Question: Interest rates and the tax code: An economy begins in steady state with an investment rate of 20 percent, a corporate tax rate of 25 percent, a real interest rate of 2 percent, a depreciation rate of 7 percent, and a price of capital that falls at an annual rate of 2 percent.
(a) What is the user cost of capital?
(b) Suppose the central bank tightens monetary policy, raising the real interest rate from 2 percent to 4 percent. By how much does the user cost of capital rise?
(c) How would your answer have differed if the corporate tax rate had been zero? Explain the effect that taxes have on the extent to which monetary policy affects the user cost of capital (and hence the investment rate).