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7 WORKING Rsarch Policy PAU 1 Economics Pubilc Policy ResearchDepartment Tha WorldBank Septernber1993 WPS 1196 CorporateTax Structure and Production Jeffrey Bernstein and 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. Rarwoh Policy PubicEocnomics WPS1196 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 and is to get these findingsout quickly, even if presentationsare less than fuillypolished. The findings.interpretations, conclusions these papersdo not necessarilyreprcsentofficialBank policy. in Center Producedby the Policy ResearchDissemination CORPORATETAX STRUCTUREAND PRODUCTION by JeffreyBernstein* AnwarShah 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- -2- 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 of ........... to Tax Instruments . 52 On the Tax Sensidvity of Capital Stock .......... . . . . . .53 On t*he Ratios .......................... Benefit-Cost 53 Endnotes ................................................ 57 References ..... .9........................................ _.cg . .i I I - 1.0 INTRODUCTION promotionare prevalentin most developingcountries. Fiscal incentivesfor investment The effectiveness these instrumentsin meetingstatedpolicy goals is an importantarea of 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 is 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 tax countriesnarnelyMexico,Pakistanand Turkey.The paper evaluatesinvestment developing 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 thesm 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 tax in 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 deductions depreciation is, basedon declinir.,balancedepreciation z = d(t + r)/(r + d), where rate d is the allowed depreciation and r is the discountrate. Thus the tax deductiondue to is 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 is 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. 3- 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 is 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 tax 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 is 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 and for three countries;Mexico,Pakdstan Turkey. The highestpost tax cost of a unit value of -4- Table 1.1 Cost of a unit value of capitalexpenditure Thscont 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, at 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 at = 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 O.15. -5. capital expenditure is found in Turkey, followed by Mexico and I-aldstan. As fuure depreciation 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. 1.2 TAX STRUCTUREAND PRODUCTION:A DYNAMICTHEORETICALMODEL 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 dimensional 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 investment 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 Quasi-fixed 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 accordingto IK = + (,a- 5)Kv.,, (2) whereI is the m dimensional Investment 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 dimensional identitymatrix. 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 p, 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, tax rX,,-V,,qw,I, iZ,.., (4) Second,there are capitalcost allowances associatedwith the depreciation the capital of 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 1.0 at differenttimes is, -7- 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 tat base for tax purposes. with sect to the hbor inputsthere are no payrolltaxes -it with respectto the MhMd, 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 'the 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 Substituting 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 8- The leP. side of equation (7) shows revenuenet of tax, net of variableinput cost and tnetof investment 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 is 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 to 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) 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 of 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 exogenous. 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 expectations 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 W, after product price, - wt (1 -u; ) (1 - j ) j - 1,...n are theafter tax variable factor tax 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) s.0 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 equations(equation(2)), 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 production 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 is 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 W - , + 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 1 values. From equation (12.1), in short-runequilibriuma firm equates after tax marginal multiplier 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 of 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 it 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 in * 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 and oligopolists.In the latter case, if firms have the samemarginalcost in short-run Cournot-Nash equilibriumthen from equation(12.1), firms have the same conjecturalelasticityin short-run equilibrium. An alternativeway that the short run equilibriumconditionscan be characterized, and emphasizesboth product market imperfections the dual relationshipbetweenprice and quantityeffectson variableprofit. Considera first order approximation the revenueof a firm to 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) productmarket From equation(14), total revenueequalsrevenueearnedin a purelycompetitive 2 plus the additionalrevenue eaned in equilibriumbecauseof oligopolypower. Definingthe or 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,) y, - 13 - subjectto the productionfunctionand the givenlevelsof the capitalinputs. Thus firms act as aftertax shadowvariableprofit, whichis definedas aftertax shadowrevenue if they, maximize 1 minus after tax variable input cost. The reason is that the degree of product market is imperfection capturedin the definitionof shadowproductprice. The short-runequilibrium can into conditions be substituted (15) to obtainthe after tax shadowvariableprofit function. I -(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 by 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 the of funds.The objectiveis to max.~ t...(8 equations(denotedby equationset (2)). The first order subjectto the capital accumulation equationset (2) into (18), are, conditions this problemat any timeperiod, after substituting for V(ft'1aAK,) - Q, +Ea (s,s+l)[v(8x:. a) 1 I8Kg) -[V(8iax/OAK 1 (19) +o1 -a) Q 1J -On ff Equationset (19) implies that the marginalcost of a capital input is equatedto the expected 19 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 the 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. 1.3 ESTIMATIONMODEL ANDTAX ELASTICMTIES the 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 and modelallows for short-run,intermediate-run long-runeffects of tax policy initiativesto differ. These effectsdiffer accordingto the extent that capitaladjustmenthas occurred. of 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 1 - 16 - where s, is the after tax normalizedshadowvariableprofit (normalization by the after tax is 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 1 -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 conditions 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. for 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$., - ,,AK,., + Q,1(1 - 8))] - 0 where Q, is the normalizedafter tax purchaseprice of capital, 6 is the depreciation and p rate is the discountrate. If we assumethat after tax relativeprices, discountrate and technologyindicatorare expectedto remainconstantthen we obtainthe following, -%Ar,1.. + (1+p)pYAK$ + p+Ka k + p, + paWk+pw, - Q,(1+p) + Q ,(1-d) (25) mo Re-arranging get we -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 of capital stock and the long-run capital stock is K, - (% p+,P,P'P&Wu P + + - Wb) - -A Therefore,by combiningequations(7) and (8) we get, - 18 - +4PAJPJO"(Pk+PW @-- 8) (2+p +(1+0.5(p+ PMPi,-[(p + Puh +4pidp;))X"1 Equation(9) showethe demand the capitalinput. It is a functionof the relativeafter for tax outputprices, variableinputprices and rentalrate, along with the discountrate and lagged quantityof the capital input. This equationis nonlinearin the parameters. estimation 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 indicator, 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 <0 profit functionmust be concavein capitaland net investmentso that, Bkk and Bi< 0. An importantfeature of this model is that there are adjustmentcosts associatedwith adoptingtheirlong-run 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 is 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 rate 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. Short-Run 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 of variablessignifiesthe short-runequilibrium the where the superscripts for the endogenous demandfunctions. 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. Intermediate-Run are The equationsfor the intermediate-run derivedfrom the short-runequations. The is processafter one period. The intermediate-run definedwithrespectto the capitaladjustment equilibrium intermediate-run conditionfor outputsupplyis I 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) -21- -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 demandis The equationfor capitalinputintermediate-run * (+.5IP) (P + pdp [(p + §WpM2 + 4PI3Pdi0J5)(Pk+ PA' + PkW + P - WA(30.4) (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, determined. 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. Long-Run in 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 of 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 elasticities The tax instrumentl tax instrument the after tax relativerentalrate of capital(sincethis is the only relativeprice on directlyaffectedby the tax policy). The secondcomponent the elasticityof the rental rate on is 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. -24- 1.4 TAX POLICY,IMPACT ON INVESTMENT 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 of the benefit-cost ratio. Investmnent Credit and Allognc Tax 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 for changein government revenueis 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 by the cost to the government generating additional of the capital. The ratiodenotesthe benefit-cost ratio. - 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 of 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 to consumption allowances. 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 (percent) 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 tax 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), PriceWaterhouse (1992),Internationl kureu of fiscalOocumentctien (196), and Cil-Dlaz (1990). -28 - changesin the tax implications thesepolicieswere overlooked. A brief reviewof historical of 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 development corporatetax liability ranging from 10% to 40% dependingupon their locationand type of activity. 1979-1986: The practice of import duty exemptionwas continued. In addition, tax upon providingtax creditin therangeof 10-25%,depending certificates(CEPROFIS) incentives 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 government were exportpromotion(CEDIS),development duty-freezones also offeredspecialincentives of specialtax preferencesto automobile,cement,publishing miningindustries. and - 29 - 1987-1900: The tax incentivescertificates scheme was significantlytightenedand targetedto priorityindustries preferredzone. Top taxcredit rate for CEPROFIwas raised and to 40% of totalphysicalinvestment 1986. In addition in Mexican-owned enterprisesare eIigibl for employment creditup to 30% of three times the annualarea minimumwage multipli: tax by the numberof newjobs created. Startingin 1989, full expensingof the present value of capital consumption allowances calculatedusing a 7.5% discountrate was offered as an alternativeoptionto standardcapit consumption allowances non-metropolitan in areas. In the metropolitan industrializedareasof 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 permissible. 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 and Mexicanindustriesfor the period1970to 1983wascollectedfrom data for thesetwo three-digit a varietyof Government Mexicosources. These two industriesare amongthe three largest of industries the industrialsector (SIC 35) comprisingof chemicals,petroleumderivatives, in rubber and plasticsproducts. Together thesetwo industriesaccountedfor 5.2 percent of total outputand 2.9 percentof total employment. The data on industrycapitalstock manufacturing rate 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 index. capital 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 that 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 and 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 Short-Runl 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 Intermediate-Run 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 Long-Run 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 benefit-cost revenue. This measureis referred to as the incremental ratio in Table M4. These are 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 benefit-cost in all runs for the two industriesexaminedhere. - 34 - Table M4 Investment Impacts Per Unit Value of Lost Tax Revenue Impact 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 manufactured goods Dythe producerand on importedgoodsby the importer. In the fiscal year 1989-90,import duties at differential rates were imposedon importedmachinery equipment.These rates variedfrom and 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 tax holidays,and investment credits. Theseare briefly discussedbelow. Furtherdetailsof tax 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, agricultural 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 and areas. equipment introduced a rate of 15%, but its application restrictedto designated was at was Since 1976-77,the creditwas madeavailableregardlessof locationand ypeof industry. This in 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 2 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 (u 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: -manufacturinggarments -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. manufacturing 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, materials. producedmiscellaneous petroleumfuel, naturalgas, and importedand domestically The quantity materialswasconstructed dividingthe totalvalueof materialsby an industry of by level materialsprice deflator.The quantityof outputwasconstructed dividingthe total value by 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. and 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 normalized 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 in elasticities 1984althoughin 1977the CIT elasticitiesare larger than comparableelasticities and for the ITC and CCA rates. The results for the short, intermediate long-runtax elasticities for capitaldemandappearin Table P3. Table P2 of Elasticity RentalRate of CapitalWith Respectto Tax Measures Apparel 1977 -0.338 -0.285 0.359 1984 -0.386 -0.225 0.034 Leather 1977 -0.326 -0.287 0.425 1984 -0.386 -0.225 0.037 - 40 - TableP3 Capital DemandElasticities ApparelLehr .Shor-Rn 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 tadtRun 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 LonzRun 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 tax 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 government ratiothan CCAchanges.For corporate rate reductions in government higherbenefit-cost tax loss impacts.Investment 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!ivenc.ss - 41 - in 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 by 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 depreciation 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 investments. - 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 for (accounting 10%of total tax revenues)as well as serve as majortool of industrialpolicy. has 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 tax 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 are reorganizations no longersubjectto capitalgains taxation. Inflationary of adjustment assets but not of liabilitieshave been also allowed. the 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 for provision bad debtminusinvestment exportallowances depreciation and and etc.) deductions is currentlytaxed at a flat rate of 46%. A 3% defencesurchargeis payableon this basic rate. and 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 5% 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 on 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 maximum 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. transactions 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. investment Corporations also set asideup to 25% of taxableincomefor futureinvestments.The can amountset aside at the discretionof the corporationis deductedfrom its taxableincome and bonds,usually depositedin an interestbearingaccount(earningthe sameinterestas government - 45 - any 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 of 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 DepreciationAlowance 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 manufacturing outputand employment 24% of manufacturing and wagesin 1985.The data on output, employment,intermediateinput and investmentwere obtained from a variety of of Government Turkeysources. The quantityof labor was measuredas the averagenumberof employees 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 by of outputwas constructedby dividingthe total valueof outputby the relevantindustryoutput price deflator. The same deflator was used both for the electrical machineryand transport equipment 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 and 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 are 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 ............... ......... . ShorRn 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 Intomediate &a ek. ak^;0.021 0.021 0.037 0.033 0.037 0.032 e-. J 0.009 0.006 0.016 0.009 0.016 0.009 3 et.,, -0.027 -0.006 -0.046 -0.009 -0.046 -0.009 Long-Run 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 and 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 increase responsewill increaseat the samerate becauseit wouldimplyan unrealistic investment in the marginalproductof capital. Thus it is reasonable expectown priceelasticityof capital to 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 new 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 of the array of producer decisionsconcerningoutput suppliesand input demandsin Mexico, Paldstanand Turkey. A dynamicproductionstructuremodelis specifiedand estimatedfor this purposefor selectedindustriesin eachof the count'. s. of 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 tax rate of capital. In Tlrkey, the rental rate is more responsiveto changes in investment allowancesthan acceleratedcapital consumptionallowances(CCAs)or the corporatetax rate reductions. TableSI 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 tax 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 allowance; incentive investment allowances; from -0.004 to -0.015with respectto changesin the corporateincometax. and Ratios: The model results suggestthat tax policy affected productionand On Benefit-Cost iestmentand further that some tax incentiveswere more effectivethan others in investment irk stimulation governmentrevenue loss (see Table S3). Among the incendves measures per examined, investmentallowancesproved to be a cost-effectiveinstrumentfor investment promotiononly to Turkish industries;and investment credits and accelerateddepreciation tax 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 in -54 - T" S2 TaI Samiiviltyof Capial Stock _ S -, AW. _~~, K ~~. -~~~~~i-~ MEXICO(1983) Dctcrgeia .012 .016 .017 - - .019 .024 .027 .031 .039 .043 Otherchemaical .006 .007 .008 - .009 .012 .013 -.014 -.019 -.021 PAKISTAN(1914) AppaDe .004 .001 .029 - .002 .005 .017 -.0004 -.000 -.003 LAherd i .002 .003 .006 - - - .001 .002 .004 -.000 -.000 -.006 TURKEY (1915) Elecrical Mach. - - - .013 .04 .034 .004 .006 .009 -.004 -.006 -.009 Noa-electrical 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 Imoact Short Run Intermediate Long Tax Instrument Run RunRun Tax 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 MachineryIndustries 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 InvestmeneAllowance 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 in 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- Enldootes 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 capitalutilization impliesthatdepreciation rates dependon prices, technology market and structure. Hencethe use of existingmeasuresof capital stockswouldbe inappropriate becauseservicelives are assumedto be independent prices and technology. Costly of 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 tax includethem alongwith capitalcost allowances. 4. is This assumption the Mortigliani-Miller hypothesis. is also possiblethat with market It 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 t-0 and credits are not expectedto changethen Q - q4(l - v, - u,(l - 40v,( S d, / (1 + -t-O 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 The 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 an the As a consequence expression be ignoredwhen definingshadowvariableprof' can - 58- 9. The functionis also twice continuously differentiable,homogeneous degreeone and of convex in after tax prices, and concavein the capitalinputs and net levels. inventment 10. It is also assumedthat the tansversalityconditions satisfied.The symbol0. signifies are 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 rate structures(0.025)was calculated an averageof the depreciation as rates on varioustypes of industrialstructures. Inclusionof othertypes of buildings structuresdid not alter and 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 - References Arrow, K., and M. Kurz. 1970. 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Turkey,Government Tax Ugarte, Fenado Sanchez. 1988. 'Taxation of Foreign Investment in Mexico: The North Ameican Perspective.' InternationalEconomicsProgram Worldng Paper DP88-7. Universityof Toronto. Processed. Policy Research Working Paper Series Contact Title Author Date for paper WPSI 178 Productivity Public of Spending, JohnBaffes 1993 September C. Jones Sectoral Allocation Choices,and Anwar Shah 37699 Economic Growth WPS1179 Howthe MarketTransitionAffected BartlomiejKaminski September1993 P. Kokila Performance the Central Export in 33716 EuropeanEconomies WPS1180The Financing Taxation U.S. and of HarryHuizinga September 1993 R. Vo Direct InvestmentAbroad 31047 WPS1181 ReformingHealthCare:A Casefor Zeijko Bogetic 1993 September F. Smith Stay-WellHealth Insurance DennisHeffly 36072 WPSI 182 CorporateGovernance Central in CherylW. Gray September1993 M. Berg and Eastern Europe:Lessonsfrom RebeccaJ. 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