Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized

7

Rsarch Policy

WORKING

1

PAU

PubilcEconomics 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 promoting 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, andshouldbe used andcited accordingly.The findings, interprettions, andconclu ions aretheauthon'own. They should nd be attributedto the World Dank,its Oard of Directors,its management,or anyof iu member countries.

PolicyRarwoh

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 framework for assessing the effects of tax policy on an array of producer decisions about output supplies and input demands in Mexico, Pakistan, and Turkey. They specify and estimate a dynamic production structure model with imperfect competition for selected industries in these countries. The model results suggest that tax policy affected production and invcstinent and further that selective tax incentives such as investmcnt tax credits, investment allowances, and accelerated capital consumption (depreciation) allowances are more cost-cffective at promoting investment than morc general tax incentives such as corporate tax ratc reductions. The long-run cost-effectiveness of these incentives - except corporate tax rate reductions, which proved costineffective in all cases -- varies by country. In Turkey, investment allowances and capital

consumption allowances were cost-effective. In Mexico, neither investment tax credits nor accelerated capital consumption allowances were cost-effective. In contrast, in Pakistan, both investment tax credits and accelerated capital consumption allowances were cost-effective. In the intermediate run, defined as tax policy impact after one year, only the investmnent allowances and arxeicra!zd capital consumption allowances available to Turkish industries proved cost-effective. To make selective tax incentives more effective, investment tax credits must be refundable and carrying forward investment and depreciation allowances must be permitted. If stimulating investment expenditure is the sole objective of tax policy, reducing the corporate tax rate is not a cost-effective instrument to achieve this objective.

The PolicyResearchWorkingPaperSericsdisseminatesthcfindingsof workunderway in theBank.An objectiveof the series is to get these findingsout quickly, even if presentationsare less than fuillypolished. The findings.interpretations,and conclusionsin these papersdo not necessarilyreprcsentofficialBank policy. Producedby the Policy ResearchDisseminationCenter

CORPORATETAX STRUCTUREAND PRODUCTION by JeffreyBernstein* AnwarShah lAble gf Contents

1.0 1.1 1.2 1.3

Introduction .. . .. .. .. .................... .... . . . .2..... Cost of CapitalExpenditures. Tax Structure and Production:a DynamicTheoreticalModel Estimation Model an6 Tax Elasticities ....................... .15 Short-Run ........... ...... Inteminediate-Run .. Long-Run .. Rental Rate Elasticities with Respect to Tax Instruments .

1 ...

.2

.....

.19

.

.

20 21 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-

-21.7 Turkey .........

1.7.1 Tax History .

43

. . . ............................

43

..................................

1.7.2 Tax PolicyEffectson the Rental Rate and Capital ..... . . . . . 1.8 Summary and Conclusiors

............

..

..

.........

..

On the Elasticityof RentalRate of CapitalwithRespect . to Tax Instruments........... On the Tax Sensidvity of Capital Stock ..........

On t*heBenefit-CostRatios ..........................

.

52

52 . . . . . .53

53 57

Endnotes ................................................ References .....

. 47

.9........................................

. .i

_.cg

I I -

1.0 INTRODUCTION Fiscal incentivesfor investmentpromotionare prevalentin most developingcountries. The effectivenessof these instrumentsin meetingstatedpolicy goals is an importantarea of publicpolicyconcernyet rigorousdevelopingcountryempiricalevidenceto guidepolicyin this as is almosteomp.etelylacldng. To addresstheseconcerns,in the past, policy makersrelied on opinion survey of firms (see for e&.ample,Guisingerand Associates, 1985), and more rceently,on marginaleffectivetax rate analysis(see for exampleBoadwayand Shah, 1992). However,noneof these approachesis able to analyzethe effects of tax policy changeson the strtvcre of production and the rate of capital accumulation.

Thispaper developsand estimatesa dynamicmodelof productionto examinetax effects on an array of produc+iondecisionsregardinginputs and ov;tputfor six industriesin three developingcountriesnarnelyMexico,Pakistanand Turkey.The paper evaluatesinvestmenttax credits, investmenttax allowances,capital cost allowancesand corporate income taxes as instrumentsfor investmentpromotion.Underan investmenttax creditcorporationsare allowed 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

expenditures.Capitalcostallowancespermit depreciationfor tax purposesas a deductionfrom 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 discusmsthe impactof taxpolicyon investmentand governmentrevenues. Sections1.5 through 1.7 prest the empiricalresults for selectedindustriesin thl samplecountries. A finalsection summarizesthesmresults.

1.1 COST OF CAPITAL EXPENDITURES Four tax instrumentsthat affectthe purchasepricesof capitalstocksare consideredhere namely;the corporateincometax rate, the alloweddepreciationrate, investmentallowanceand investmenttax 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 denominatedin the local currency. Dealingfirst with the alloweddepreciationrate, supposethat depreciationoccurs at an annual rate of 30%. In addition,the expenditureon the machinemust be capitalizedand assumethat the future depreciationdeductionsare discountedat the rate of 15%. The present value of depreciationdeductionsbasedon declinir.,balancedepreciationis, z = d(t + r)/(r + d), where d is the allowed depreciationrate and r is the discountrate. Thus the tax deductiondue to depreciationis 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 machineis 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.

3It 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 reductionis 0.46. The tax reductionin the depreiaon deductionscae is 23% smallerthan the tax reductionfrom immediatewrite-off. Neot, considerthe investmenttax 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. The first, is zumwhichis the depreciationpart. The secondis *zu v whichis the amountthat the tax creditreducesthe depreciationbase. The third is v whichis the investmenttax credit. 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 mwchineis 0.68. Some countries, for example Turkey, rather than offring a credit for investment expenditureallow a fractionof these expendituresto 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 - [zu1 + u0O]. If z = 0.77, u

=

0.46 and # (the

allowancerate) - 0.10 then the tax allowancecontributes0.40 to ax reductionwith the final cost of the machineequal to 0.60. Table 1.1 showsexamplesof the post tax cost of unit value machineryand equipment for three countries;Mexico,Pakdstanand Turkey. The highestpost tax cost of a unit value of

-4Table 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, straightlinedepreciationat 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 balancedepreciationat 0.10, v = 0.30, and z = 0.7 for r =0.OS and z = 0.46 for r = J. 15.

'u, = 0.46, decliningbalancedepreciationat 0.25, investmentallowancerate -

0.30, this is the minimumrate allowedand z - 0.875 for r - 0.05 and z0.719 for r

O. 0 15.

-5.

capital expenditure is found in Turkey, followed by Mexico and I-aldstan. As fuure depreciationdeductionsare 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 technologyof a representativefirm withinan Mndustry can be definedas y, X f(Kv,.,v,, A14, Aj

(1)

where y is the outputquantity,K is the m dimensionalvectorof quasi-fixedfactors,v is the n dimensionalvector of variablefactorsand A is the indicatorof the level of technology. The productionfunctionis denotedby f, which is definedfor nonnegativeinput quantities,and is nonnegativewithpositivemarginalproducts. The productionfunctionalso decline.withrespect to the net investment vector, AK = K,- K,. . Adjustmentcosts are represented through the net

investmentvectorin 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 productionprocess(see for example,Treadway[1971,19/4], Mortensen(1973]and EIpstein(1981]). The subscriptt representsthe time period I Quasi-fixedfactors 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 dimensionalInvestmentvector, a is an m dimensionaldiagonalmatrixof 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 dimensionalidentitymatrix. 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, +1P ,&ANst - r,B, I - TOt- D t -0.

(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),p, 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 OA

(30.1)

The labor and materialinputdemandfunctionsfor the intermediate-runare describedas -VI+I

,Pi + PWAU + Ppf': + pkKs + Pi.Aa

(30.2)

-21-Va.-

-

PO

+ p+,-P 5

+ 0.50e,

+ 0.SPWr2

-

P,S2 - O.Sp.w" P/W

A

+ P -

(30.3)

+ O.SpU(K8.j - K8Y

The equationfor capitalinputintermediate-rundemandis *

(+.5IP)

[(p + §WpM2

(P + pdp

+ 4PI3Pdi0J5)(Pk+ PA'

* (1 + O.S(p+

-

+ PkW

+

P

-

WA(30.4)

(30.4)

p + p&fi)2

+ 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 manner. The intermediate-run demandfor capitaldependson predeterminedvariables. These variablesare relativeaftertax prices, indicatorof technology,discountrate and short-runcapital input. Next, the cutput supply and variable input demandsare simultaneouslydetermined. Thesevariablesdependon the after tax relativeprices of outputand labor (not therental rate), the technologyindicatorand the short-rundemandfor capital.

Long-Run In the long-run,AK, - 0. Thus, investmentin the long-runonlyoccurs for replacemen purposes. The long-runoutputsupplyequationis yS

-

+

f P^W *P

+

P;X

+ PwA,

(31.1

-

22 -

The labor and materialinputuemandequationsfor the long-runare I

I~ + -

p1

S

pph?6

+ PA Po + PkKXI

-

plc

~~~~~~~~~~~~~~~~~I

- O.SPPP

-

(31.2)

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*Wl + PhA, - W,J

(31.4)

In the long-run,since the ca;.tal adjustn 'nt processis completed,output suppliesand inputdemandsare functionsof the iong-rundemandfor capital. Thedemandfor capitaldepends on exogenousvariables. Once this denlandis obtained,then outputsupply,labor and material 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 In order to determinethe effectof tax policyin stimulptinginvestment,it is necessary to determinethe tax irnstrumentelasticitiesof capitaldemandin each of the productionruns. The tax instrumentlelasticitiesconsistof two components.The first elementis the effectof the tax instrumenton the after tax relativerentalrate of capital(sincethis is the only relativeprice directlyaffectedby the tax policy). The secondcomponentis 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

+ 8)(1 U(&z u+ 5/8U))U&/,(1-u)O

(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 - u) < o

(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, -

Z)u-IWb(1 - u.)> 0U

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 governmentof stimulatngcapitaldemand. This ratio we refer to as the benefit-costratio. Investmnent Tax Credit and Allognc For an investmenttax credit, the changein governmentrevenueis a

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

(36)

The superscripte denotesthe particularequil£brium,e = s,i,l for short, intermediateand longrun. 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 depreciationfor tax purposes,then the changein governmentrevenueis AGR; -

-J(

(1-8)K-i)Ou

p

(37)

If depreciationfor tax purposesis straightline,and tax creditsdo not affect it, then the changein governmentrevenueis 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

P psy- -_8ysWtV

E

-

-

CCA, - IIA

(39)

where (withone type of capital, see equation(5)). (40)

cCA* - E;.oQOs.-*d 5

where I. "-

(KR'

ITA.

-

(--8) KR' 1 ).

*, Qs (KR -

Also

(1-8)K:)

Now the changein governmentrevenuein 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(investmenttax credit, tax allowance,capital cost allowance,income tax). The numeratoris the additionalcapitalgeneratedby a specifictax instrument. The denominatoris the cost to the governmentof generatingthe additionalcapital. 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 componentof 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 metropolitanareasand in all sectorsexcept the automobiles.In major metropolitanareas only 60% of suchvalue can be deductedin the first year and the remaining40% subjectedto capital consumptionallowances. 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 schecduleddepreciationallowancesfor the life of each type of assets calculatedat a 7.5 percent annualrate of interest(see Gil-Diaz, 1990). Tax incentivesregime in Mexicohas also undergonesignificantchangesover time. Duringthe past two decades,tax policywas seen as a majorvehiclefor regionaland sectoraldevelopmentwhile revenue

- 27Table NI

Nexico: TaX regime Corporate income t

-H-::-unerol1

Toxation of DIsinmes Income, A Coapartive (percent)

Perspective

(1991 S--:::-v.!:-ffexi 35 * 3.9 * 38.9

tkIted Statei 34 + 6 40

Withhotding tax rates Interest DivIdends Technology trenefer fees Royalties

3S 0-40 21 40

30 30 30 30

Indexation of deductfons Loss carry forward Losscarrybackiard Niniumu/atternative Ninima tax

Fult 5 0 2 assets tox

tat gairm toxation Capitalgalintaxation Coverage Indexation Rate

No Mo 15 7 3 3 20X an taxableincom inclusive 0.175Yan capita(in exces of $10 of tax preference *Illioncreditable againt 3X surtaxon corporate profits

Fult Full 35

FulL No 34

Two-thirds No 28

go No. PresentValueof CCAs lediately daductible

Yes No

Yes Mo

rate:

fDvidends deductien Fullexpensing of investumnt Investment tax credi s

10) 19M

-

Energy irnestmnt. rehabilitation of real estate, targeted job credit

O9)

28 + 15

43

26 25 25 25

Regiontl wnd R&D

2/ In Mexicotheprofit-sharing rateand, in the UnitedStates nd tan d, the averae* provincial or statetax rates are addedto the basicfederalrate. Source: Ugerte(1966),PriceWaterhouse (1992),Internationlkureu of fiscalOocumentctien (196), and Cil-Dlaz(1990).

-28

-

implicationsof thesepolicieswere overlooked. A brief reviewof historicalchangesin the tax 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 developmentwere grantedimport duties relief varyingfrom 50% to 100%and reductionin 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 incentivescertificates(CEPROFIS)providingtax creditin therangeof 10-25%,dependingupon location,and type and size of the industry, for investmentin physicalassetswere introduced. These certificateswere negotiableand could be used againstany federaltax liabilityby the holder. These certificatesprovedquitepopularand in 1983amountedto 0.83 percentof GDP in revenue losses. While the manufacturingsector was a major beneficiaryof this scheme, mining,agricultureand transportationindustres also receivedsignificantamountof resources. Amongthe manufacturingindustries,paper and publishing,chemicalsand food and beverages receiveda majorityof the assistance. WhileCEPROFISwerethe mostimportantfiscalincentive,Mexicangovernmentoffered also offeredspecialincentiveswere exportpromotion(CEDIS),developmentof duty-freezones specialtax preferencesto automobile,cement,publishingand miningindustries.

- 29 1987-1900: The tax incentivescertificates scheme was significantlytightenedand targetedto priorityindustriesand preferredzone. Top taxcredit rate for CEPROFIwas raised to 40% of totalphysicalinvestmentin 1986. In additionMexican-ownedenterprisesare eIigibl for employmenttax creditup to 30% of three times the annualarea minimumwage multipli: by the numberof newjobs created. Startingin 1989, full expensingof the present value of capital consumptionallowances calculatedusing a 7.5% discountrate was offered as an alternativeoptionto standardcapit consumptionallowancesin non-metropolitan areas. In the metropolitanindustrializedareasof 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 technologicalresearch(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;detergentsand otherchemicals. The data for thesetwo three-digitMexicanindustriesfor the period1970to 1983wascollectedfrom a varietyof Governmentof Mexicosources. These two industriesare amongthe three largest industriesin the industrialsector (SIC 35) comprisingof chemicals,petroleumderivatives, rubber and plasticsproducts. Together thesetwo industriesaccountedfor 5.2 percent of total manufacturingoutputand 2.9 percentof total employment. The data on industrycapitalstock was developedby using the perpetualinventorymethodwith an assumeddepreciationrate of 0.08, representinga weightedaverageof assumeddepreciationrates of 0.1 for machineryand equipmentand 0.025 for structures respectively.) Quantityof labor was measuredas the averagenumberof employeesduring the year. The price of labor was derivedby dividingthe total employmentcost during the year by average number of employees. Quantity of intermediateinput, was obtainedby dividingthe cost of intermediateinputsby the input price index. We wil now examinethe effectsof corporatetax policyinitiativesin stimulatingcapital expendituresin the short, intermediateand long runs for the case of Mexico. The three tax instrumentsthat we considerfor Mexicoare the corporateincometax (CM rate, the investment tax credit (ITC) rate, and the capital cost allowance(CCA)rate. As discussedearlier on the theoreticaland 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 elasticitiesof the tax instrumentson the rent rate.

-

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 1979

Other Chemicals 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

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

-0.049

-0.043

-0.026

-0.021

Intermediate-Run

Long-Run

eu,,

-

33 -

1.5.3 Tax Incentives,InvestmentImpactsand ForegoneRevenues Althoughfocusingon investmentexpenditureonlyprovidesa partial view of the effects of tax policy, in this section,we calculateinvestmentinputper unitvalue of foreigngovernment revenue. This measureis referred to as the incrementalbenefit-costratio in Table M4. These calculationsare 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 deterioratedin recentyears and the measureis not cost-effectivein any of the runs. Accelerated capital consumptionallowances, have also proved to be not cost-effectivetax incentive instrumentsas the benefit-costratio for this measureis less than one in all runs for the two industries. Finally, while corporate tax rate reductions have had fairly large impacts on stimulatingcapital expendituresin the detergentsand other chemicalsindustries, revenues foregonefromsuchreductionsfar exceedthe positiveinvestmentimpactstherebyyieldinga low benefit-costratio. 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

Impact Intermediate Run

Long Run

Tax Instrument

Industry

Year

InvestmentTax Credit

Detergents Other Chemicals

1979

0.55 0.28

0.69 0.36

0.74 0.40

Detergents Other Chemicals

1983

0.44 0.26

0.51 0.32

0.54 0.34

Detergents

Mean (s.d.)

0.57 (0.08) 0.26 (0.02)

0.71 (0.13) 0.35 (0.02)

0.77 (0.16) 0.40 (0.03)

Detergents Other 'hemicals

1979

0.40 0.20

0.50 0.27

0.54 0.29

Detergents Other Chemicals

1983

0.32 0.19

0.38 0.24

0.40 0.25

Detergents

Mean (s.d.)

0.42 (0.06) 0.19 (0.01)

0.52 (0.09) 0.26 (0.02)

0.57 (0.12) 0.29 (0.03)

Detergents Other Chemicals

1979

0.05 0.01

0.06 0.02

0.07 0.02

Detergents Other Chemicals

1983

0.03 0.01

0.04 0.01

0.05 0.01

Detergents

Mean (s.d.)

0.04 (0.01) 0.01 (0.00)

U.06 (0.01) 0.01 (0.00)

0.06 (0.01) 0.02 (0.00)

Other Chemicals

Accelerated Capitol Consumption Allowance

Other Chemicals

Corporate Income Tax Rate Reductions

Other Chemicals

-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 domesticallymanufacturedgoods Dythe producerand on importedgoodsby the importer. In the fiscal year 1989-90,import duties at differentialrates were imposedon importedmachineryand equipment.These rates variedfrom 20% to 50% if similarmachinerywas not manufacturedin Pakistan,and a higherrate of 80% 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,tax rebates,regionaland industryspecific tax holidays,and investmenttax credits. Theseare briefly discussedbelow. Furtherdetailsof the currenttax regimeare givenin TableP1. Tax holidays: Tax holidaysfor two years for specificindustries(e.g. engineeringgoods) and specificregions(mostof the countryexcept majormetropolitanareas) were introducedin 1959-60. The holidayperiod was subsequentlyraised to four years in 1960-61. These tax holidayswere eliminatedin 1972-73but reinstatedagainin 1974-75. Presentlytax holidaysfor

-36 -

five years are permittedto engineeringgoods, poultryfarmingand processing,dairy farming, cattle or sheep breeding, fish farming,data processing,industriesmanufacturingagricultural 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,and replacementof plant and equipmentwas introducedat a rate of 15%, but its applicationwas restrictedto designatedareas. Since 1976-77,the creditwas madeavailableregardlessof locationand ypeof industry. This credit was withdrawnin 1989-90but reintroducedin 1990-91. Acceleratedcapital consumptionallowances: Capital consumptionallowancesfollow acceleratedschedulesfor machineryand equipment,transportvehiclesand housingfor workers (25%), oil explorationequipment(100%), ship building(20-30%),and structures(10%)on a decliningbalancemethod. Expendituresrelating to research and development,transfer and adaptationof technologiesand royaltiesare eligiblefor full expensing.

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. The data on thesetwo manufacturingindustrieswascollectedprimarilyfrom the variousissues of the two annual publications of the Governmentof Pakdstai.namely the Census of ManufacturingIndustriesand the EconomicSurvey. The wearingapparel industryin 1984 contributed0.63 percentof the total manufacturingoutput and employedroughlyone percent of the total manufacturinglabor force. The leather and leatherproductsindustry,on the other

-

37 -

Table Pl The Structure of Corporate IncomeTax System in Pakistan 1990-91. A. CIT ras applied to all incomecxcept dividendsand bonus shares: 30 1. Incometax rate 2. Super tax rue: -Bakng oompmi 25 -Non-bankingcorpanies (NB) 20 3. Suchargae 10 D. CIT azeapplied to intcrcorporatcdividends(ID) & bonus shares (BS): 0 1. Income tax on D nd BS 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 S 2. Dcbenturesnegniable bonds 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(u % 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 manufacturingoutputin 1984. The quantityof labor is measuredas total numberof days workedduring the year and a labor price index was developedby dividingtotal employmentcost during the year by the numberof days worked. The value of materialsor intermediateinputs include electricity, petroleumfuel, naturalgas, and importedand domesticallyproducedmiscellaneousmaterials. The quantityof materialswasconstructedby dividingthe totalvalueof materialsby an industry level materialsprice deflator.The quantityof outputwasconstructedby dividingthe total value of output by an industry output deflator. The series on capital stock were developedby employingperpetualinventorymethodto investmentseriesand assuminga depreciationrate of 0.08. This representsa weightedaverageof assumeddepreciationrates of 0.1 for machinery and equipmentand 0.025 for structuresrespectiveiy. We now considerthe effectsof the three tax instruments;the investmenttax credit (ITC) 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 magnitudeof the ITC elasticityincreasedfrom 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 normalizedafter 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 elasticitiesin 1984althoughin 1977the CIT elasticitiesare larger than comparableelasticities for the ITC and CCA rates. The results for the short, intermediateand long-runtax elasticities for capitaldemandappearin Table P3.

Table P2 Elasticityof 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,,,, ek,,

0.011 0.009

Xt*

-0.012

0 004 0.002

0.003 0.003

0.002 0.001

-0.004

-0.004

-0.0002

-0.021

0.008 0.005 -0.007

0.006 0.006 -0.008

0.003 0.002 -0.0003

0.046

0.029

0.016

0.006

0.038

0.017

0.014

0.004

-0.048

-0.003

-0.021

-0.0006

tadtRun

e*,,, e.- ,0.016 e,k LonzRun et.,, et.

euk

0.019

1.6.3 Tax Incentives, Investment Impacts and ForegoneRevenues the benefitcost ratios for eachof Emetax incentivefor Pakistanare presentedin Table P4 for the mostrecent year (1984)in the data as wellas for an earlieryear (1977),togetherwith the meanand standarddeviationfor the 1977-84period. In carrvingout thesecalculatiors,we note that investmentis most responsiveto changes in investmenttax credit. The loss Li governmentrevenuesare quite similarfor ITC and CCAs,and therefore,ITC yieldsa slightly higherbenefit-costratiothan CCAchanges.For corporatetax rate reductionslossin government revenuesfar exceedth^ investmentimpacts.Investmentimpactsfor all measureswerc smaller in recentyears comparedto earlieryearsfor the short and immediateruns due to the observed decline in own price elasticity of capital in recent years. Thus the table suggeststhat the investmenttax credit becamea cost-effectivemeasurefor boLhindlustriesin recent years based on its long run impact only. A similar patternof cost-efftct!ivenc.ss emergesfor accelerated

- 41 -

capital consumptionallowances. Such allowanceswere not cost-effectivein 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 outweighedby major revenuelosses to the nationaltreasury. Thus for Pakistaniindustries,the three tax incentives consideredwere ineffectivein stimulatinginvestmentin recent years but in view of a better recordof accelerateddepreciationallowancesand investmenttax creditsin earlieryears, perhaps 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 Leather

Mea7

0.40 0.26

0.76 0.25

1.11 0.24

Apparel Leather

198.4

0.28 0.11

0.71 0.28

2.50 2.54

Appure

Mean (s.d.)

0.40 (0.18) 0.24 (0.22)

0.76 (0.34) 0.36 (0.32)

0.70 (2.13) 0.37 (1.44)

Apparel Leather

1977

0.52 0.18

0.64 0.18

0.81 0.17

Apparel Leather

1984

0.23 0.09

0.59 0.23

2.10 2.13

Apparel

Mean (s.d.)

0.31 (0.13) 0.19 (0.18)

0.60 (0.27) 0.28 (0.26)

0.51 (1.70)l 0.25 (1. 14)

Apparel Leather

1977

0.05 0.01

0.13 0.01

L.21

0.02

Apparel Leather

1984

0.00 0.00

0.00 0.00

0.00 0.00

Apparel

Mman (s.d.)

0.00 (0.06) 0.00 (0.00)

0.)4 (0.04) 0.00 (0.00)

0.08 (0.07) 0.01 (0.01)

Leather Accelerated Capital Consumption Allowances

Leather

Corporate Income Tax Rate Reductions

Leather

-43

-

1.7 TURKEY 1.7.1 Tax History Thecorporateincometax in Turkeyprovidesa significantsourceof governmentrevenues (accountingfor 10%of total tax revenues)as well as serve as majortool of industrialpolicy. The governmenthas 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 significanttax base changes(see Bulutogluand Thirsk, 1990).Preferentialtreatmentof publicenteprises has beeneliminatedsince 1980. Intercompany dividends distribution have been made exempt from taxation and corporate reorganizationsare no longersubjectto capitalgains taxation. Inflationaryadjustmentof assets but not of liabilitieshave been also allowed. In the following,we briefly summarizethe 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 provisionfor bad debtminusinvestmentand exportallowancesand depreciationdeductionsetc.) is currentlytaxed at a flat rate of 46%. A 3% defencesurchargeis payableon this basic rate. In addition,a 1% tax is payableto the SocialAssistanceand SecurityFund, and an additional 1% tax is leviedfor the Apprenticeship,Vocationaland TrainingEncouragementFund, for a combinedcorporatetax rate of 49.38%. Corporatetax is withheldat sourceat varying rates with 0% rates for dividenddistributions,5% for incomefrom crude oil exploration,10%on

-44 -

interestand moveablepropertyincome,20% for incomefrom immoveableproperty,and 25% 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. Depreciationon 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 Financepublishesmaximumdepreciation rates (on a straight-linebasis)permissiblefor tax purposes. These rates typicallyare 4% for factory buildings, 15% - 20% for transportequipment, and 12.5% for machineryand equipment.

A value-addedtax is leviedat a generalrate of 12%. Bankingand insurancetransactions are subjectto a 3 % tax (BrMT).There is an investmentincentiveallowancein Turkey which 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 government. Unusedinvestmentallowancescan be carried forwardindefinitely. The rate of investmentallowancevaries by regionand type of investment. Corporationscan 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 governmentbonds,usually

- 45

-

about 20% p.a.) with the CentralBank. It can be withdrawnany 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. A largenumberof non-taxincentivesare availableto eligibleinvestments.Theseinclude low interestcredit, fundsfor workingcapital,allocationof 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 Withholding tax rates on payments by a domestic corporation to a foreign corporation Rental from fixed assets Leasing Royalties on patents Professional services Petroleum services Interest on trade receivables Other interest (loans and deposits) Withholding taxes on payments to nonresident individuals Rentals from immovable assets Royalties on patents Services (professional) interest on receivables & deposits Value-added tax Standard rate Agricultural product Basic foods, books, natural gas Luxury goods Petroleum products Banlkng and Insurance transactions tax Investment incentive allowance Export allowance Export earnings of manufacturer Export earnings of traders Export of fresh truit, vegetables International Transport Tourist establishments

46

20 0.5 25 15 S 10 10 20 25 15 10 12 1 6 20 13 5 30-100 of the cost of specified assets 12 3 12 12 20

DepreciationAlowance Straight-line Declining-balance Source: Price Waterhouse (1992)

25 50

-

47 -

1.7.2 Tax PollcyEffects on the Renl Rate and Capital The model Is appliedto three Turldshindustries;non-electricalmachinery(SIC 382), electricalmachinery(SIC383)and transportequipment(SIC384)industriesin the privatesector only and covers the period 1973 to 1985. These industries accountedfor 20% of total manufacturingoutputand employmentand 24% of manufacturingwagesin 1985.The data on output, employment,intermediateinput and investmentwere obtained from a variety of Governmentof Turkeysources. The quantityof labor was measuredas the averagenumberof employeesduring the year. The price index was constructedby dividingtotal employmentcost duringthe year by averagenumberof employees. Intermediateinputsor materialsincluderaw materials, components, containers, fuel and electricity. The quantity of materials was constructedby 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 equipmentindustries. The capitalstockseries weredevelopedby applyingperpetualinventory methodto investmentseries and by assumingdepreciationrate equal to 0.08, representinga weightedaverageof assumeddepreciationrates of 0.1 for machineryand equipmen and 0.025 for structures.1 The effectsof the three tax instrumentson the rental rate of capital are given in Table T2. Sincethe normalizedafter tax rentalrate on capitalis the samefor the three industries,the results foundfor the tax elasticitiesare 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

f1988

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

0.021

0.037

0.033

0.037

0.032

0.009

0.006

0.016

0.009

0.016

0.009

-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

.....

~~~i

1974 i 74

19

...............

.........

.

ShorRn

Intomediate

&a ek. ak^;0.021 Je-.

3et.,, Long-Run

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 -

and therby yieldinga low benefit-costratio for sucha policychange. The revenuelosses are largerfor theinvestmentallowancethanfor changesin capitalconsumptionallowancesand since investmentimpactsare higherfor the formermeasure,the net effectis to yield similarbenefitcost ratios for the two measures. The benefit-costratio is smaller for almost all measuresin 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 investmentresponsewill increaseat the samerate becauseit wouldimplyan unrealisticincrease in the marginalproductof capital. Thus it is reasonableto expectown priceelasticityof capital to decline over time. In conclusion, the table suggests that investment allowancesand

accelerateddepreciationprovisions proved to be effectiveinstrumentsof public policy for investmentpromotion,especiallybased on their intermediateand long run impacts. The same couldnot however,be saidaboutcorporatetax rate reductionswhichclearlyresultedin windfall gains to existingcapital withoutencouragingnew investment.

Table T4 Invoitmen hmpctdsPer Unk Value of Lost Tax Revenue

: ;.

; jj:

nvestinet Allowance

i i jjji;*

. .;

R .

Electrical Machinery Non-Elect-cl Mchinery Trnapon Equipment

1975

0.63 1.00 1.14

0.97 1.59 1.71

1.50 2.62 2.56

Electial Machinery Non-EloctricalMachinery Tranport Equipmet

19U.

0.40 0.86 1.00

0.72 1.42 1.54

1.54 2.49 2.40

Electrical Machinery

Mean (s.d.)

0.53 (0.012) 0.81 (0.17) 0.85 (0.23)

0.84 (0.17) 1.29 (0.28) 1.34 (0.35)

1.37 (0.29) 2.12 (0.51) 2.19 (0.60)

ElBouia Machinery Non-Electio Machinery Transport Equipmet

1975

0.56 0.89 1.01

0.86 1.42 1.53

1.33 2.34 2.28

Elebia Machinery Non-Electic Machinery TanAport Equipment

1985

0.38 0.51 0.94

0.6" 1.33 1.44

1.45 2.34 2.25

Electrical Machinery

Mean (s.d.)

0.47 (0.10) 0.72 (0.14) 0.76 (0.20)

0.75 (0.14) 1.15 (0.23) 1.20 (0.31)

1.22 (0.24) 1.39 (0.43) 1.94 (0.51)

erical Machincry Non-Blootl Machinay Tranport Equipment

1975

0.32 0.16 0.20

0.56 0.27 0.31

0.84 0.45 0.50

EletoariclMachinery Non-ElectricalMachinery Traupot Equipment

1985

0.20 0.07 0.03

0.21 0.11 0.06

0.28 0.19 0.10

ElectricalMachinery

Mean (s.d.)

0.06 (0.36) 0.05 (0.37) 0.08 (0.71)

0.01 (0 28) 0.03 (0.51) 0.02 (0.23)

0.00 (0.45) 0.07 (0.38) 0.12 (0.96)

Non-Electrica Machinery Transport Equipment

c apiwal naumptionAllowUanc

Non-Electical Machinery Trasponation Equipment

orporale IncomeTax Reduction

Non-ElectricalMachinery Transport Equipmenz

52 1.8 SUMMARYAND CONCLUSIONS This paper providesan empiricalframeworkfor the assessmentof 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 Elasticityof 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 investmenttax 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 reductions. TableSI Elasticityof Rental Rateof Capitalwith Respectto Tax Measures

Mexico(1983)

-0.409

-

-0.635

Pakistan(1984)

-0.386

-

-0.225

1.021 0.035

Turkey (1985)

-

-0.099

0.101

-0.341

-

53 -

On the Tax Sensitivityof the CapitalStock: The capitalstock exhibitssensitivityto tax changes but this sensitivityvaries by tax measure,by industryand by the adjustmentperiod. TableS2 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 investmenttax credits. For Palistani industries,the responsivenessof capitalstock to changesin corporateincometax is quite small - elasticityestimatesrange from 0.0002 to -0.006; for investmenttax credit elasticityestimatesrange from 0.002 to 0.029; and finallyfor capitalcostallowancesbetween0.001 and 0.017. Thelast twosets of elasticitiesare compatable 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 investmentincentiveallowance;from 0.004 and0.015 withrespectto changesin the capitalcost allowances;and from -0.004 to -0.015with respectto changesin the corporateincometax.

On Benefit-CostRatios: The model results suggestthat tax policy affected productionand irkiestmentand further that some tax incentiveswere more effectivethan others in investment stimulationper governmentrevenue loss (see Table S3). Among the incendves measures examined, investmentallowancesproved to be a cost-effectiveinstrumentfor investment promotiononly to Turkish industries;and investmenttax credits and accelerateddepreciation provisionshad a mixed success while corporate tax reductions met with dismal failure in promotinginvestmentin a cost-effectivemannerin all cases for all countries. In terms of their

-54 T"

S2

TaI Samiiviltyof Capial Stock _

S

-,

~~,

AW. _K

~~.

-~~~~~i-~

MEXICO(1983) Dctcrgeia

.012

.016

.017

-

Otherchemaical

.006

.007

.008

AppaDe

.004

.001

LAherd i

.002

ElecricalMach.

-

Noa-electrical Mach. Tansport Equipment

.019

.024

.027

.031

.039

.043

-

.009

.012

.013

-.014

-.019

-.021

.029

-

.002

.005

.017

-.0004

-.000

-.003

.003

.006

-

-

-

.001

.002

.004

-.000

-.000

-.006

-

-

.013

.04

.034

.004

.006

.009

-.004

-.006

-.009

-

.021

.033

.032

.006

.009

.015

-.006

-.009

-.015

-

.020

.032 .051

.006

.009

.015

-.006

-.009

-.015

-

PAKISTAN(1914)

TURKEY (1915)

-

55 -

Table S3 InvestmentExpendituresper Unit Value of Lost Tax Revenue

Short Run Tax Instrument InvestmentTax Credit Mexico:DetergentsIndustries Mexico:Other ChemicalIndustries Pakistan:ApparelIndustries Pakistan:LeatherIndustries

Imoact Intermediate Run

0.44 0.26 0.28 0.11

0.51 0.32 0.71 0.28

0.S4 0.34 2.50 2.54

AcceleratedCapitalConsumptionAllowances Mexico:DetergentsIndustries Mexico:Other ChemicalsIndustries Pakistan:ApparelIndustries Pakistan:LeatherIndustries Turkey: ElectricalMachineryindustries Turkey: Non-ElectricalMachineryIndustries Turkey:TransportIndustries

0.32 0.19 0.23 0.09 0.38 0.81 0.94

0.38 0.24 0.59 0.23 0.68 1.33 1.44

0.40 0.25 2.10 2.13 1.45 2.34 2.25

CorporateIncomeTax RateReductions Mexico:DetergentsIndustries Mexico:OtherChemicalsIndustries Paidstan:ApparelIndustries Paldstan:LeatherIndustries Turkey: ElectricalMachineryIndustries Turkey:Non-Elctrical MachineryIndustries Turkey: Transport.ndustries

0.03 0.01 0.001 0.00 0.20 0.07 0.03

0.04 0.01 0.0002 0.00 0.21 0.11 0.06

0.05 0.01 0.007 0.00 0.28 0.19 0.10

InvestmeneAllowance Turkey: ElectricalMachineryIndustries Turkey:Non-ElectricalMachineryIndustries Turkey:TransportEquipmentIndustries

0.40 0.86 1.00

0.72 1.42 1.54

1.54 2.49 2.40

Long RunRun

-56 -

long-runimpacts, investmnent tax creditswere cost-effectivein 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 current investmentsrelevantfor investmnent tax credits. The long run cost-effectivenessof these incentives,except corporatetax rate reductionswhichproved cost-ineffectivein all cases, vares by country. In Turkey, investmentallowancesand capital consumptionallowanceswere costeffective. In Mexico, both investrnenttax credit and acceleratedcapitalconsumptionallowances were not cost-effective.In contrast, in Pakistan, both the investnent tax credit and accelerated capitalconsumptionallowanceswere cost-effective.In the intermediaterun, definedas tax policy impact after one year, only the investmnentallowances and accelerated capital consumption 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 twicecontinuouslydifferentiable,and quasi-concavein the inputsand net investments.

2.

The issue of capital utilizationis not addressedin this model. The problemof costly capitalutilizationimpliesthatdepreciationrates dependon prices, technologyand market structure. Hencethe use of existingmeasuresof capital stockswouldbe inappropriate becauseservicelives are assumedto be independentof prices and technology. Costly capitalutilizationimpliesthat capitalstock measurementand technologydetermination must be modelled simultaneously. This is an interesting, complex, but secondary problemto determiningthe effects of tax policy on outputsupplyand input demand.

3.

We abstractfromintroducinginvestmenttax allowances.The modelcan be modifiedto includethem alongwith capitalcost allowances.

4.

This assumptionis the Mortigliani-Miller hypothesis.It is also possiblethat with market imperfectionsfirmscan influencethe rate of returnon theirfinancialcapital(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

t-0

u+,.(l -T 1,v1 ,)d 1 ,)/(1

+

p)'). If, inaddition, thetaxrates

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 conjecturalelasticityare not assumedto be constant. Equation(12.1) containstheir equilibriummagnitudes.The productionfunctionis also part of the first order conditions.The second order conditionsare assumed to be satisfied.The symbolV representsthe gradientvector.

7.

Recall that (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 conditionscharacterizingan equilibrium As a consequencethe expressioncan be ignoredwhen definingshadowvariableprof'

-

58-

9.

The functionis also twice continuouslydifferentiable,homogeneousof degreeone and convex in after tax prices, and concavein the capitalinputs and net inventmentlevels.

10.

It is also assumedthat the tansversalityconditionsare satisfied.The symbol0. signifies a m dimensionalvector of zeros.

11.

Sincedepreciationrates for the sampleindustriesare not available,Jorgensonand Yun (1991)estimatesfor U.S. industrieswere used. The depreciationrate for non-residential structures(0.025)was calculatedas an averageof the depreciationrates on varioustypes of industrialstructures. Inclusionof othertypes of buildingsand structuresdid not alter rate significantly. The depreciationrate for producerdurable the above epron equipment(0.10) was calculatedas an averageof the depreciationrates on a numberof electrical,non-electricaland transportationmachineryand equipmentcategories. Pleasenote that whileVariousstudiesuse a rangeof depreciationrates, theseare similar 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. Publc investment,the Rste of Return and ODtimalSocial Pogicy,Baltimore,JohnsHopkdnsPres. Bernstein,J.I., and M.I.Nadiri. 1986. "Financingand investmentin plant and equipmentw,in M.H.Pestonand 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 applicationto Canadianindustries', CanadianJoural of Economics.,24, 638659.

Boadway,R. and A. Shah. 1992. The Roleof InvestmentIncentivesin DevelopingCountries. 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. Diaz, Gil-Diaz. 1990. Reformingtaxes in DevJ1opingCountries:Mexico's ProtractedTax Reform. Processed,CountryEconomicsDepartment,WorldBank Ehdaie, J. 1991. RevenueGeneratingand InvestmentAspectsof the CorporateIncomeTax Systemin Pakistan:An Agendafor Raform.Processed.CountryEconomicsDepartment, WorldBank. 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 MultivariateFlexibleAcceleratorModel: Its EmpiricalRestrictionsand an Applicationto U.S. Manufacturing.' Economea, v.52, pp. 647-674. Epstein,L.G. and A. J. Yatchew. 1985. 'The EmpiricalDeterminationof Technologyand Expectations: A SimplifiedProcedure,' Ioumal of Econometrics,v.27, pp. 235-258. Guisinger, Stephen and Associates. 1985. Investment incentives and Performance Ruiiments. PraegerPublishers,New York.

-60Hall, 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. InternationalBureau of Fiscal Documentation: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 CuentasNacionalesde Mexico. Mexico,Bancode. 1986. 'La Encuestade Acervos,Depreciaciony Formacionde Capitaldel Banco de Mexico." Documento Interno, Reporte Metodologico, Direccion de InvestigacionEconomica. Mexico,Bancode. 1986The MexicanEconomy Mexico,D.F. Bancode. 1987. IndicadoresEconomicos. Mexico, Bancode. 1988. 'Enquesta Semestralde Coyuntura,2e semestre1987." Direccion de InvestigacionEconomicaGerenciadel SectorReal. Febrero de 1988. Mexico,Governmentof. Ministryof Finance. UnpublishedTax Data. Mortensen,D. 1973. 'Generalizedcosts of adjustmentand dynamicfactordemandtheory", Econometriga,_41, 657-666. Pakistan, Governmentof. Federal Bureau of Statistics.Census of ManufacturingIndustries. VariousIssues. Karachi Pakistan,Governmentof. FinanceDivision. Economic Islamabad

StatisticalSupplement:1987-88.

Pakistan,Governmentof. FinanceDivision. PublicFinanceStatistics. VariousIssues Price Waterhouse. 1992. CorporateTaxes: A WorldwideSummary. New York. Steigum,E. 1983. 'A financialtheoryof investmentbehavior",Eonometnca. 53, 637-6451 Treadway, A. 1971. "On the rationalmultivariateflexibleaccelerator",Econometrica .39, 845-1355.

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61 -

Tradway, A. 1974. "The globallyoptimalflexibleaccelerator', Iournalof EconomicTheory, 7, 17-39. TUSIAD1987. "a TuridshEcnomy. Turkey, Governmentof. State Institute of Statistics. Statistical Yearbook of Turkey. PublicationNo. 1250. Variousyears. Turkey,Governmentof. TreasuryDcVartment.UnpublishedTax Data. Ugarte, Fenado Sanchez. 1988. 'Taxation of Foreign Investment in Mexico: The North Ameican Perspective.' InternationalEconomicsProgram Worldng Paper DP88-7. Universityof Toronto. Processed.

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