This paper develops an economic theory of replacement investment that can provide a basis for specifying an econometric model of investment behavior. The long-run and short-run effects of changes in the interest rate and in tax laws are examined. The paper also investigates several reasons why the common assumption of a technologically constant rate of replacement is incorrect even as an asymptotic limit. LARGE VARIATIONS in capital spending continue to motivate econometric studies of investment behavior. The past decade has seen the development of attempts to model net investment as the adjustment of the capital stock to a desirable level. Building on earlier work by Lutz [35], Haavelmo [21], and others, Jorgenson and his collaborators (e.g. [24, 28, 31, and 33]) have provided an operational model of net capital accumulation that relates desired capital to the cost of capital services. Although serious objections have been raised about the specification of the optimal capital stock (including [5, 9, 13, and 15]) and about the arbitrary nature of the adjustment dynamics [37], it is likely that some form of this general model will continue to provide a framework for future investment studies. In contrast to these developments of a theory of capital expansion, replacement investment continues to be analyzed in terms of a non-economic model of technical necessity. Jorgenson and others have adopted the simplifying assumption that replacement investment is a constant proportion of the capital stock.2 This assumption has been challenged and contrary evidence has been offered by Feldstein and Foot [14] and Eisner [10]. The purpose of the current paper is to examine several aspects of a theory of replacement investment. We hope not only to show that a model with a constant replacement rate is implausible and unsatisfactory but also to provide a basis for better empirical work in the future. The magnitude of replacement investment (the annual rate of replacement investment generally exceeds expansion investment) makes this issue a matter of substantial importance.

Extending the traditional treatment of the corporate tax to an economy with a progressive personal tax fundamentally changes the analysis. While the corporate tax system (CTS) does increase the total tax rate on corporate source income for some investors, the exclusion of retained earnings implies that the CTS lowers the tax rate for high-income investors. Analyzing such an economy requires replacing the traditional "equal-yield" equilibrium condition with a more general portfolio balance model. In this model, introducing a CTS can actually increase the corporate share of the capital stock even though the relative tax rate on corporate income rises.

Extending the traditional treatment of the corporate tax to an economy with a progressive personal tax fundamentally changes the analysis. While the corporate tax system (CTS) does increase the total tax rate on corporate source income for some investors, the exclusion of retained earnings implies that the CTS lowers the tax rate for high-income investors. Analyzing such an economy requires replacing the traditional "equal-yield" equilibrium condition with a more general portfolio balance model. In this model, introducing a CTS can actually increase the corporate share of the capital stock even though the relative tax rate on corporate income rises.

D URING the past two decades, gross investment has on average been divided approximately equally between net capital accumulation and replacement. Because of its relation to economic growth, the process of net accumulation has received nearly all of the attention in the investment literature. However, gross investment is the important variable for aggregate demand and therefore for stabilization. Moreover, an understanding of the process of replacement and modernization investment is necessary for a correct analysis of expansion investment. Recent econometric studies of investment behavior, both those in the neoclassical tradition and of the flexible accelerator type, rely on the assumption that replacement investment (Ir) is proportional to the capital stock (K). In some studies, this assumption is used to estimate a replacement investment series by finding a constant proportional depreciation rate (8) which reconciles the gross investment during the period being studied with the capital stock at the starting and ending dates.' This replacement series is then subtracted from gross investment (Ig) to yield a net investment series (In) which serves as the dependent variable in the regression analysis. In other studies, gross investment is used as the dependent variable; the lagged capital stock is then added to the regressors and its coefficient is assumed to estimate the rate of depreciation. Common to both methods, however, is the assumption that the ratio of replacement investment to the capital stock is constant. This assumption has two important effects. First, it influences the estimated parameters of the net investment behavior. Second, it implies that gross investment can be explained and forecast by a simple mechanical technological rule once net investment behavior and the starting capital stock are given. As Jorgenson and Stephenson [131 have emphasized, induced replacement investment can be a very important part of the short-run demand effect of changes in the policy variables that influence the accumulation of net capital.2 The assumption that replacement investment is proportional to the capital stock has long been used in an ad hoc way. More recently, Jorgenson [12] has shown that renewal theory implies that, in the long run, if the capital stock is growing at a constant rate, replacement investment approaches a constant proportion of the capital stock, whatever the initial age distribution and replacement rates for individual types of capital goods. He has, moreover, gone further than previous investigators and tested aspects of this theory [Jorgenson and Stephenson, 14]. More specifically, in econometric studies of two-digit investment behavior with Ig as the dependent variable he included the lagged capital stock among the regressors and performed tests on the estimated coefficient, 8; First, he showed that the null hypothesis that Ir is not related to the capital stock (8 = 0) could be rejected at low levels of significance in fifteen of the eighteen industries studied. Second, he showed that the values of 8 obtained in this way were generally not appreciably different from the values which reconciled the change in capital stock with the net investment series. It is important to note that these tests do not establish that replacement investment is proportional to the capital stock. In particular, they do not imply rejection of the following alternative hypothesis: Replacement investment varies around some average nonzero level in a way which is systematically related to other short-run economic forces. This alternative hypothesis is also not contradicted by * We are grateful for comments from the participants in the Harvard econometrics seminar in the fall term of I969 and for partial financial support of this research by the National Science Foundation (Grant No. GS-2241). 'For a description of this method, see Jorgenson and Stephenson [14]. 2The notion of a constant depreciation rate also enters neoclassical investment theory in a quite different way; the depreciation rate (a) is a parameter in the user cost of capital. See, e.g., Jorgenson [111.

This paper examines the effect of federal deductibility of state and local taxes on the fiscal behavior of state and local governments. The primary finding is that deductibility affects the way that state-local governments finance their spending as well as the overall level of spending.

This paper presents a list of the top 20 articles published in the American Economic Review during its first 100 years. This list was assembled in honor of the AER's one-hundredth anniversary by a group of distinguished economists at the request of AER's editor. A brief description accompanies the citations of each article.