User cost elasticity of capital revisited

The response of business capital to user costs is central to economic evaluations of tax and monetary policies. Despite intensive research effort though, no consensus about the size of this elasticity has been achieved. The divergence in prior estimates may arise because previous studies have neglected cointegration among capital, its user costs, and sales. Using German firm-level panel data, this study shows that estimating a distributed lag (DL) model which is prevalent in prior literature, leads to low estimates of the user cost elasticity and important cash flow effects. Properly accounting for the equilibrium relationship in an error correction model (ECM), which is in other respects a full reparametrization of the DL model, yields a much larger estimate of the user cost elasticity close to -1, that is the neoclassical benchmark, and no response of capital to cash flow variables.