The tax system creates a "tax wedge" for investment, making the pretax return on investment higher than the after-tax return on investment. This is important because investors require the pretax return to cover both the opportunity cost and the tax cost of investment. If the tax wedge is large, fewer projects will be undertaken because the after-tax return for some projects will be below the opportunity cost of investment. For example, consider an investment with a pretax return of 10 percent and an after-tax return of 7.5 percent, meaning the tax wedge is equal to 25 percent of the pre-tax return. If investors decide they require an 8 percent after-tax return in order to cover the opportunity cost of the investment, taxes will stop the otherwise profitable project from being undertaken. By lowering the effective tax rate on investment, the pretax return is unaffected but the after-tax return will rise. For example, if the effective tax rate is reduced to zero, then the tax wedge is eliminated and the after-tax return rises to 10 percent. Note that the tax wedge does not need to be eliminated for our hypothetical project to be financed-the effective tax rate only needs to be reduced to the point where the after-tax return is 8 percent. However, completely eliminating the tax wedge removes taxes from the investment decision. Two main contributors to the tax wedge on investment returns are depreciation schedules and the double tax on corporate profits.

   A primary source of the inefficiency created by the tax wedge is the depreciation schedules that treat investments very differently depending on their business sector, asset life, and source of financing. Depreciation schedules tell how much of an investment's acquisition cost can be deducted from the taxpayer's taxable investment income in any year. There are two distortions associated with the tax depreciation system. First, spreading the deduction for the acquisition cost over a number of years lowers the present value of the total tax deduction relative to fully deducting the cost in the year purchased. By lowering the present value of the deduction, the depreciation system raises the tax cost and the total effective cost of investment. This makes some projects unprofitable and reduces the economy-wide level of investment. Second, the depreciation system distorts the allocation of investment among various sectors of the economy because the depreciation schedules lead to sectoral differences in effective marginal tax rates. Under an income tax system, the amount of investment cost counted each year should ideally equal the true economic depreciation of the asset. For example, if an asset loses 10 percent of its useful value per year, then an ideal income tax depreciation schedule would allow 10 percent of the cost to be excluded from income each year. When tax depreciation is not the same as economic depreciation, the tax system distorts investment decisions regarding the allocation of capital investment.