The importance of measurement error in the cost of capital

Conventional estimates of the impact of taxes on investment may be seriousl y biased by measurement error in the cost of capital, The existence and siz e of such error, however has not been documented Using panel data on differ ent types of capital equipment, this paper provides direct evidence of meas urement error in the tax component of the cost of capital accounting for ab out 20 percent of the tax term's variance. Correcting for the error with in strumental variables (IV) estimation shows that taxes significantly affect both prices and investment and that conventional results may be off by as m uch as a factor of four.