of new capital, and the amount of the subsidy is given by ITC. As just one example, in 1981, the U.S. government created a 10 percent investment tax credit to spur the economy out of its recession, so we might suppose ITC = 0.10.
(a) How does the arbitrage equation change in the presence of the investment tax credit?
(b) What is the user cost of capital in this case?
(c) What happens to the user cost of capital if the investment tax credit is exactly equal to the corporate income tax rate? Why?