Abstract: Proponents of investment subsidies occasionally claim that subsidies increase the supply of used capital and relax financial constraints for young firms, resulting in a larger market for used capital and higher entry rates. However, that overlooks current law, under which increases in subsidies penalize the sale of used assets, so the usual intuition may reverse. To understand the competing incentives, I build an investment model featuring firms choosing whether to retain used assets or sell them to financially constrained firms. In partial equilibrium, higher subsidies reduce the supply of used assets. In general equilibrium, however, the reform alters firms’ retention decisions---by shifting the marginal product of retained capital through diminishing returns---which can either offset or amplify the direct reduction in used asset sales, yielding ambiguous effects on the equilibrium price, market size, and entry. Exploiting cross-industry variation in exposure to bonus depreciation, I test the model’s predictions using firm-level data from Compustat and industry measures of entry from the Business Dynamics Statistics. Increases in bonus reduce used capital sales and lower entry. These findings highlight an important trade-off in tax policy design, suggesting that incentives intended to spur investment may inadvertently hinder capital reallocation and firm turnover.
