Corporate Tax Structure

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					                                        7      WORKING

                                               Policy ResearchDepartment
                                                     Tha WorldBank
                                                       WPS 1196

CorporateTax Structure
   and Production

                                               Jeffrey Bernstein
                                                 Anwar Shah

              Investment tax credits, investment allowances, and accelerated
              capital consumption allowances are more cost-effective in pro-
              moting investment than more general tax incentives such as
              corporate tax rate reductions.

Policy Research Working Papes dissinate the rindings of work in pmgress and encournge the exchange of ideas arnong Bank saff nd
all othersintersted in development issues Thesepapers, distributed hy the ResearchAdvisory Staff, carry thenamnesof the authors,reflect
only theirviews, andshould used and
                            be         cited accordingly. findings, interprettions, andconclu ions are
                                                        The                                               theauthon'own. They should
nd be attributedto the World Dank,its Oard of Directors,its management,or anyof iu member countries.



This paper-a product of the Public Economics Division, Policy Research Department-is part of a larger
effort in the department to evaluate public policies for private sector development in developing countries.
The study was funded by the Bank's Research Support Budget under research project "An Evaluation of
Tax Incentives for Industrial and Technological Developmnent"(RPO 675-10). Copies of the paper are
available free from the World Bank, 1818 !4 Street NW, Washington, DC 20433. Please contact Carlina
Jones, room NIO-063, extension 37699 (September 1993, 61 pages).

Bernstein and Shah provide an empirical frame-                 consumption allowances were cost-effective. In
work for assessing the effects of tax policy on an             Mexico, neither investment tax credits nor
array of producer decisions about output supplies              accelerated capital consumption allowances were
and input demands in Mexico, Pakistan, and                     cost-effective. In contrast, in Pakistan, both
Turkey. They specify and estimate a dynamic                    investment tax credits and accelerated capital
production structure model with imperfect                      consumption allowances were cost-effective. In
competition for selected industries in these                   the intermediate run, defined as tax policy
countries.                                                     impact after one year, only the investmnent
                                                               allowances and arxeicra!zd capital consumption
    The model results suggest that tax policy                  allowances available to Turkish industries
affected production and invcstinent and further                proved cost-effective.
that selective tax incentives such as investmcnt
tax credits, investment allowances, and acceler-                    To make selective tax incentives more
ated capital consumption (depreciation) allow-                 effective, investment tax credits must be refund-
ances are more cost-cffective at promoting                     able and carrying forward investment and
investment than morc general tax incentives such               depreciation allowances must be permitted. If
as corporate tax ratc reductions. The long-run                 stimulating investment expenditure is the sole
cost-effectiveness of these incentives - except                objective of tax policy, reducing the corporate
corporate tax rate reductions, which proved cost-              tax rate is not a cost-effective instrument to
ineffective in all cases -- varies by country. In              achieve this objective.
Turkey, investment allowances and capital

 The PolicyResearchWorkingPaperSericsdisseminates findingsof workunderway in theBank.An objective the series
                                                       thc                                                    of
 is to get these findingsout quickly, even if presentationsare less than fuillypolished. The findings.interpretations,
 conclusions these papersdo not necessarilyreprcsentofficialBank policy.

                                 Producedby the Policy ResearchDissemination



                                        lAble gf Contents

    1.0   Introduction ..    .   ..       ..        ..        ....................                               1
    1.1   Cost of CapitalExpenditures.       .... . . . .2.....                                  ...   .2

    1.2   Tax Structure Production: DynamicTheoretical
                       and            a                                 Model        .....
    1.3   Estimation Model an6 Tax Elasticities .......................       .15

            Short-Run ...........                  ......                            .19
            Inteminediate-Run              ..                                                                   20
            Long-Run                 ..                                                                         21
            Rental Rate Elasticities with Respect to Tax Instruments .                       .              .   22

    1.4 Tax Policy, Impact on Investmentand Government Revenues .24
    1.5Mexico                       .            ..........                                                     26

            1.5.2 Tax Policy Effects on the Rental Rate and Capital .30
            1.5.3 Tax Incentives, Investment Impacts and Foregone
                             Reveues       .33

    1.6 Pakistan .35

            1.6.1 Tax History .35
            1.6.2 Tax Policy Effects on the Rental Rate :md Capital .36

*   Of Carleton University and National Bureau of Economic Research, and World Bank,
    respectively. This is one of a series of papers prepared for the research project (RPO
    No. 675-10) on tax incentivesdirected by Anwar Shah, PRDPE. Research assistance for
    this paper by Bjom Larsen, John Baffes, and CostasChristou is gratefully acknowledged.
    The authors are grateful to Frank Lysy for comments.

         1.7 Turkey .........                       . . ............................
                                                           .                                                          43

                   1.7.1 Tax History .               ..................................                               43
                   1.7.2 Tax PolicyEffectson the Rental Rate and Capital ..... . . . . .                          . 47

         1.8 Summary and Conclusiors                  ............                ..      ..   .........     ..   .   52

                  On the Elasticity RentalRate of CapitalwithRespect
                        to Tax Instruments                 .                                                          52
                  On the Tax Sensidvity of Capital Stock ..........                              . . . . . .53
                  On t*he          Ratios ..........................
                        Benefit-Cost                                                                                  53

Endnotes ................................................                                                             57

References .....             .9........................................                                     

                                                              . .i
                                               I I -

                                    1.0 INTRODUCTION
                                     promotionare prevalentin most developingcountries.
       Fiscal incentivesfor investment

The effectiveness these instrumentsin meetingstatedpolicy goals is an importantarea of

publicpolicyconcernyet rigorousdevelopingcountryempiricalevidenceto guidepolicyin this

as is almosteomp.etelylacldng. To addresstheseconcerns,in the past, policy makersrelied

                                            Guisingerand Associates, 1985), and more
on opinion survey of firms (see for e&.ample,

rceently,on marginaleffectivetax rate analysis(see for exampleBoadwayand Shah, 1992).
However,noneof these approaches able to analyzethe effects of tax policy changeson the

strtvcre of production and the rate of capital accumulation.

                                     a       modelof productionto examinetax effects
       Thispaper developsand estimates dynamic
                        decisionsregardinginputs and ov;tputfor six industriesin three
on an array of produc+ion
         countriesnarnelyMexico,Pakistanand Turkey.The paper evaluatesinvestment

credits, investmenttax allowances,capital cost allowancesand corporate income taxes as
          for        promotion.Underan investment creditcorporations allowed
instruments investment                          tax                are

to deduct againsttheir tax liabilitiesa fraction of expenditureson new additions to physical

capital stock. Tax credits providea direct subsidy to such activities. An investmenttax

allowance allows a deduction from taxable income based on            a   fraction of investment

                                 permit depreciation tax purposesas a deductionfrom
expenditures.Capitalcostallowances                 for

taxableincome. Corporateincometax reductionspermit a lower rate of taxationon corporate
income. The paper is organized into the following sections. Section 1.1 presents i!lustrative

calculationson the post-tax cost of capital expenditures under altemate tax policy provisions and

a historyof tax changesin threecountries. Section1.2 presentsthe theoreticalmodel. Section
 1.3 specifiesthe empiricalframeworkand derives relevantelasticityformulate. Section 1.4
                                           and        revenues. Sections1.5 through
 discusmsthe impactof taxpolicyon investment government

 1.7 prest the empiricalresults for selectedindustriesin thl samplecountries. A finalsection

 summarizes    results.

                        1.1 COST OF CAPITAL EXPENDITURES
                           that                                                   here
        Four tax instruments affectthe purchasepricesof capitalstocksare considered
namely;the corporateincometax rate, the alloweddepreciation              allowanceand
                                                          rate, investment

investment creditrate. To see the effectsof tax policyon the after tax or post tax pu-,hase

prices, consider a machine that has a price of one unit denominated the local currency.
Dealingfirst with the alloweddepreciationrate, supposethat depreciationoccurs at an annual
rate of 30%. In addition,the expenditure the machinemust be capitalized assumethat
                                        on                            and
the future depreciationdeductionsare discountedat the rate of 15%. The present value of
depreciation                                            is,
                    basedon declinir.,balancedepreciation z = d(t + r)/(r + d), where

d is the allowed depreciation and r is the discountrate. Thus the tax deductiondue to

depreciation 0.77.

       Next considerthe corporateincometax rte. In the presentexamplethe tax reduction

due to depreciationequals0.77u,, where u is the corporateincometax rate and the post tax

cost of the unit value of the machine 1 - 0.77u,. If the corporateincon.S tax rate is 0.46, and

thereis taxableincome,thenthe post tax cost is 0.65 and the tax reductionis 0.35 on a machine

of unit value in the local currency.
        It is of interest to compare the tax reductiondue to depreciationdeductionsand the
 reductiondue to the immediatewrite-off of the machine. In the latter case, assumingthere is

 taxableincome,the tax reductionis u, Lndthe post tax cost is 1 - u,. Hencewith a corpora^e

tax ate of 0.46 the post tax cost is 0.54 and the tax reduction 0.46. The tax reductionin the

                   cae is 23% smallerthan the tax reductionfrom immediatewrite-off.
depreiaon deductions

       Neot, considerthe investment credit. Let the credit rate be v. The tax reduction

on the unit valueof the machineis zg,(l -v) + . There are three aspects to this tax reduction.

                                        part. The secondis *zu v whichis the amountthat
The first, is zumwhichis the depreciation

                                    base. The third is v whichis the investmenttax credit.
the tax creditreducesthe depreciation

Thusthe post tax cost of the unitvalue machineis 1-[zU,(l-v) +v]. If u. is 0.46 and v is 0.10

then the tax reductionis 0.42 and the post tax cost of the mwchine 0.68.

       Some countries, for example Turkey, rather than offring a credit for investment
expenditure                                    to
           allow a fractionof these expenditures be deductedfrom taxable incomein the

year such outlaysare made. This is an investmenttax allowance. Under such a regime, the

post tax cost of the unit valueof machineis 1 - [zu + u0O]. If z = 0.77, u
                                                  1                          =   0.46 and # (the

                                                      0.40 to ax reductionwith the final
allowancerate) - 0.10 then the tax allowancecontributes

cost of the machineequal to 0.60.

      Table 1.1 showsexamplesof the post tax cost of unit value machineryand equipment

for three countries;Mexico,Pakdstan Turkey. The highestpost tax cost of a unit value of

                                        Table 1.1

                      Cost of a unit value of capitalexpenditure


 Mexico'                                                          0.46   0.53

 Paklstanb                                                        0.43   0.52

 Turkeyr                                                          0.46   0.53

Cu,= 0.42, straightlinedepreciation 0.10, this is an averagerate, v = 0.30,

and z = 0.811 for r = 0.O5and z     =    0.S77for r   =   0.15.

 -u = 0.55, this includesthe supertaxrate, declning balancedepreciation 0.10, v

= 0.30, and z = 0.7 for r =0.OS and z = 0.46 for r = J. 15.

                                       at               allowancerate -
'u, = 0.46, decliningbalancedepreciation 0.25, investment

0.30, this is the minimumrate allowedand z - 0.875 for r - 0.05 and z-

0.719 for r   0
 capital expenditure is found in Turkey, followed by Mexico and I-aldstan. As fuure
            deductionsare discountedat a hignerrate. their value diminishesand the post tax

 cost of the expenditurerises. This can be seenf:oni the table, as the secondcolumnfiguresare

 higherthan those foundin the first column.

       The technology a representative
                     of              firm withinan Mndustry can be definedas
       y, X f(Kv,.,v,, A14, Aj                                                            (1)

where y is the outputquantity,K is the m dimensional
                                                   vectorof quasi-fixedfactors,v is the n
          vector of variablefactorsand A is the indicatorof the level of technology. The
productionfunctionis denotedby f, which is definedfor nonnegative
                                                                input quantities,and is
nonnegative positivemarginal
          with             products. The production
                                                  functionalso decline.withrespect
to the net investment vector, AK = K,- K,. . Adjustmentcosts are represented through the net

         vectorin the productionfunctionand are measuredas foregoneoutput. The cost of

changinga quasi-fixedfac:oris the loss in outputthat could have been produced. Adjustment

costsare, thereby,internalto the production
                                          process(see for example,Treadway[1971,19/4],
Mortensen(1973]and EIpstein
                          (1981]). The subscriptt representsthe time period I

                 factors are also referred to as capitalinputs. In this model, capital inputs
relate to various ypes of plant and equipment. The stocks of the capital inputs accumulate


      IK =      + (,a- 5)Kv.,,                                                           (2)
 whereI is the m dimensional
                                    vector, a is an m dimensional
                                                                diagonalmatrixof fixed

 depreciationrates such that Og
                              s     s 1,    I - 1, ..., m. It is assumedthat capital servicesare

 proportionalto the capital stocks (see Bernsteinand Nadiri [1988D).lIn addition, I. is the


        Finns sel their products,hire or purchasefactorsof producuon,investin captal stocks

 and financetheir operations,such that the flowof fundsis givenby,

        p y, - wsTv_t-Ig + AB, +1 ,&ANstr,B, I - TOt D t -0.
                                 P    -            -                                        (3)

 The productprice is denotadby p, w is the vector of variableinput prices, q is the vector of

 capitalpurchaseprices, B is the value of outstandingbond issues,AABB, - Bj. is the value
 of net bondissues (netof retirements), is the price of shares,N, is the quantityof ouuwanding
 shares, AN,, - N, - N., are new share issues, rbis the interestrate on bonds, T. aie income

taxes and D is the value of dividends.

        The flow of funds can be further decomposedby consideringincome taxes. First,

investmentincentivesare often in the form of credits sucihthat at time t with a credit rate of

O<V,zt,<-j,...m. the ith capitalstock investment credit is,

        rX,,-V,,qw,I,   iZ,..,                                                             (4)

       Second,there are capitalcost allowances
                                             associatedwith the depreciation the capital
stocks. In general,depreciatioz'
                               deductionsequal di, on a unit value of the originalcost of the
ith capitalstock of age r. Sincecapitalmustbe fully depreciated,
                                                               then it must be the case that
E        1,      a 1, ..., m. The capitalcost allowance timet for the ith capitalstockinstalled
                 -                                    at

at differenttimes is,

        CCA 9 * s qs , I,.,(l -,v1,)d,r
          1        1                                            ...   m                          (5)
                  '   O0

where 0 5 #, S 1 is the prportion of the investment credit v.hih reducesthe depreciztiori

base for tax purposes.
           with sect to the hbor inputsthere are no payrolltaxes -it with respectto the

intemediateinputsther are valueaddedtaxes. Let the tax rate on hejth variableinputat time

t be n <q, < 1 and so the post value added tax is 2;. ogw,.               The incometax is definedat

ime t by therate O < u,, < 1, basedon revenuenet of the post value added tax cos+ ,f

.able    inputs,net of inteet payments,net of capitalcost allowancesznd net of investment

tax creditsl. Thus incometaxesat time t are

             X_       uOI(P.We     T   %-)V-rk,         s-iCW-iUC              + wTt v           (6)

                           identitymatrix, (sois a diagonalmatrix of value added tax rates
whereI, is the n dimensional
                                                   identity vector, CCA and ITC are m
(includingpayroll tax rates), i is the m dimensional

dimensionalvectors of capital cost allowances and investment tax credits respectively.

           equation(6) (the incometax equation)into the flow of funds equation(given as

equation(3), yields,

        ,Yty wT as - p),vj(I - %)
           -                                                 +
                                           q;- I +i,,(u,,CC-,k lTC,

            * [D/(pl..)             1 PgNg- + rbt(I - u,)BD,X
                             + Apr/Pg     1                                                      (7)

              A (PN)       - ABt
 The leP. side of equation (7) shows revenuenet of tax, net of variableinput cost and tnetof
          expenditures.The right side of the equationshowsthe flowof fundsto bondholders

 and shareholders. Equations(1), (2). and (7) summarizethe technology,capitalaccumulation

 and flowof funds for the representative
                                       firm in the industry.
       Turningto the natureof marketstructure,the first marketto be considered the product
 market. P..oduct
                demandis representedby

       p,UD (Yr,e,),                                                                    (8)

where Y M.       J is industryoutput, with"hesuperscriptrepres nting the particularfirm, and

c is a vector of exogenousvariablesaffectingproductdemand. The iiverse prod' :t demand

functionis given by D, which is defined for nonnegativeindustryoutput, nonnegativeand
decreasingin industryoutput. Impliedby the inverseproductdemandfunction,is that firms
withinan industryproduce homogeneou,
                                   products. Moreover,dependingon the conjectural
relationshipbetweenthe outputof a firm and industry,the productmarketin the modelcan be
competitive,monopolistic oligopolistic Bernsteinand Mohnen(1991]).
                       or            (see

       Second,the variableand capitalinputmarketsare assumed be competitive.Thusfirms
face exogenous
             variableand quasi-fixed
                                   inputprices. The last set of marketsare the financial
markets. Giventhe less developed
                               natureof the economy,firms are not able to affecithe rates

of return on their shares or bonds.These rtes of returns are essentiallyconstrainedby world
financialmarkets. Definefinancialcapitalas V, = P,N, + B, and so AV, = A(p&,) + AB,
                                                                          1      1

then equation(7) can be rewrittenas

       Fe- [r,, + r,(l - u, ) A,_J](I+ 1_,)-' V,_1- AV,                                (9)

 whereF, is the left sideof equation(7), whichis net aftertax revenue,the rate of return on the

                     5 ,
shares of a firm isr rS.            +±     , and the leverage ratio is A, 1 -   . The rate of

return on sharesconsistsof the payoutratio, whichis dividendsper value of outstandingshares,

plus the capitalgains (or losses)on the shareprices. The leverageof a firm is A whichis the

ratio of debt to financialcapital. Definep as the coefficient V, in equation(9). It is the

rate of return on financialcapitalwhichis a weightedaverageof the rates of return on equity

and debt. It is assumed that the rte of return on financialcapital issued by a firm is


        the objectiveof a firm is to operate in the interest of its owners by maximizingthe
expectedpresentvalue of the flow of funds to its shareholders. In the contextof the present
model,becausethe ratesof returnon equityand debtcapitalare exogenous,and thereforecannot
             by           the                                 the
be influenced shareholders, objectiveis equivalentto maximizing expectedpresent

value of the flow of funds to shareholders and bondholders. In other words a firm maximizes

                                   capital. The objectivecan be obtainedfromequation(9).
the expectedpresentvalueof financial

Solvingfor V and applyingthe conditional
            1                                     operatoryields.

       J, -, E   i a(t, ) P,y,[Ps W,J,
                                -        -Qr I, - " M,J                                  (10)

where EA the expectations
       is                                 on           knownat time t, the discount
                        operatorconditional 'nformnation

ratetherate ofreturn on fancial capital,a(t, t) -1, a(t, t+l) a (1 + p)-1 , p m - u) is the
   is                                                                          p(i

after product price, - wt (1 -u; ) (1 - j ) j - 1,...n are theafter tax variable factor

                                vector of after tax capital stockpurchaseprices,
prices, and Q is an m dimensional
                                                  -   10-

 Ql, - qi, (1 - V.' - i     a( t,s + r9)a( t,s)l ue,,.,r(1-I,            d)

 and M is an m dimensional
                         vector of tax reductionsat time t, due to capitalcost allowances

 arising from past investment expenditures, M,         -    u,5 i   q   , I,   (1 - *1 1 .,v,)d 1 ,* At any

 time t, M does not affect outputsupplyand inputdemanddecisionsbecausefrom the vantage

 point of the present the vector is predetermined. A sgnificant featureof a dynamicmodelis
 that current and future talxrates, cedits and allowancesare explicitlyaccountedfor in the
analysis.Indeed,the future taxpurchaseprices of the capitalstocksshowsthe array of current

and future tax policyinstrumentswhichaffectthe analysis.1

        A firm maximizesthe expectedpresent value of the flow of funds (in other words the

right side of equation(10))by selectingoutputsupply, variableinput and investmentdemand

subjectto the productionfunction(equation(1)), capitalaccumulation
the inverseproductdemandfunction(equation(8)), the exogenous
                                                           currentand future after tax
factor prices and discountrates. This program can be solved in two stages. The first stage

relates to the short run decisionsand the secondstage concernsthe intertemporal

choices. Conditionalon the capital stocks, output supply and variable factor demand are
determined. With this solution,a firm then proceedsto determinethe demandfor the capital
inputs. In breaking the prob.em into two subsets, the first stage solution or short-run

equilibrium foundby maximizing
                             after tax variableprofit at eachpoint in dme. Thus
       ma*x P,y, - W* v.
       ( y,V   )                                                                                     (11
sub3ect equations(1) and (8), and giventhe capitalstocks. Substituting
      to                                                             equation(8) into(11),

the first order conditionsare,
                   D(Y"p~~      ~   ~~~e          l

           - , + lf,   v,   O                                                           (12.2)

 where t   a Y(oD/M/p       is the inverseprice elasticityof productdemand,e . (py/a)yyy is the

conjecturalelasticity,X is the Lagrangianmultiplierand the superscripte denotesequilibrium
values. From equation (12.1), in short-runequilibriuma firm equates after tax marginal

revenueto marginalcost. The Lagrangian        equalsmarginalcost. Equationsc: (12.2)
implies that relative after tax variable factor prices equal relative marginalproducts of the
respectivevariablefactors. Equationset (12) holds for all time periods and, of course, for all

firms in the industry. Equationset (12)showshow tax policyaffectsthe short-runequilibrium
The corporateincometax rate doesnot directlyaffectthe short-runequilibrium.From equation

set (12) relativevariablefactorprices and the relativeproductprice (all prices are normalized
for exampleby the nth variablefactorprice)are independent the corporateincometax rate.

The reason is that the corporateincometax is a tax on variableprofit in the short run, and as

a consequence, is basedon the residualof the short run incomestream. Third, the corporat

incometax rate, like the investmenttax credit and capitalcost allowancerates indirectlyaffect

the short-runequilibrium                     on
                        throughtheirinfluence the demandfor the capitalinputs. Change
in these rates affect the after tax purchaseprice of the capital inputs and thereby alter th
                        factors. These changesin the capitalinputlevelsthen influenceth
demandfor the quasi-fixed
shortrun supplyof outputand demandfor the variablefactorsof production.

      The short-runequilibriumconditionsare consistentwith a numberof product market

structures. The conjectual elasticity, e, shows the nature of firm interdependence the
                                            * 12-

product market. If e - 0 then the productmarketis purely competitiveas firms are price

takers. If o    -                                                 as
                    1 then the product marketis purely monopolistic there is only a single

producer.If e * y/y then the productmarketis oligopolistic the firms are characterzedas

           oligopolists.In the latter case, if firms have the samemarginalcost in short-run

equilibriumthen from equation(12.1), firms have the same conjecturalelasticityin short-run


       An alternativeway that the short run equilibriumconditionscan be characterized,

emphasizesboth product market imperfections the dual relationshipbetweenprice and

quantityeffectson variableprofit. Considera first order approximation the revenueof a firm

in equilibrium,

       D( Y,, c,)y - D(Y', eg)yt D(Y,',et) (I + 4 Vj,](y, -y,')                        (13)

Collectingterms yields,

       pty - pt,(l + etE8)yt
                         - p,*y&','e''                                                 (14)

From equation(14), total revenueequalsrevenueearnedin a purelycompetitive
plus the additionalrevenue eaned in equilibriumbecauseof oligopolypower. Definingthe

purelycompetitive shadowproductprice as p,' . pt'(l    + g,)e,) and the after tax shadow

productprice as P,'- pt'( - u.) then the short-runequilibrium         (equation (12)can
                                                             conditions       set

be obtainedby

      max.     P:y, - W. v.(
       (y v,)
                                               - 13 -
 subjectto the productionfunctionand the givenlevelsof the capitalinputs. Thus firms act as

                 aftertax shadowvariableprofit, whichis definedas aftertax shadowrevenue
 if they, maximize
 minus after tax variable input cost.     The reason is that the degree of product market

imperfection capturedin the definitionof shadowproductprice.

       The short-runequilibrium         can            into
                               conditions be substituted (15) to obtainthe after tax

shadowvariableprofit function.

           -(Pe,       K
                    W,,K,    AK,,A,)                                                    (16)

where ?e is after tax shadowvariableprofit,III is the after tax shadowvariableprofit function

whichis definedfor non-negative
                              after tax prices and capitalinputs,increasingin the after tax
shadowproductprice and capital inputs,decreasingin the after tax variable factorprices and
             in                2
net investment the capitalstocks.
       The dual relationship                                              can
                            betweenprice and quantityeffectsin equilibrium be seen by
differentiatngthe aftertax shadowvariableprofitfunctionby the after tax shadowproductprice

and the after tax variablefactorprices. This yields,

       y5 ' -4                                                                       (17.1)

       v - -V l3n                                                                    (17.2)

The short-runequilibriumoutputsupplyand variablefactordemandscal be obtainedfrom the

after taxshadow variable profit function. It implies that short-run equilibrium can be

characterized equations
                      (16), (17.1)and (17.2). The attractivefeatureof thisapproachis that

reducedform outputsupplyand variablefactordemandequationsare readily obtainablefrom
the after tax shadowvariableprofit function.
                                                - 14-
        The secondstage of the programinvolvesthe deterninationof demand for the capital

inputs. This stage relates to the intertemporalaspects of productiondecisions.Capital input

demandcan be obtainedby considering expectedpresentvalue of the after tax shadowflow

of funds.The objectiveis to


                                 equations(denotedby equationset (2)). The first order
subjectto the capital accumulation
                                                           equationset (2) into (18), are,
conditions this problemat any timeperiod, after substituting

        V(ft'1aAK,)         - Q, +Ea (s,s+l)[v(8x:.       a)
                                                      1 I8Kg)   -[V(8iax/OAK
                                                                       1                  (19)
        +o1 -a) Q 1J -On

Equationset (19) implies that the marginalcost of a capital input is equatedto the expected
marginalbenefit of that capital input. The marginalcost consistsof two components;the

after tax marginaladjustmentcost and the after tax purchaseprice. The expectedmarginal

benefitconsistsof three components; expectedafter tax marginalprofit, the expectedafter

tax adjustment savingand aftertax purchaseprice savingfrominstallingand purchasing
             cost                                                                 (or

renting) the respectivecapital input in the previous period. Equation set (19) shows the

intertemporaltrade-offbetweengreaterexpectedfuture after tax profit due to increasesin the

capitalinputsand smallercurrentafter tax profit resultingfrom increasesin the capital inputs.

It is importantto notice that this equationset containsall current, as well as, expectedfuture

tax, credit and allowancerates. These rates enter throughthe after tax purchaseprices of the

capital inputs.
                                             15 -
       The completeset of equilibrium         are
                                     conditions given by equations(16), (17) and (19).

Equations(16) and (17) define a short run equilibrium,while equations(16), (17) and (19)

define a temporaryequilibriumof producer behavior. In the temporary equilibriumoutput

supply,variablefactorand capitalinputdemandsare determined.

       This sectionparameterizes dynamicmodel of productionpresentedin section 1.2.

Thedynamicnatureof the modeloffersmanyadvantages determining impactof taxpolicy
                                               in          the

on outputsupplyand inputdemands. First, the modeltreats capitalinputsdifferentfrom other

factorsof productionas producersmustincuradjustment
                                                  coststo investin capital. Second,the
modelallows for short-run,intermediate-run long-runeffects of tax policy initiativesto

differ. These effectsdiffer accordingto the extent that capitaladjustmenthas occurred.
       In the empiricalspecification the model, it is assumedthat there is one output, two
                                    inputs),and one quasi-fiscal
variablefactors(laborand intermediate                          factor. In order to estimate

the dynamicmodel of productionwe need to parameterizethe after tax normalizedshadow

variableprofit function(givenas equation(16) ). This functionis assumedto be normalized

quadraticand is writtenas

          +0-5[P     A         + ff Ps'
                          +PgWk' Pa 8-1+POO'](0                                     ~~~~~~~~~~

         + pPWgS + pop-          +     'As

         +   P&W&,       + PkW&A + Pk3Kh$ + O.SIAsK2
                                                     -    16 -
 where s, is the after tax normalizedshadowvariableprofit (normalization by the after tax
 price of intermediateinputs), PI, is the 'fter tax normalizedshadow price of output (see

 equations(13)-(1S)), is the normalized
                    W,.               labor inputprice or normaliz wage rate, K, is the

capitalinput, A, is the indicatorof technology &K,representsnet investment. variables
                                             and                          All

are indexedby the timeperiod s.
        From the profit function, we find the equilibriumconditionsfor output supply and

variable factor demandsby differentiatingthe after tax no-mnalized
                                                                 shadowvariable profit

function(e4uation withrespectto the relevantprices. Thus we obtainthe following
                 20)                                                           specific

output supplyand input demandfunctions(whichwe are givenas equations(17.1) and (17.2)

in section1.2),

        Y - pp + PP3 + PpWI + PPkK8+ P AI.
                                      1                                             (21)

        -vi - PI PX W + P
                 +                    + PA-,    +   Pf3A,                           (22)

Since -v         no -P ay+W v1, then the intermediate input demand equation is

           -v.   =Po   + Pa-I    + %A, + ,A,1       -05          3P,   -O

                 +O.5p kK       +0.5P,A,' -    ,P,PW + PkIK,lA,
                                                   1.                               (23)

                 + 0.Sp,AK2

       Thus, equations(21), (22)and (23)definethe short-runequilibrium         basedon
the normalizedquadraticafter tax shadowvariableprofit function. These equationsshow how

after tax outputand variableinputprices affectoutputsupplyand variableinputdemands,given

the levelsof the capitalstocks.
                                                   - 17 -
           The equilibriumcondition the capitalinput, is givenby equation(19) in section1.2.
 Basedon the normaized quadradc after tax shadowvariableprofit function, the equilibrium

conditionfor capitalcan be writtenas
               pIAK9 - Q +(I+p)-Y[,(pk + PI&K5 P
                          (                  +               +      I1&W                  (24)

              + PaA$., - ,,AK,.,   + Q,1(1 - 8))] - 0

where Q, is the normalizedafter tax purchaseprice of capital, 6 is the depreciation and p
is the discountrate.

          If we assumethat after tax relativeprices, discountrate and technologyindicatorare
expectedto remainconstantthen we obtainthe following,

   -%Ar,1.. + (1+p)pYAK$ + p+Ka k + p,
                               +                        paWk+pw, - Q,(1+p) + Q   ,(1-d) (25)
Re-arranging get

 -p/a1.   1   +(pi (2+p)P)K,, -(I+p)PuK.. * W-s-(Pk + POP$ PRWb+
                                                               P2M)                       (26

wherethe normalizedafter tax rental rate is Wk.-Q,(p+8).

          Equation(26) definesa secondorder differenceequationin terms of the

capitalstock. The solutionto this equationis a flexibleaccelerator,

          Ks - K2 1 - m (K, -K,-1)                                                       (27)

whrce m a - OS(p + Pkk/P -[(P + Pkk/ g )+4Pkk pt lo-) is the speedof adjustment the

capital stock and the long-run capital stock is K, -             (% p+,P,P'P&Wu P
                                                                         +    +      - Wb) -

          Therefore,by combiningequations(7) and (8) we get,
                                           -   18 -

          +4PAJPJO"(Pk+PW                      @--                                       8)

          +(1+0.5(p+ PMPi,-[(p + Puh


       Equation(9) showethe demand the capitalinput. It is a functionof the relativeafter

tax outputprices, variableinputprices and rentalrate, along with the discountrate and lagged

quantityof the capital input. This equationis nonlinearin the parameters.
       TMe                                   of                         (21),(22),
                                                      madeup of equations
                   modelconsistsof the system equations

(23) and (28). These equationsdescribea temporaryequilibrium. There are four endogenous

variablesoutput supply Y,, labor and materialinput demandsv,, and v. and capital input

                                                         variablesare the normalized
demand,K,. In addition,in the productionmodelthe exogenous

after tax prices, P,W,h,WJ,, the discountrate, p, laggedcapital,Kg,,the technology

                                       variablesand nonlinearin the parameters.
A, . The modelis linearin the endogenous

                       are       by                equations(21), (22),(23) and (28)
      The modelestimates obtained jointly estimating

using the maximumLikelihoodestimator.The estimatedprofit functionmust be convex in

prices. Thus the parametersmust satisfy p.,> 0 p > 0 and p. - P      >   0. In addition,the

profit functionmust be concavein capitaland net investmentso that, Bkk and Bi< 0.

      An importantfeature of this model is that there are adjustmentcosts associatedwith

capitalaccumulation.These costspreventproducersfrom immediately

                                                       and               adjust towards
desiredlevelsof capital,and therebyalso labor, materials output. Producers
                                                      -   19 -
 the long run. The speedof adjustment givenby m in equation(27). The dynamicadjustment

 processhas implicadons the effectiveness tax policychanges. For example,in the shnrt-
                      for               of

 run output supply dependson existing capital, but not on the rental rate. This means that
 changesin the capitalcost allowancerate whichalter the rental rate of capitaldo not have an

 effect on the supply of output. However,as capital adjustmentoccurs and the capital input
changesin responseto the new capitalcost allowance then outputsupplyis affectedby the

 new rate. Thus, in a dynamic context it is important to distinguishbetween the short,

intermediateand long-runeffectsof tax policy. In the short run, no capiti adjustmenthas

occurred,in the intermediate capitaladjustment occurredfor one period, and in the long
                           run               has

run, the capital adjustment process has been completed.


       The short-runequilibriumconditionsare based on equations(21), (22), (23) and (28)
-Theshort-runequllibriumconditionfor outputsupplyis

       Y-'       +p,,P:+p$wi+p,&K,+1,A                                               (29.1)

The laborand materialinputshort-rundemandfunctionsare

             -   Pa+Puwb
                 p1 py +PsP:l+PziAa                                                  (29.2

        -'   .    o   Ph%.      +,^       0.58
                                        -*~             0.5g

             *   O    e,       0.5.,NA. 2 - P,P.'WI   + P1*,.IA,                     (29.3

             + 0.5p(I, 5   -

The equationfor the short-rundemandfor the capitalinputis
                                           -   20 -

                 -0.5        PA r
                                1          it           A
                     Pik11    Pi,+ lPM~                Pi,)
                (t    + PpkaPs PaW +
                             +     *PkA,        -     Wx)                           (29.4)

              + (1 - o- p + Phk + E(P + PAkp+ 4Pi*] )bJ

                                        variablessignifiesthe short-runequilibrium the
where the superscripts for the endogenous


       The short-runequilibrium         of
                               magnitudes outputsupplyand inputdemandsare determined
in the followingmanner. Theshort-rundemand capitaldependson predetermined
                                         for                            variables.

These variablesare relativeafter tax prices, indicatorof technology,discountrate and lagged
capital input. Next, the output supply and variable input demands are simultaneously

determined. These variablesdependon the aftertax relativepricesof outputand labor (not the

rentalrate), the technologyindicatorand laggedcapitalinput.


      The equationsfor the intermediate-run derivedfrom the short-runequations. The
               is                                         processafter one period. The
intermediate-run definedwithrespectto the capitaladjustment

intermediate-run          conditionfor outputsupplyis

      Y'.+         *
                 pp+ P,P + P         + P,,K,' + P>A
                                     *j%                                           (30.1)

                                               for                  are
      The labor and materialinputdemandfunctions the intermediate-run describedas

      -VI+I          ,Pi + PWAU Ppf': + pkKs + Pi.Aa
                              +                                                    (30.2)

               -Va.-           -   PO             + p+,-P 5           P,S2 - O.Sp.w"

                               + 0.50e,         + 0.SPWr2        -    P/W         + P -       A           (30.3)

                               + O.SpU(K8.j - K8Y

       The equationfor capitalinputintermediate-run

                       *       (+.5IP)      (P + pdp                 [(p + §WpM2

                       + 4PI3Pdi0J5)(Pk+ PA'                     + PkW        +   P       -   WA(30.4)
                       * (1 + O.S(p+                         -            fi)2
                                                                     p + p&

                       + 4p,Jpj 0.5) K,'
       Giventhe technologyindicatorand relativeprices, these equationsshowthe equilibrium

after one year. The superscript i indicates the intermediate-run. The intermediate-run

equilibriummagnitudesof outputsupply and input demandsare determinedin the following
                           demandfor capitaldependson predetermined
manner. The intermediate-run                                      variables. These

                                              of          discountrate and short-runcapital
variablesare relativeaftertax prices, indicator technology,
input. Next, the cutput supply and variable input demandsare simultaneously

Thesevariablesdependon the after tax relativeprices of outputand labor (not therental rate),
the technologyindicatorand the short-rundemandfor capital.


      In the long-run,AK, - 0. Thus, investment the long-runonlyoccurs for replacemen

purposes. The long-runoutputsupplyequationis

      yS   -               +            *P
                                        f P^W      +   P;X           + PwA,                              (31.1
                                                     -   22 -

        The labor and materialinputuemandequationsfor the long-runare

                         I               S               ~~~~~~~~~~~~~~~~~I
                        I~ + -   p1   pph?
                                         6     plc                                      (31.2)

             -          Po + PkKXI PA
                                +            - O.SPPP           -   OPiWs

                     + 0.5sp;K + 0.5s P + O.Sp",< - pb,bW,                              (31.3)

                     + PjaK A,

       Capitalinputdemandis givenby the followingequation

        K,       -    (-'/Pi,)[Pk + pA,P;+ PI* + PhA, - W,J
                                             Wl                                         (31.4)

       In the long-run,since the ca;.tal adjustn 'nt processis completed,output suppliesand
inputdemandsare functions the iong-rundemandfor capital. Thedemandfor capitaldepends

           variables. Once this denlandis obtained,then outputsupply,labor and material
on exogenous

demandscan be determined. Sincethe long-rundemandfor capitalaffectsoutputsupply,labor

and materialdemandsthen the rental rate affects thesevariables.Indeed,in the long-runall

inputs are variablefactors.

Rental Rate Elasticities with Respect to Tax Instrments

                                                                investment, is necessary
       In order to determinethe effectof tax policyin stimulpting         it

                              elasticities capitaldemandin each of the productionruns.
to determinethe tax irnstrument          of

                            consistof two components.The first elementis the effectof the
The tax instrumentl
tax instrument the after tax relativerentalrate of capital(sincethis is the only relativeprice

directlyaffectedby the tax policy). The secondcomponent the elasticityof the rental rate on

the demandfor capitalin each of the productionruns.
                                                -   23 .
        We now consider the effects of the tax instrumentson the after tax relative rental rate.

The elasticity of the after tax rental rate with rspect to the lTC rate is

                -Q,(P          u+ /8U))U&/,(1-u)O
                        + 8)(1 U(&z5                                                           (32)

Increases in the lTC rate lower the relative price of the capital input. In cases where investment

tax or incentive allowance (IIA) exist, the elasticity of rental rate of capital with respect to

allowance rate is:

         ca,v -Q(p + d) (u + g(8'aI*a*))*a,/Iw*u(1 < o
                                               - u)                                            (33)

Next, the effects of changes in the capital cost allowance (CCA) rate also operate through the

rental rate. This elasticity is

        ez,,w - -Q(p    +   8)u.,(&z,/t3dd,fW,(l - u) < 0                                      (34)

I.creases in the CCA rate lower the relative price of the capital input.

        The corporate income tax (Cm rate affects the normalized or relative after tax rental

rate. However, the CIT does not directly affect the other relative output and input prices. The

CIT elasticity on the rental rate is

        C*" -     Q(p   +     ,)(1 V, -
                                 -          0U u-IWb(1 - u.)>
                                             Z)                  0                            (35)

Clearly, decreases in the CIT rate cause the relative price of the capital input to fall.

       The effect of tax policy on capital demand in each of the short, intermediateand long-run

is obtained by calculating the tax effect on the rental rate and then multiplyingthis effect by the

rental rate elasticity of capital demand.

                                    AND GOVERNMENTREVENUES
       In this sectionwe present the results of changesin each tax instrumenton the demand
for capitalper cost to the government stimulatngcapitaldemand. This ratio we refer to as

the benefit-cost
Investmnent Credit and Allognc

       For an investment credit, the changein government
                       tax                             revenueis

              a   Qt(14 - (l-a)K: 1 )v,                                                (36)

The superscripte denotesthe particularequil£brium, = s,i,l for short, intermediate long-
                                                 e                               and

run. For an allowancewitha rate of *, thenin the formula,v, is replacedby ,u . For a 1%

changein a rate multiplythe formulaby 0.01.

Cagital Cost Allowance

      If depreciationfor tax purposesis decliningbalance, and tax credits do not affect
depreciation tax purposes,then the changein government
            for                                      revenueis

       AGR; -            -J(   (1-8)K-i)Ou   p                                        (37)

      If depreciation tax purposesis straightline,and tax creditsdo not affect it, then the

changein government

      AGR;      - Q((v)-(1-8)R                                 ))(                    (38)
                                                          - 25 -
 Corrate       Income Tax

           The base for the incometax rate is revenuenet of variablecost, interestpaymentsand
allowances(all allowances,for examplecapitalcost and investment). Definethe base in year

 s as

           E       psy- -_8ysWtV
                   P                -              -   CCA, - IIA                       (39)

where (withone type of capital, see equation(5)).

           cCA* - E;.oQO- s.-*d
                       5                                                                (40)

where I. "-        (KR'   -   (--8) KR' 1 ).       Also

           ITA.      *, Qs (KR -        (1-8)K:)

Now the changein government
                          revenuein this case is

           AGR, - E:uc

Bnefit-Cost Ratio

           ;   =    Ac                                                                  (41)

where the numerator is the nominal value of capital (before tax, not normalized)in the

appropriateequilibrium,multipliedby the elasticityof capital with respect to the j tax

inmtrument         tax
         (investment credit, tax allowance,capital cost allowance,income tax). The
numeratoris the additional
                         capitalgenerated a specifictax instrument. The denominatoris

the cost to the government generating additional
                         of         the        capital. The ratiodenotesthe benefit-cost

                                           - 26 -
                                       1.5 MEICO

 1.5.1 Tax History
        The structureof corporateincometaxationin Mexicohas undergonemajorchangesin

 recent years. During the 80's Mexicancc-porate tax system allowed indexationof capital
 consumptionallowances only. Full indexationof the corporate income tAx base is now
permitted. With indexation,corporationsare no longer allowed to deduct the inflationary
component of interest expenditures nor would they have to accumulatethe inflationary

component interest income (see Gil-Diaz, 1990, p. 79.) TaxableProfits (definedas gross

receipts minus purchasesand businessexpenses,and net losses carried forward from other

periods)are subjectto tax at a rate of 35% (a rate of 42% prevailedin the pre-1987period).
Depreciationdeductionsare indexed or as an alternative,the present value of depreciation
calculatedat a discount rate of 7.5% may be deducted fully in all regions except major

           areasand in all sectorsexcept the automobiles.In major metropolitan
metropolitan                                                                 areas only
60% of suchvalue can be deductedin the first year and the remaining40% subjected capital


       It is instructiveto comparethe Mexicantaxationof businessincomewith a few of its

capitalexportingpartnersnamelyUnitedStatesand Canada. Table MI showsthat Mexicohas

movedsome distancetowards a cash flow type of taxationby allowinga deductionfor the

present valu'. of the schecduled
                               depreciationallowancesfor the life of each type of assets
calculatedat a 7.5 percent annualrate of interest(see Gil-Diaz, 1990). Tax incentivesregime

in Mexicohas also undergonesignificant
                                     changesover time. Duringthe past two decades,tax

policywas seen as a majorvehiclefor regionaland sectoraldevelopment
                                                                  while revenue
                                                                        - 27-
                                                                        Table NI

                                         Nexico:    Toxation of DIsinmes Income, A Coapartive      Perspective

 TaX regime                   -H-::--               S--:::-v.!:-ffexi
                                                   (1991                        tkIted State
                                                                                           i     10)
                                                                                                 19M      -                   O9)
 Corporate income t   rate:    unerol1      35 * 3.9 * 38.9                     34 + 6 40                           28 + 15   43
 Withhotding rates
   Interest                                 3S                                     30                                   26
   DivIdends                                0-40                                   30                                   25
   Technology trenefer fees                 21                                     30                                   25
   Royalties                                40                                     30                                   25
 Indexation of deductfons                    Fult                                  No                               Mo
 Loss carry forward                           5                                    15                                7
 Losscarrybackiard                            0                                     3                                3
 Niniumu/atternative Ninima tax              2 assets tox                          20X an taxable
                                                                                                incom inclusive 0.175Yan capita(in exces of $10
                                                                                   of tax preference            *Illioncreditableagaint 3X
     tat gairm toxation                                                                                         surtaxon corporateprofits
 Capital galintaxation
   Coverage                                  Fult                                  FulL                             Two-thirds
   Indexation                                Full                                  No                                   No
   Rate                                       35                                   34                                   28
  fDvidends deductien                         go                                   Yes                                  Yes
 Fullexpensing investumnt
                of                            No. Present
                                                        Valueof CCAs               No                                   Mo
                                             lediately daductible
 Investment tax credi s                                                            Energy irnestmnt.                Regiontl wnd R&D
                                                                                   rehabilitation of real estate,
                                                                                   targeted job credit

2/ In Mexicotheprof t-sharing
                  i         rateand, in the United                           provincial statetax rates are addedto the basicfederalrate.
                                                  States nd tan d, the averae*        or
Source: Ugerte(1966),
                                                    kureu of fiscalOocumentctien
                                                                              (196), and Cil-Dlaz
                                          -28   -

                                                                     changesin the tax
implications thesepolicieswere overlooked. A brief reviewof historical

incentiveregimein Mexicois presentedbelow:

       1955-1972: Between20% (for secondaryindustries)and *0% (for basic industries)

corporateincomeof Mexicanmajorityownedenterpriseswasexemptedfromcorporatetaxation

for periods varyingbetweenfive to ten years. The same industriesalso could receive, upon

application,exemptionfrom certainindirecttaxes and importduties on capitalgoodsimports.
       1972-1979: Industries that were seen to promote decentralizationand regional

          were grantedimport duties relief varyingfrom 50% to 100%and reductionin
corporatetax liability ranging from 10% to 40% dependingupon their locationand type of

       1979-1986: The practice of import duty exemptionwas continued. In addition, tax
                              providingtax creditin therangeof 10-25%,depending

location,and type and size of the industry, for investmentin physicalassetswere introduced.

These certificateswere negotiableand could be used againstany federaltax liabilityby the

                         provedquitepopularand in 1983amountedto 0.83 percentof GDP
holder. These certificates

                                         sector was a major beneficiaryof this scheme,
in revenue losses. While the manufacturing
                                                                    amountof resources.
                                   industres also receivedsignificant
mining,agricultureand transportation

                     industries,paper and publishing,chemicalsand food and beverages
Amongthe manufacturing
receiveda majorityof the assistance.
      WhileCEPROFISwerethe mostimportant              Mexican
                                       fiscalincentive,               offered

                            were exportpromotion(CEDIS),development duty-freezones
also offeredspecialincentives                                     of

specialtax preferencesto automobile,cement,publishing miningindustries.
                                          - 29 -
       1987-1900: The tax incentivescertificates scheme was significantlytightenedand

 targetedto priorityindustries preferredzone. Top taxcredit rate for CEPROFIwas raised
 to 40% of totalphysicalinvestment 1986. In addition
                                 in                 Mexican-owned
                                                                enterprisesare eIigibl
for employment creditup to 30% of three times the annualarea minimumwage multipli:

by the numberof newjobs created.

       Startingin 1989, full expensingof the present value of capital consumption

calculatedusing a 7.5% discountrate was offered as an alternativeoptionto standardcapit

          allowances non-metropolitan
                   in               areas. In the metropolitan
MexicoCity, D.F., Monterreyand Guadalajara,
                                          only 60% of the presentvalue of depreciatio
allowancescould be deductedin the first year. R&D investmenttax credit at 15% for the
purchaseof technological
                       research(20% for smalland microenterprises),and 20% for capital

purchases by technologicalenterprises (30% for small and micro enterprises) were also

       1991-Prtsent: Effective 1991 all CEPROFI related incentives were eliminated.

However,the immediatedeductionof presentvalue of investmentexpendituresdiscountedat

7.5% per annumstill remains.
                                             * 30 -
1.5.2 Tax Policy Effects on the Rental Rate and Capital

         The modelwas appliedto two Mexicanindustries;detergents otherchemicals. The

                            Mexicanindustriesfor the period1970to 1983wascollectedfrom
data for thesetwo three-digit

a varietyof Government Mexicosources. These two industriesare amongthe three largest
industries the industrialsector (SIC 35) comprisingof chemicals,petroleumderivatives,

rubber and plasticsproducts. Together thesetwo industriesaccountedfor 5.2 percent of total
            outputand 2.9 percentof total employment. The data on industrycapitalstock
was developedby using the perpetualinventorymethodwith an assumeddepreciation of
                                                        rates of 0.1 for machinery
0.08, representinga weightedaverageof assumeddepreciation                         and

equipmentand 0.025 for structures respectively.) Quantityof labor was measuredas the
                        during the year. The price of labor was derivedby dividingthe
averagenumberof employees

total employmentcost during the year by average number of employees. Quantity of
           input, was obtainedby dividingthe cost of intermediate
intermediate                                                     inputsby the input price

         We wil now examinethe effectsof corporatetax policyinitiativesin stimulating

expenditures the short, intermediate long runs for the case of Mexico. The three tax
           in                      and

instruments we considerfor Mexicoare the corporateincometax (CM rate, the investment

tax credit (ITC) rate, and the capital cost allowance(CCA)rate. As discussedearlier on the

theoretical empiricalmodels,only the relativeprice of the capitalinput is directlyaffected

by tax policy initiatives(see equations(32)-(35)). Thus, the relativeafter tax rental rate is a

crucial variable in the determinationof the effects of tax policy initiatives on capital

expenditures. In table M2 we present the elasticities the tax instruments the rent rate.
                                                    of                  on
                                              -   31 -
Since the normalized after tax rental rate on capital is the same for both industries, the results

found for the elasticities of rental rate of capital with respect to the three instruments are also

the same. These elasticities remain relatively constant over the sample period. As seen in table

M2, a 1 percent increase in the CCA rate results in a 0.63 percent decrease in the normalized

after tax rental rate, whereas a 1 percent rise in the ITC rate leads to a 0.41 percent decline in

the relative rental rate. In fact, a 1 percent increase in the CIT rate leads to around a 1.00

percent increase in the after tax relative rental rate. The results for the short, intermediate and

long-run tax elasticities for capital demand appear in Table M3.

                                            Table M2

              Elasticities of Rental Rate of Capital with Respect to Tax Measures

 Year                                                      e

  1979                           -0.405                   -0.621                  0.895

  1980                           -0.409                  -0.635                   0.918

 1981                            -0.409                  -0.635                   0.962

 1982                            -0.409                  -0.635                   1.021

 1983                            -0.409                  -0.635                   1.021
                              - 32 -
                             Table M3

                   Capital Demand Elasticities

                     Detergents                  Other Chemicals
                    1979                1983       1979              1983
ekft               0.015               0.012      0.008             0.006
e- ,               0.024               0.019      0.013             0.009
e,,                -0.034              -0.031    -0.018            -0.014
es,                0.020               0.016      0.011            0.007
e-,                0.031               0.024      0.016            0.012
eit                4-0.045             -0.039    -0.023            -0.019
e,k,,              0.022               0.017      0.012            0.008
ekse.              0.034               0.027      0.018            0.013
eu,,               -0.049              -0.043    -0.026            -0.021
                                           -   33 -
                              Impactsand Foregone
1.5.3 Tax Incentives,Investment                  Revenues

       Althoughfocusingon investmentexpenditureonlyprovidesa partial view of the effects

of tax policy, in this section,we calculateinvestment
                                                    inputper unitvalue of foreigngovernment
revenue. This measureis referred to as the incremental          ratio in Table M4. These

calculations presentedfor the mostrecent year (1983)in the data as well as wiearlier year

(1979), together with the mean and standard deviationfor the 1979-83period. The table

suggests that the effectivenessof investment tax credit for both Mexican industries has

           in                                               in
deteriorated recentyears and the measureis not cost-effective any of the runs. Accelerated

capital consumptionallowances, have also proved to be not cost-effectivetax incentive

                             ratio for this measureis less than one in all runs for the two
instrumentsas the benefit-cost
industries. Finally, while corporate tax rate reductions have had fairly large impacts on

stimulatingcapital expendituresin the detergentsand other chemicalsindustries, revenues
                                                         impactstherebyyielding low
foregonefromsuchreductionsfar exceedthe positiveinvestment                     a

           ratio. Thus it is apparentthat ali three tax incentivesprovedto be cost-ineffective

in all runs for the two industriesexaminedhere.
                                               - 34 -
                                              Table M4

                       Investment Impacts Per Unit Value of Lost Tax Revenue

                                                               Short Run       Intermediate   Long
Tax Instrument              Industry                Year                       Run            Run

InvestmentTax Credit        Detergents              1979       0.55        0.69               0.74
                            Other Chemicals                    0.28        0.36               0.40

                            Detergents              1983       0.44        0.51               0.54
                            Other Chemicals                    0.26        0.32               0.34

                            Detergents             Mean       0.57         0.71               0.77
                                                   (s.d.)     (0.08)       (0.13)             (0.16)
                            Other Chemicals                   0.26         0.35               0.40
                                                              (0.02)       (0.02)             (0.03)

Accelerated Capitol         Detergents              1979      0.40         0.50               0.54
Consumption Allowance       Other 'hemicals                   0.20         0.27               0.29

                            Detergents              1983      0.32         0.38               0.40
                            Other Chemicals                   0.19         0.24               0.25

                            Detergents             Mean       0.42         0.52               0.57
                                                   (s.d.)     (0.06)       (0.09)             (0.12)
                            Other Chemicals                   0.19         0.26               0.29
                                                              (0.01)       (0.02)             (0.03)

Corporate Income Tax        Detergents             1979       0.05         0.06               0.07
Rate Reductions             Other Chemicals                   0.01         0.02               0.02

                           Detergents              1983       0.03         0.04               0.05
                           Other Chemicals                    0.01         0.01               0.01

                           Detergents              Mean       0.04         U.06               0.06
                                                   (s.d.)     (0.01)       (0.01)             (0.01)
                           Other Chemicals                    0.01         0.01               0.02
                                                              (0.00)       (0.00)             (0.00)
                                          -35   -
                                     1.6 PAISTAN

 1.6.1 Tax HListory
       Pakistan has followeda stablecorporatetax rate regime since the early 1960s. The

 corporateincometax at 30% and a super tax at 20-25% have been maintzinedconsistently
 during the last two decades. Only in the fiscal year 1989-90the super tax rte was brought

 down to 15%. Foreign direct investmentreceives tax treatment equivalent to domestic
investment.Lossesare allowedto be carriedforwardsix years, but no carrybackof suchlosses

is permitted. A sales tax at 12.5%is payableon all domestically
                                                                         goods Dythe
producerand on importedgoodsby the importer. In the fiscal year 1989-90,import duties at
           rates were imposedon importedmachinery equipment.These rates variedfrom
20% to 50% if similarmachinery not manufactured Pakistan,and a higherrate of 80%
                              was             in
appliedto importedmachinerywith domesticsubstitutes.
       The regime of fiscal incentivesthrough the corporate income tax has experienced

significantchanges over time, as Palistan has relied upon a variety of fiscal incentivesto

stimulateinvestment. Thcse includeacceleratedcapital consumptionallowancesfor certain

physicalassets, full expensingfor R&D investments, rebates,regionaland industryspecific

tax holidays,and investment credits. Theseare briefly discussedbelow. Furtherdetailsof

the currenttax regimeare givenin TableP1.
      Tax holidays: Tax holidays two years for specificindustries(e.g. engineering
                               for                                               goods)
and specificregions(mostof the countryexcept majormetropolitan
                                                             areas) were introducedin

1959-60. The holidayperiod was subsequentlyraised to four years in 1960-61. These tax

       were eliminated 1972-73 reinstated
holidays              in     but         againin 1974-75. Presentlytax holidaysfor
                                          -36 -

five years are permittedto engineeringgoods, poultryfarmingand processing,dairy farming,

cattle or sheep breeding, fish farming,data processing,industriesmanufacturing
machinery,and also to all industriesin designatedareas of the country.

       Investmenttax credits: Industriesare eligible for varying tax credits according to

location. A general tax credit for balancing,modernization, replacementof plant and

equipment introduced a rate of 15%, but its application restrictedto designated
        was        at                                 was

Since 1976-77,the creditwas madeavailableregardlessof locationand ypeof industry. This

credit was withdrawnin 1989-90but reintroduced 1990-91.

       Acceleratedcapital consumptionallowances: Capital consumptionallowancesfollow

acceleratedschedules machinery equipment,transportvehicles housingfor workers
                   for        and                        and

                              (100%), ship building(20-30%),and structures(10%)on a
(25%), oil explorationequipment

                                                                       transfer and
                                   relating to research and development,
decliningbalancemethod. Expenditures

adaptation technologies royaltiesare eligiblefor full expensing.
          of          and

1.6.2 Tax PolicyEffects on the RentalRate and Capital

      The r.odel was applied to the wearing apparel (SIC Code: 322) and the leather and

leatherproductsindustries(SIC Code: 323)industriesof Paldstanfor the period 1966to 1984.

                                 industrieswascollectedprimarilyfrom the variousissues
The data on thesetwo manufacturing

of the two annual publications of the Governmentof Pakdstai.namely the Census of

ManufacturingIndustriesand the EconomicSurvey. The wearingapparel industryin 1984

                                                output and employedroughlyone percent
contributed0.63 percentof the total manufacturing

                         labor force. The leather and leatherproductsindustry,on the other
of the total manufacturing
                                                         -   37 -

                                                     Table Pl
                        The Structure of Corporate IncomeTax System in Pakistan 1990-91.
    A. CIT ras applied to all incomecxcept dividendsand bonus shares:

               1. Incometax rate                                                                              30
              2. Super tax rue:
                          -Bakng oompmi                                                                      25
                          -Non-bankingcorpanies (NB)                                                         20
               3. Suchargae                                                                                   10
     D. CIT azeapplied to intcrcorporatcdividends(ID) & bonus shares (BS):
               1. Income tax on D nd BS                                                                        0
               2. Super tax on dividendsrcived by
                         -Domestic publio companies                                                            5
                         -Poreign compania                                                                   IS
                         -Domeadoprivate companies                                                           20
              3. Super tax on bonus sharesissued by
                         -publio companiea                                                                   10
                         -privaescompanies                                                                   is
    C. Tax rebae:
               1. Tax rebateson super tax for NB public oompaniae(NBPUC)                                     10
              2. Tax rebateson super tax for small companics                                                  5
              3. Tax rebata on super tax for companiesangagedin spocifc economicactivities                10-15
              4. Tax rbata on income & super taxes for exportu                                            25-75
    D. Tax Crediuson the amount of investmentin:
              1. Sharel/debenturesof the Equity ParticipationFund                                            50
              2. Dcbenturesnegniable bonds                                                                    S
              3. Shars of industrialcompanie set up in Lackwardareas                                      10-30
              4. Plant/machinery for bal., mod., repl. or extension(BMR.E)                                   15
    E. Depreciaton AllowaLncea
              1. 'Normal (annual) depreciationallowsnca (ND)                                               5-30
              2. Extra shiAworking LUcwances % of ND) on plant                                           50-100
              3. Initialdeprociationallowances                                                           25-100
    P. Pull tax holiday, raging from 4-10 yesrs, for comparies engagodin:
             -key industrice
             -anufacturing electrical equipment/itscomponents& set up in NWP
             -fih' catching, cattle/sheepbreeding & dairy faJrming
             -wcxpiora;5on  of specific minertl
             -an indt4riLl undertakingaet up in an export processingzone
             -producingdefense equipment or arnuemnt. set up in specific Lreas
             -industia undertaings set up in specific backwardregions
       Purta tax holidays (25-50% of the capital), ranging for 5-10 year, for oompanies set up in specific
             regions and engaged in manufaucturing  goods, ship buildinp and navigadon, or generaion and supply of
             electrical energy or hydraulicpower.

     Surwhage are levied on total income and super taxes if the company's taxable income, includingdividends,
      exceds Rs. 100,000.
'    In the cae of NBPUCs,this is an additionaltLx rebate on super tax.

Source: Ehdai, J. 1991).
                                              -   38 -
hand, in 1984, accountedfor 1.8% of total value of output and employedone percent of

manufacturinglabor force. Together, these two industries accountedfor 2.4 percent of

            outputin 1984.

       The quantityof labor is measuredas total numberof days workedduring the year and
                                                           cost during the year by the
a labor price index was developedby dividingtotal employment

numberof days worked. The value of materialsor intermediateinputs include electricity,
petroleumfuel, naturalgas, and importedand domestically

The quantity materialswasconstructed dividingthe totalvalueof materialsby an industry
            of                     by

level materialsprice deflator.The quantityof outputwasconstructed dividingthe total value

of output by an industry output deflator. The series on capital stock were developedby
employing                                   seriesand assuming depreciation of
        perpetualinventorymethodto investment                 a           rate

0.08. This representsa weightedaverageof assumeddepreciationrates of 0.1 for machinery

and equipment 0.025 for structuresrespectiveiy.

       We now considerthe effectsof the three tax instruments; investment credit (ITC)
                                                             the        tax

rate, capitalcost allowance(CCA)rate and corporateincometax (CIT) rate on the rentalrate
of capital. Table P2 showsthe emprical results we obtainedfor the elasticitiesof rental rate
of capital with respect to various tax measuresfor Palistan's wearingapparel and leather

productsindustries. The magnitude the ITC elasticityincreased
                                of                           from 1977to 1984. In 1984,

a 1 percent rise in the ITC rate leads to a fall of 0.39 percentin the normaized after tax factor

price of the capital input. Over the sameperiodtime, the CCA elasticityof the relativerental

rate of capital decreased. The CIT elasticitiesdiffer slightlyacross the leatherproductsand

wearing apparel industries,but over time the elasticitiesdiffer dramatically. In the leather
                                            - 39 -
productsindustrya 1 percentchangein the CIT rate leads to a 0.42 percentrise in 1977in the

         after tax rentalrate of capital. However,in 1984, increasesin the CIT rate result
in a rise of only 0.04 percentin the relativerentalrate. In 1977,a 1 percentincreasein the CIT

rate results in a 0.36 percent increasein the relative rental rate in the apparel industry. By
1984,a risein the CIT rate leads to a rise in the price of capitalinput of about 0.03 percentin

the same industry. The ITC elasticitiesare larger in absolutevalue than the CCA and CIT
elasticities 1984althoughin 1977the CIT elasticitiesare larger than comparableelasticities

for the ITC and CCA rates. The results for the short, intermediate long-runtax elasticities

for capitaldemandappearin Table P3.

                                          Table P2
             Elasticity RentalRate of CapitalWith Respectto Tax Measures

 1977                          -0.338                  -0.285                  0.359

 1984                          -0.386                  -0.225                 0.034

 1977                          -0.326                 -0.287                  0.425

 1984                          -0.386                 -0.225                  0.037
                                            -   40 -

                                  Capital DemandElasticities


  e,,,,                                    0.011          0 004          0.003       0.002
  ek,,                                     0.009          0.002          0.003       0.001
   Xt*                                     -0.012        -0.004         -0.004     -0.0002
  e*,,,                                    0.019          0.008          0.006       0.003
  e. ,0.016                                               0.005          0.006       0.002
  e,k                                      -0.021        -0.007         -0.008     -0.0003
  et.,,                                    0.046         0.029           0.016       0.006
  et.                                      0.038         0.017           0.014       0.004
  euk                                      -0.048        -0.003         -0.021     -0.0006

1.6.3 Tax Incentives, Investment Impacts and ForegoneRevenues

          the benefitcost ratios for eachof Eme incentivefor Pakistanare presentedin Table
P4 for the mostrecent year (1984)in the data as wellas for an earlieryear (1977),togetherwith

                                           period. In carrvingout thesecalculatiors,we
the meanand standarddeviationfor the 1977-84

note that investmentis most responsiveto changes in investmenttax credit. The loss Li

         revenuesare quite similarfor ITC and CCAs,and therefore,ITC yieldsa slightly

                 ratiothan CCAchanges.For corporate rate reductions in government
higherbenefit-cost                                 tax            loss

revenuesfar exceedth^ investment                impactsfor all measureswerc smaller
                                                                runs due to the observed
in recentyears comparedto earlieryearsfor the short and immediate

decline in own price elasticity of capital in recent years. Thus the table suggeststhat the

                                          measurefor boLhindlustries recent years based
investmenttax credit becamea cost-effective                        in

                                                                  emergesfor accelerated
on its long run impact only. A similar patternof cost-efftct!
                                          - 41 -
capital consumptionallowances. Such allowanceswere not cost-effective the short and
intermediaterun, and became cost effectivein recent years based on the long run impact.

Finally,corporatetax rate reductionshad very largepositiveimpactson stimulatinginvestment

on both the apparelor leatherproductsindustriesbut theseimpactswere outweighed major
revenuelosses to the nationaltreasury. Thus for Pakistaniindustries,the three tax incentives

                                       investmentin recent years but in view of a better
consideredwere ineffectivein stimulating
recordof accelerated          allowances investment creditsin earlieryears, perhaps
                                       and        tax

a redesign of such incentiveswith some considerationfor refundabilityprovisions and
eliminationof regulatory bottleneckswou!d help restore their effectivenessin stimulating

                                      -   42 -
                                     Table P4

               Investment Impacts Per Unit Value of Lost Tax Revenue

   IstmentTax Credit      Apparel         Mea7      0.40          0.76     1.11
                          Leather                   0.26          0.25     0.24

                          Apparel         198.4     0.28          0.71     2.50
                          Leather                   0.11          0.28     2.54

                          Appure          Mean      0.40          0.76     0.70
                                          (s.d.)   (0.18)        (0.34)   (2.13)
                         Leather                    0.24          0.36     0.37
                                                   (0.22)        (0.32)   (1.44)

Accelerated Capital      Apparel          1977      0.52         0.64      0.81
Consumption Allowances   Leather                    0.18         0.18      0.17

                         Apparel          1984      0.23         0.59      2.10
                         Leather                    0.09         0.23      2.13

                         Apparel          Mean      0.31          0.60     0.51
                                          (s.d.)   (0.13)        (0.27)   (1.70)l
                         Leather                    0.19          0.28     0.25
                                                   (0.18)        (0.26)   (1. 14)

Corporate Income Tax     Apparel          1977      0.05         0.13      L.21
Rate Reductions          Leather                    0.01         0.01     0.02

                         Apparel          1984     0.00          0.00     0.00
                         Leather                   0.00          0.00     0.00

                         Apparel       Mman         0.00         0.)4      0.08
                                       (s.d.)      (0.06)       (0.04)    (0.07)
                         Leather                    0.00         0.00      0.01
                                                   (0.00)       (0.00)    (0.01)
                                            -43   -

                                        1.7 TURKEY

 1.7.1 Tax History

       Thecorporateincometax in Turkeyprovidesa significant                 revenues
                                                          sourceof government
 (accounting 10%of total tax revenues)as well as serve as majortool of industrialpolicy.

 The government changedboththe tax rate and the tax basemanytimesduring the past three
 decades. The statutorycorporatetax rate hoveredaround 10%during the SO's, rose to 20%

 in the 60's and to 25%in the 70's. In 1980,it was raised to 50%,loweredto 40% in 1981and

then raised again to 46% (plusa defensesurchargeof 3%) in 1985and has stayedat that level

sincethen.Overtheseyearsthere also havebeen significant base changes(see Bulutogluand
                         treatment publicenteprises has beeneliminated
Thirsk, 1990).Preferential       of                                  since 1980. Inter-

company dividends distribution have been made exempt from taxation and corporate

reorganizations no longersubjectto capitalgains taxation. Inflationary         of
                                                                      adjustment assets

but not of liabilitieshave been also allowed.

       In the following,we briefly summarize currentprovisionsof the corporatetaxation

and investmentincentivesregimeswhich appear in Table T1. Taxable income of corporate

entities (definedas book profits before taxes plus increases in pension reserves and general

provision bad debtminusinvestment exportallowances depreciation
                                and              and                   etc.)

is currentlytaxed at a flat rate of 46%. A 3% defencesurchargeis payableon this basic rate.
In addition,a 1% tax is payableto the SocialAssistance SecurityFund, and an additional

                                      Vocationaland TrainingEncouragement
1% tax is leviedfor the Apprenticeship,                                 Fund, for a
combinedcorporatetax rate of 49.38%. Corporatetax is withheldat sourceat varying rates
with 0% rates for dividenddistributions, for incomefrom crude oil exploration,10%on
                                          -44 -
                                                               property,and 25%
interestand moveablepropertyincome,20% for incomefrom immoveable

for salariesand wagesand patentsand royalties.

       Depreciationallowancesare based on historicalcosts adjustedby the wholesaleprice

indexminus 10% and take the form of ten-yearinterestbearingbonds. Eitherthe straight-line

or decliningbalance methodof depreciationmay be chosen for any asset, but no switch is

allowed from the straight-lineto the decliningbalancemethod during the life of the asset.
Depreciation moveablefixedassetsacquiredon or after January1, 1983maybe takenunder

a straight-linemethodat any rate chosenby the tax payer, up to an annualmaximumof 25%.
If the decliningbalance methodis used, the maximumallowable depreciationrate is 50%.
Assetshavingvaluesless than 5,000 TL can be deducted. For structuresand moveablefixed
assetsacquiredbeforeJanuary1, 1983,the Ministryof Financepublishes      depreciation

                        basis)permissiblefor tax purposes. These rates typicallyare 4% for
rates (on a straight-line

factory buildings, 15% - 20% for transportequipment, and 12.5% for machineryand equipment.

      A value-added is leviedat a generalrate of 12%. Banking insurance
                  tax                                        and

                                                    incentiveallowancein Turkey which
are subjectto a 3 % tax (BrMT).There is an investment

is a deductionfrom the taxableincome for corporatetax purposes. The deductionis claimed
in the year of investmenton that portion of investment which is not subsidizedby the
                           allowances be carried forwardindefinitely. The rate of
government. Unusedinvestment        can

         allowancevaries by regionand type of investment.

      Corporations also set asideup to 25% of taxableincomefor futureinvestments.The

amountset aside at the discretionof the corporationis deductedfrom its taxableincome and
depositedin an interestbearingaccount(earningthe sameinterestas government
                                         - 45   -

about 20% p.a.) with the CentralBank. It can be withdrawn time with authorizationfrom

the State PlanningOfficeand used for investment.

      For tax purposes, capital is depreciatedat a rate of up to 50% for machineryand

equipment. Further assetscan be revaluedat the end of every calendaryear.
                                      are       to
      A largenumberof non-taxincentives available eligibleinvestments.Theseinclude

low interestcredit, fundsfor workingcapital,allocation foreignexchange,and allowancefor
importof used equipment.
                                          -46   -

                                        Table Ti

             The Structure of Corporate Income Tax System in Turkey 1990/91
                                   (Figures in percent)

  Corporate Income Tax: General                              46
  Withholding tax rates on payments by a domestic
  corporation to a foreign corporation
    Rental from fixed assets                                20
    Leasing                                                 0.5
    Royalties on patents                                    25
    Professional services                                   15
    Petroleum services                                      S
   Interest on trade receivables                            10
   Other interest (loans and deposits)                      10
 Withholding taxes on payments to nonresident individuals
   Rentals from immovable assets                            20
   Royalties on patents                                     25
   Services (professional)                                  15
   interest on receivables & deposits                       10
 Value-added tax
   Standard rate                                             12
   Agricultural product                                      1
   Basic foods, books, natural gas                          6
   Luxury goods                                             20
   Petroleum products                                       13
 Banlkng and Insurance transactions tax                     5
 Investment incentive allowance                             30-100 of the cost of
                                                            specified assets
 Export allowance
  Export earnings of manufacturer                           12
  Export earnings of traders                                3
  Export of fresh truit, vegetables                         12
  International Transport                                   12
  Tourist establishments                                    20
   Straight-line                                            25
   Declining-balance                                        50

Source: Price Waterhouse (1992)
                                             -   47 -
 1.7.2 Tax PollcyEffects on the Renl Rate and Capital

        The model Is appliedto three Turldshindustries;non-electrical
                                                                    machinery(SIC 382),
 electricalmachinery(SIC383)and transportequipment
                                                 (SIC384)industriesin the privatesector

 only and covers the period 1973 to 1985. These industries accountedfor 20% of total

             outputand employment 24% of manufacturing
                                and                  wagesin 1985.The data on
output, employment,intermediateinput and investmentwere obtained from a variety of
 Government Turkeysources. The quantityof labor was measuredas the averagenumberof

        during the year. The price index was constructed dividingtotal employment
                                                       by                       cost

duringthe year by averagenumberof employees. Intermediate
                                                        inputsor materialsincluderaw
materials, components, containers, fuel and electricity. The quantity of materials was

constructed dividingtotal valueof materialsby an industrymaterialsdeflator. The quantity

of outputwas constructedby dividingthe total valueof outputby the relevantindustryoutput

price deflator. The same deflator was used both for the electrical machineryand transport

        industries. The capitalstockseries weredevelopedby applyingperpetualinventory

methodto investmentseries and by assumingdepreciationrate equal to 0.08, representinga

weightedaverageof assumeddepreciation
                                    rates of 0.1 for machinery equipmen and 0.025

for structures.1
       The effectsof the three tax instrumentson the rental rate of capital are given in Table
T2. Sincethe normalized
                      after tax rentalrate on capitalis the samefor the three industries,the
results foundfor the tax elasticities also the same. From tableT2, we observethat the IA

elasticity increases over the sampleperiod, whereas the CCA and CIT elasticitiesremain

relativelyconstant. Over the first half of the sampleperiod, a 1 percentincreasein the IIA rate
                                             -   48 -
decreases the afkr tax rental rate by 0.20 percent. Over the second half of the period, the

elasticity ranges from -0.24 to -0.35. For most of the period the elasticity associated with the

CIT rate ranges from 0.21 to 0.28 and then decreases of the last few years. Generally, the

CCA rate clasticity ranges from 0.70 to 0.10 for most of the period. The results for the short,

intermediate and long-nm tax elasticities for capital demand appear in Table T3.

                                            Table T2

            Elastcities of Rental Rate of Capital With Respect To Tax Measures

._   _                   _     _

 1973                              -0.199               -0.065                 0.210
 1974                              -0.195               -0.086                 0.242
 1975                              -0.196               -0.084                 0.238
 1976                              -0.199               -0.067                 0.212
 1977                          -0.197                   -0.078                 0.229
 1978                          -0.193                   -0.098                 0.260
 1979                          -0.193                   -0.096                 0.259
 1980                          -0.242                   -0.129                 0.386
 1981                          -0.348                   -0.147                 0.259
 1982                          -0.345                   -0.155                 C.276
 1983                          -0.258                   -0.064                 0.057
 1984                          -0.258                   -0.063                 0.055
1985                           -0.341                   -0.099                 0.101
                                               -   49 -
                                             Table T3

                                    CapitalDemand Elasticities

                         1974        1985           1974 i      19                 1974            f1988
                .....   ~~~i                              74    ...............       .........      .
  ewk,,                 0.014       0.013           0.024       0.021             0.024            0.020
  e-,,                  0.006       0.004           0.010      0.006              0.010            0.006
  eb,,                  -0.017     -0.004          -0.029      -0.006             -0.029          -0.006
  ek. ak^;0.021                     0.021          0.037       0.033              0.037           0.032
  J                     0.009       0.006          0.016       0.009              0.016           0.009
  et.,,                 -0.027     -0.006          -0.046      -0.009             -0.046          -0.009
  eti,                  0.034      0.034           0.059       0.052              0.055           0.051
  e-,                   0.015      0.009           0.026       0.015              0.026           0.015
  Ckck                  0.042      -0.009          -0.074      -0.015             -0.074          -0.015

1.7.3 Tax Incentives, Investment Impacts and Foregone Revenues

         Table T4 presents the benefit-cost ratios for the three Turkish industries for two years

1975 and 1985 and the mean and standard derivation for the sample period 1975-1985. A 1%

Lhicase in investment allowance (IIA) had the largest effect on capital while a similar change

in capital consumption allowances (CCAs) and corporate tax rate reductions had relatively

smaller impacts. This is because the elasticityof rental rate of capital with respect to investment

allowances is much higher than with respect to capital consumption allowances and corporate

tax rate reductions. The loss in tax revenue associated with tax rate reduction are quite large
                                           -   50 -
                                    ratio for sucha policychange. The revenuelosses are
and therby yieldinga low benefit-cost

                                                             allowances since
                      allowance for changes capitalconsumption
largerfor theinvestment       than        in
investmentimpactsare higherfor the formermeasure,the net effectis to yield similarbenefit-

                                                 ratio is smaller for almost all measuresin
cost ratios for the two measures. The benefit-cost
1985relativeto 1975. This results from a declinein the elasticityof capitalstock to a change

in its own rental rate. Note that the capitalstockincreasesover time, implyingthat if the own
price elasticityof capital were to be constant,investmentresponseto changesin rental rate

would have to increaseat the same rate as the increasesin capital stock. It is unlikelythat
         responsewill increaseat the samerate becauseit wouldimplyan unrealistic
in the marginalproductof capital. Thus it is reasonable expectown priceelasticityof capital
to decline over time. In conclusion, the table suggests that investment allowancesand

accelerateddepreciationprovisions proved to be effectiveinstrumentsof public policy for
         promotion,especiallybased on their intermediate long run impacts. The same
investment                                             and

                                                        whichclearlyresultedin windfall
couldnot however,be saidaboutcorporatetax rate reductions

gains to existingcapital withoutencouraging investment.
                                                     Table T4
                                 Invoitmen hmpctdsPer Unk Value of Lost Tax Revenue

              : ;.       :
                      ; jj       i i jjji;*    . .;                            R .

nvestinet Allowance           Electrical Machinery               1975          0.63       0.97      1.50
                              Non-Elect-cl Mchinery                            1.00       1.59      2.62
                              Trnapon Equipment                                1.14       1.71      2.56

                              Electial Machinery                 19U.          0.40       0.72      1.54
                              Non-EloctricalMachinery                          0.86       1.42      2.49
                              Tranport Equipmet                                1.00       1.54      2.40

                              Electrical Machinery               Mean          0.53       0.84      1.37
                                                                 (s.d.)        (0.012)    (0.17)    (0.29)
                              Non-Electrica Machinery                          0.81       1.29      2.12
                                                                               (0.17)     (0.28)    (0.51)
                              Transport Equipment                              0.85       1.34      2.19
                                                                               (0.23)     (0.35)    (0.60)

         c apiwal            ElBouia Machinery                   1975          0.56      0.86       1.33
 naumptionAllowUanc          Non-Electio Machinery                             0.89      1.42       2.34
                             Transport Equipmet                                1.01      1.53       2.28

                             Elebia Machinery                   1985           0.38      0.6"      1.45
                             Non-Electic Machinery                             0.51      1.33      2.34
                             TanAport Equipment                                0.94      1.44      2.25

                             Electrical Machinery               Mean          0.47       0.75       1.22
                                                                (s.d.)        (0.10)     (0.14)    (0.24)
                             Non-Electical Machinery                          0.72       1.15      1.39
                                                                              (0.14)     (0.23)    (0.43)
                             Trasponation Equipment                           0.76       1.20      1.94
                                                                              (0.20)     (0.31)    (0.51)

orporale IncomeTax            erical Machincry                  1975          0.32       0.56      0.84
   Reduction                 Non-Blootl Machinay                              0.16       0.27      0.45
                             Tranport Equipment                               0.20       0.31      0.50

                             EletoariclMachinery                1985          0.20       0.21      0.28
                             Non-ElectricalMachinery                          0.07       0.11      0.19
                             Traupot Equipment                                0.03       0.06      0.10

                             ElectricalMachinery               Mean           0.06       0.01      0.00
                                                               (s.d.)         (0.36)     (0 28)    (0.45)
                             Non-ElectricalMachinery                          0.05       0.03      0.07
                                                                              (0.37)     (0.51)    (0.38)
                             Transport Equipmenz                              0.08       0.02      0.12
                                                                              (0.71)     (0.23)    (0.96)
                                              52 -
                          1.8 SUMMARYAND CONCLUSIONS

       This paper providesan empiricalframeworkfor the assessment tax policyeffectson

the array of producer decisionsconcerningoutput suppliesand input demandsin Mexico,

Paldstanand Turkey. A dynamicproductionstructuremodelis specifiedand estimatedfor this

purposefor selectedindustriesin eachof the count'. s.

On the Elasticity RentalRateof Capitalwith Respt to Tax Instruments:The tax sensitivity

of rental rate of capitalis quite inelasticwith the singleexceptionof its elasticitywith respect
to corporatetax rate in Mexicowhich is unitary(see Table SI). In Mexico,the rental rate of
capitalis most sensitiveto corporatetax changesand relativelyless to accelerateddepreciations

and investment tax credits. In Pakistan, the sensitivityranking of three instruments is

completelyreversedand investment creditchangeshave the greatestinfluenceon the rental

rate of capital. In Tlrkey, the rental rate is more responsiveto changes in investment

allowancesthan acceleratedcapital consumptionallowances(CCAs)or the corporatetax rate

              Elasticityof Rental Rateof Capitalwith Respectto Tax Measures

 Mexico(1983)                  -0.409                -           -0.635           1.021
 Pakistan(1984)                -0.386                -           -0.225           0.035
 Turkey (1985)                    -             -0.341           -0.099           0.101
                                            -   53 -

On the Tax Sensitivity the CapitalStock: The capitalstock exhibitssensitivity tax changes
                     of                                                     to

                   varies by tax measure,by industryand by the adjustmentperiod. TableS2
but this sensitivity

providescomparativeevidenceon the tax sensitivityof the capital stock by industry, by tax

measure, and by adjustmentperiod. For Mexico, elasticityestimatesrange from -0.014 to

-0.043 for corporatetax changes;from 0.009 to 0.027 for CCAs;and from 0.006 to 0.017 for

changesin investment credits. For Palistani industries,the responsiveness capitalstock
                   tax                                                  of

to changesin corporateincometax is quite small - elasticityestimatesrange from 0.0002 to
                                       estimatesrange from 0.002 to 0.029; and finallyfor
-0.006; for investment credit elasticity

                    between0.001 and 0.017. Thelast twosets of elasticities compatable
capitalcostallowances                                                     are

withthe onesobtainedfor theMexicanindustries.For Turkishindustries,changesin investment

allowancesmatter more for the effects on capital formation than alternate tax measures.
Specifically,elasticityestimatesrange from 0.013 to 0.052 with respect to changes in the
                          from 0.004 and0.015 withrespectto changesin the capitalcost

allowances; from -0.004 to -0.015with respectto changesin the corporateincometax.

              Ratios: The model results suggestthat tax policy affected productionand
On Benefit-Cost

  iestmentand further that some tax incentiveswere more effectivethan others in investment

stimulation governmentrevenue loss (see Table S3). Among the incendves measures

examined, investmentallowancesproved to be a cost-effectiveinstrumentfor investment
promotiononly to Turkish industries;and investment credits and accelerateddepreciation

provisionshad a mixed success while corporate tax reductions met with dismal failure in
                                   mannerin all cases for all countries. In terms of their
promotinginvestment a cost-effective
                                                                      -54 -
                                                               T"        S2

                                          TaI Samiiviltyof Capial Stock

                                                _   S   -,   AW. _~~,



Dctcrgeia            .012   .016   .017     -                    -                   .019   .024   .027   .031      .039          .043

Otherchemaical       .006   .007   .008     -                                        .009   .012   .013   -.014    -.019         -.021


AppaDe               .004   .001   .029     -                                        .002   .005   .017   -.0004   -.000         -.003
LAherd i             .002   .003   .006     -                    -            -      .001   .002   .004   -.000    -.000         -.006

TURKEY (1915)

        Mach.        -      -      -        .013                  .04         .034   .004   .006   .009   -.004    -.006         -.009
           Mach.     -                      .021                  .033        .032   .006   .009   .015   -.006    -.009         -.015
Tansport Equipment   -                      .020                  .032 .051          .006   .009   .015   -.006    -.009         -.015
                                       -   55 -
                                   Table S3
                       Expenditures Unit Value of Lost Tax Revenue
              Investment          per

                                            Short Run    Intermediate   Long
Tax Instrument                                           Run            RunRun
Investment Credit
 Mexico:DetergentsIndustries                      0.44       0.51        0.S4
 Mexico:Other ChemicalIndustries                  0.26       0.32        0.34
 Pakistan:ApparelIndustries                       0.28       0.71        2.50
 Pakistan:LeatherIndustries                       0.11       0.28        2.54
AcceleratedCapitalConsumption Allowances
Mexico:DetergentsIndustries                       0.32       0.38        0.40
Mexico:Other Chemicals  Industries                0.19       0.24        0.25
Pakistan:ApparelIndustries                        0.23       0.59        2.10
Pakistan:LeatherIndustries                        0.09       0.23        2.13
Turkey: ElectricalMachineryindustries             0.38       0.68        1.45
Turkey: Non-Electrical                            0.81       1.33        2.34
Turkey:TransportIndustries                        0.94       1.44        2.25

CorporateIncomeTax RateReductions
Mexico:DetergentsIndustries                   0.03          0.04        0.05
Mexico:OtherChemicalsIndustries               0.01          0.01        0.01
Paidstan:ApparelIndustries                    0.001         0.0002      0.007
Paldstan:LeatherIndustries                    0.00          0.00        0.00
Turkey: ElectricalMachineryIndustries         0.20          0.21        0.28
Turkey:Non-Elctrical MachineryIndustries      0.07          0.11        0.19
Turkey: Transport.ndustries                   0.03          0.06        0.10

 Turkey: ElectricalMachineryIndustries        0.40          0.72        1.54
 Turkey:Non-ElectricalMachineryIndustries     0.86          1.42        2.49
 Turkey:TransportEquipment  Industries        1.00          1.54        2.40
                                              -56 -

                           tax                          in
 long-runimpacts, investmnent creditswere cost-effective two of the four industriesstudied.

 Accelerated capital consumption allowances also registered a similar performance and had

 incremental benefit-cost ratio exceedingone in the long run for five out of seven industries

 studied. Corporate tax rate reductions stimulated investmentsbut resulted in revenue losses

exceedingthis stimulativeimpact in all cases and in all runs consideredin this study. Note that

corporate tax rate reductions apply to a larger base of pre-tax profits than the smaller base of

                                        tax                                       of
current investmentsrelevantfor investmnent credits. The long run cost-effectiveness these

incentives,except corporatetax rate reductionswhichproved cost-ineffective all cases, vares

by country. In Turkey, investmentallowancesand capital consumptionallowanceswere cost-

effective. In Mexico, both investrnenttax credit and acceleratedcapitalconsumptionallowances

were not cost-effective.In contrast, in Pakistan, both the investnent tax credit and accelerated

                                                                  run, definedas tax policy
capitalconsumptionallowanceswere cost-effective.In the intermediate

                                          allowances and accelerated capital consumption
impact after one year, only the investmnent

allowancesavailable to Turkish industriesproved cost-effective.

       In conclusion, selective tax incentives such as investment tax credits, investment

allowancesand acceleratedcapitalconsumptionallowancesare morecost-effectivein promoting

investment than more general tax incentivessuch as corporate tax rate reductions. In order to

make selectivetax incentivesmore effective,investmenttax creditsmust be refundableand carry

forward of investment and depreciationallowancesbe permitted. If stimulationof investment

expenditureis the sole objectiveof tax policy, corporatetax rate reductionis not a cost-effective

instrumentto achieve this objective.
                                               -   57-

 1.    The model can be readily generalizedto include multipleoutputs. The production
       functionis also assumedto be twicecontinuously
                                                    differentiable, quasi-concave the
                                                                  and           in
       inputsand net investments.
2.    The issue of capital utilizationis not addressedin this model. The problemof costly
                       impliesthatdepreciation rates dependon prices, technology market
      structure. Hencethe use of existingmeasuresof capital stockswouldbe inappropriate
      becauseservicelives are assumedto be independent prices and technology. Costly
      capitalutilizationimpliesthat capitalstock measurement technology
                                                              and            determination
      must be modelled simultaneously. This is an interesting, complex, but secondary
      problemto determiningthe effects of tax policy on outputsupplyand input demand.
3.    We abstractfromintroducinginvestment allowances.The modelcan be modifiedto
      includethem alongwith capitalcost allowances.
4.                   is
      This assumption the Mortigliani-Miller
                                           hypothesis. is also possiblethat with market
                  firmscan influence rate of returnon theirfinancial
      imperfections                 the                             capital(see Steigum
      [1983]and Bernsteinand Nadiri [1986]for dynamicmodelsin this context).
5.    The formulafor the after tax purchaseprices of the capital stockscan be simplified.If
      the discountrates are not expectedto changethen

      Q,j   qgs(1 -V,,-(i         u+,.(l -T 1,v1 ,)d 1 ,)/(1       +   p)'). If, inaddition, thetaxrates
      credits are not expectedto changethen Q - q4(l           -   v, - u,(l - 40v,( S d, / (1 +
      The latter is the more standardformulaand is a specialcase of the after tax purchase
      price formulaused in the model (see Hall and Jorgenson[1967, 1969]and Arrow and
      Kurz (1970)).
6.    The inverseprice elasticityand the conjectural
                                                   elasticityare not assumedto be constant.
      Equation(12.1) containstheir equilibrium  magnitudes. productionfunctionis also
      part of the first order conditions.The second order conditionsare assumed to be
      satisfied.The symbolV representsthe gradientvector.

7.    Recall that (<Oaide>o so the last set of terms on the right side of equation (14),
      includingthe minussign is positive.
8.    The additionalrevenueand therebyprofit arising from oligopolypower does not vary
      when it is evaluated at the equilibrium point. Thus the term affects the calculation of
      variableprofitbut doesnot affectthe first order conditions
                                                               characterizing equilibrium
      As a consequence expression be ignoredwhen definingshadowvariableprof'
                                          -   58-
9.    The functionis also twice continuously differentiable,homogeneous degreeone and
      convex in after tax prices, and concavein the capitalinputs and net          levels.
10.   It is also assumedthat the tansversalityconditions satisfied.The symbol0. signifies
      a m dimensional  vector of zeros.
11.   Sincedepreciation  rates for the sampleindustriesare not available,Jorgensonand Yun
      (1991)estimates U.S. industries
                       for                 were used. The depreciation for non-residential
      structures(0.025)was calculated an averageof the depreciation
                                        as                             rates on varioustypes
      of industrialstructures. Inclusionof othertypes of buildings structuresdid not alter
      the above epron         rate significantly. The depreciationrate for producerdurable
      equipment(0.10) was calculatedas an averageof the depreciation    rates on a numberof
      electrical,non-electrical transportation
                               and                machinery equipment
                                                            and            categories.

                                                                 rates, theseare similar
                                 studiesuse a rangeof depreciation
      Pleasenote that whileVarious
      to the rates assumedhere. For example,Epsteinand Yatchew(1985)use a figure of
      0.107 and Epsteinand Denny(1983)use a range between0.102 and 0. 111.
12.   See endnoteNo. 11.
13.   See endnoteNo. 11.
                                        -   59 -

 Arrow, K., and M. Kurz. 1970. Publc investment,the Rste of Return and ODtimal
      Pogicy, Baltimore,JohnsHopkdnsPres.
                                               and        in                    in
Bernstein,J.I., and M.I.Nadiri. 1986. "Financing investment plant and equipmentw,
      M.H.Peston R.E.Quandtad., Pries. Co petitin o,                OxfordEngland:
      Philip Allan/Barnes Noble.

Bernstein,J.I., and M.I. Nadiri. 1988. "Corporatetaxes and the structureof production,a
      selectedsurvey, in J. Mintz and D. Purvis ed., The Impa of Taxationon Business
      AcdI3i, KingstonCanada:John DeutschInstitute,Queen's University.

Bernstein,J.I., and P. Mohnen. 1991. "Pricecost margins,exportsand productivitygrowth,
      with an application Canadian industries', CanadianJoural of Economics.,24, 638-

Boadway,R. and A. Shah. 1992. The Roleof Investment          in
                                                   Incentives Developing  Countries.
     Forthcomingin Anwar Shah, editor, Fiscal Incentivesfor Investmentin Develoin
     Conties, WorldBank, Washington,   D.C.
Bulutoglu,Kenan, andf WayneThirsk. 1991. 'Tax Reformin Turkey'. Public Economics
      Divisio,WorldBank, Washington,D.C. Processed.

                                                 Countries:Mexico's ProtractedTax
Diaz, Gil-Diaz. 1990. Reformingtaxes in DevJ1oping
      Reform. Processed,CountryEconomics  Department,WorldBank
Ehdaie, J. 1991. RevenueGeneratingand InvestmentAspectsof the CorporateIncomeTax
      Systemin Pakistan:An Agendafor Raform.Processed.CountryEconomics Department,

Epstein, L.G. 1981. 'Duality theory and functionalforms for dynamic factor demands%,
      Rejew of EconomicStudies,48, 81-95.

Epstein, L.G. and M.G.S.Denny.1983. 'The Multivariate
                                                    FlexibleAcceleratorModel: Its
      Empirical            and            to
                Restrictions an Application U.S. Manufacturing.' Economea, v.52,
      pp. 647-674.

Epstein,L.G. and A. J. Yatchew. 1985. 'The EmpiricalDetermination Technologyand
                               Procedure,' Ioumal of Econometrics,
      Expectations: A Simplified                                 v.27, pp. 235-258.
Guisinger, Stephen and Associates. 1985. Investment incentives and Performance
      Ruiiments. PraegerPublishers,New York.
 Hall, R.E., and D.W. Jorgenson. 1967. 'Tax policy and investmentbehavior", American
        E-conomicReview.57, 391-414.

 Hall, R.E., and D.W. Jorgenson. 1969. "Tax policy and investmentbehavior, reply and
        further results", AmericanEconomicReview,59, 388-401.
            Bureau of Fiscal Documentation:
International                             1988. Tax SystemProfiles. Mexico,Pakdstan,
       Turkey. VariousIssues.
Jorgenson,D. and K. Y. Yun. 1991. Tax Reformand the Costof Capital. OxfordUniversity
       Press, 1991.

MexicoD.F., Bancode Mexicovariousyears. Sistemade CuentasNacionales Mexico.

Mexico,Bancode. 1986. 'La Encuestade Acervos,Depreciacion Formacionde Capitaldel
     Banco de Mexico." Documento Interno, Reporte Metodologico, Direccion de

Mexico,Bancode. 1986The MexicanEconomy

Mexico,D.F. Bancode. 1987. Indicadores

Mexico, Bancode. 1988. 'Enquesta Semestralde Coyuntura,2e semestre1987." Direccion
     de Investigacion
                    EconomicaGerenciadel SectorReal. Febrero de 1988.

                of.                             Tax
Mexico,Government Ministryof Finance. Unpublished Data.

Mortensen,D. 1973. 'Generalizedcosts of adjustment dynamicfactordemandtheory",
Pakistan, Government Federal Bureau of Statistics.Census of ManufacturingIndustries.
      VariousIssues. Karachi

Pakistan,Government FinanceDivision. Economic                    Supplement:
                                                       Statistical         1987-88.

Pakistan,Government FinanceDivision. PublicFinanceStatistics. VariousIssues

Price Waterhouse. 1992. CorporateTaxes: A WorldwideSummary. New York.

                                               behavior",Eonometnca. 53, 637-6451
Steigum,E. 1983. 'A financialtheoryof investment

Treadway, A. 1971. "On the rationalmultivariateflexibleaccelerator",Econometrica
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Tradway, A. 1974. "The globallyoptimalflexibleaccelerator', Iournalof EconomicTheory,
     7, 17-39.

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