Investment stimuli under government present-biased time preferences

This paper examines the net benefit accruing to a present-biased government contemplating the option of speeding up investment setting a lower tax rate on future profits or an investment subsidy as an incentive. The literature generally suggests the use of an investment subsidy rather than a reduced tax rate. However, this study shows that, depending on the degree of present-biasedness, it may be more advantageous for the government to set a lower tax rate. The government, in fact, when selecting the instrument to be used for speeding up investment, trades off the immediate and certain cost of a subsidy against the random tax revenues accruing from the investment. Hence, from the short-sighted perspective of current government, a lower tax rate may appear optimal as long as the consideration given to the earnings of future governments is small and/or the current government's duration is short.