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The shifting of the corporation income tax : theory and evidence Wickham, Peter Hugh 1969

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THE SHIFTING OF THE CORPORATION INCOME TAX: THEORY AND EVIDENCE by PETER HUGH WICKHAM B.A., U n i v e r s i t y o f E s s e x , 1968 A THESIS SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE DEGREE OF M.A. i n t h e Depar tment o f ECONOMICS We a c c e p t t h i s t h e s i s as c o n f o r m i n g to . t h e r e q u i r e d s t a n d a r d : THE UNIVERSITY OF BRITISH COLUMBIA Augu s t , 1969 • In present ing th is thesis in p a r t i a l f u l f i lment of the requirements for an advanced degree at the Un ivers i ty of B r i t i s h Columbia, I agree that the L ibrary sha l l make i t f r e e l y ava i l ab le for reference and Study. I fur ther agree that permission for extensive copying of this thesis for s cho la r l y purposes may be granted by the Head of my Department or by his representat ives. It is understood that copying or pub l i ca t i on of th i s thesis for f i n a n c i a l gain sha l l not be allowed without my wr i t ten permission. Department of €eottOU*g? The Un iver s i t y of B r i t i s h Columbia Vancouver 8, Canada Date /Uq*>r £<), nb°J ABSTRACT Over t h e l a s t t e n y e a r s a s e r i e s o f e m p i r i c a l s t u d i e s have been p u b l i s h e d t h a t c l a i m t o t e s t by s t a t i s t i c a l methods whethe r c o r -p o r a t i o n s , f a c e d w i t h t h e i m p o s i t i o n o f a t a x on t h e i r b u s i n e s s income, can i n t h e s h o r t - t e r m i n c r e a s e t h e g r o s s p r o f i t s so as t o m a i n t a i n t h e i r ne t o f t a x r a t e o f r e t u r n on c a p i t a l . These s t u d i e s have used v a r i o u s methods but t h e r e s u l t s y i e l d c o n t r a d i c -t o r y e v i d e n c e as t o whethe r t h e p r o p o s i t i o n c o u l d o r c o u l d no t be a c c e p t e d as h a v i n g v a l i d i t y . The r e s u l t s s u g ge s t ed t h a t a f r e s h l ook a t t h e t h e o r e t i c a l a n a l y s i s on t h e c o r p o r a t e t a x be u n d e r t a k e n . The methodo logy f o l l o w e d was t o make a s e r i e s o f s i m p l i f y i n g assump^ t i o n s such t h a t f o c u s c o u l d be d i r e c t e d t owa rd s an e x a m i n a t i o n o f d e c i s i o n - m a k i n g w i t h i n t h e f i r m and w i t h i n t h e i n d u s t r y on wh i ch t h e t a x was imposed. Fo r t h e f i r m t h e e f f e c t i v e r a t e o f t a x i s dependent no t o n l y upon t h e s t a t u t o r y r a t e o f t a x but a l s o upon t h e d e p r e c i a t i o n p r o v i s i o n s i n f o r c e ; w i t h an e f f e c t i v e t a x r a t e g r e a t e r t h a n z e r o , t h e t a x c e t e r i s p a r i b u s r e d u c e s t h e r a t e o f r e t u r n on i n v e s t m e n t p r o j e c t s . However, i t was found t h a t t o g a i n f u l l e r r e s u l t s as t o t h e e f f e c t o f t h e t a x , more d e t a i l e d spec i f i ca t ' on o f t h e e n v i r o n m e n t w i t h i n wh i ch t h e f i r m o p e r a t e s i s needed. The c l a s s i c a l models o f pu re c o m p e t i t i o n and pu re monopoly were s t u d i e d ; s h o r t - r u n p r o f i t m a x i m i s a t i o n i s assumed in such mode l s . The t a x i m p o s i t i o n l ed t o t h e p r e d i c t i o n t h a t t h e a f t e r - t a x r a t e o f r e t u r n f e l l i n t h e s h o r t - r u n ; i n t h e l o n g - r u n i f t h e t a x imposed on normal p r o f i t s , c a p i t a l moved o u t o f t h e i n d u s t r y . C o n s i d e r a t i o n was t h e n g i v e n t o o l i g o p o l i s t i c i n d u s t r i e s . P r o f i t m a x i m i s a t i o n was s t i l l assumed, but w i t h t h e r e a l i s a t i o n t h a t o v e r t h e p l a n n i n g h o r i z o n t h e f i r m , d e p a r t u r e s fromv.fuI I • s h o r t - r u n p r o f i t m a x i m i s a t i o n were p r o b a b l e . The r e a s on s f o r such b e h a v i o u r were e x a m i n e d . The t a x was t h e n imposed. In p a r t i c u l a r c a s e s t h e t a x a f f e c t e d t h e c o n s t r a i n t s ' t o a l l o w p r i c e i n c r e a s e s and an i n c r e a s e -i n t h e g r o s s r a t e o f r e t u r n . In o t h e r s t h e c o n s t r a i n t s rema ined unchanged and no s h o r t - r u n a l l e v i a t i n g a c t i o n was p o s s i b l e . R e l a x a t i o n o f t h e a s s u m p t i o n s o f t h e t h e o r e t i c a l a n a l y s i s was t h e n a l l o w e d , so t h a t t e s t a b l e p r e d i c t i o n s c o u l d be p u t f o r w a r d . S e v e r a l o f t h e r e c e n t s t u d i e s were t hen examined t o see whethe r t h e i r f r a m e -work, d a t a and e s t i m a t i n g e q u a t i o n s were adequa te t o t e s t t h e h y p o -t h e s e s pu t f o r w a r d . The c o n c l u s i o n drawn was t h a t t h e use o f annua l t i m e s e r i e s o v e r f o r t y y e a r s was i n a d e q u a t e f o r such a p u r p o s e . TABLE OF CONTENTS CHAPTER I INTRODUCTION ' CHAPTER II RETURNS TO INVESTMENT, THE NATURE OF PROFITS, AND THE TAX 4 CHAPTER III INDUSTRIAL STRUCTURE AND THE TAX EFFECTS 13 CHAPTER IV TESTING HYPOTHESES AND THE EMPIRICAL EVIDENCE 33 BIBLIOGRAPHY 48 L i s t o f T a b l e s T a b l e 1. Summary o f the Recent E m p i r i c a l E v i d e n c e 3 T a b l e 2. Rates o f R e t u r n i n M a n u f a c t u r i n g 1926-29 and 195^-58 35 L i s t o f F i g u r e s F i g . 1. E q u i l i b r i u m f o r the F i r m i n P u r e C o m p e t i t i o n .... l ^ f F i g . 2. P o t e n t i a l S h i f t i n g i n the O l i g o p o l y Case 26 F i g . 3. A g g r e g a t i o n and P o t e n t i a l Short-Run S h i f t i n g .... 32 INTRODUCTI ON In 1963, M. K r z y z a n i a k and R. Musgrave ( t r a d i t i o n a l l y a b b r e v i a t e d t o K-M i n t h e l i t e r a t u r e ) p roduced t h e f i r s t p o s t - w a r b o o k - l e n g t h a t t e m p t t o a s s e s s e c o n o m e t r i c a I Iy t h e e f f e c t s o f t h e c o r p o r a t e income t a x e s on t h e r a t e o f r e t u r n i n m a n u f a c t u r i n g i n d u s t r i e s o v e r t h e p e r i o d I935-42 and i 948 -59 .^ T h e i r a n a l y s i s a t t e m p t e d t o f o c u s on s h o r t - t e r m s h i f t i n g o f t h e t a x , and t h e i r s t a r t l i n g c o n c l u s i o n i n v i e w o f t h e t r a d i t i o n a l v i ew c o n c e r n i n g t h e e f f e c t s o f t h e t a x i n t h e s h o r t - r u n , was t h a t c o r p o r a t i o n s were a b l e by some means (imp I i c i t t y r e s e r v e marke t power) i n t h e f a c e o f r i s i n g t a x r a t e s , t o m a i n t a i n t h e i r ne t r a t e o f r e t u r n , and i n f a c t even i n c r e a s e t h i s ne t r a t e . The r e c e p t i o n g i v e n t h e s e f i n d i n g s was d e c i d e d l y m i x e d . S e v e r a l e c o n o m i s t s found enough c o n f i d e n c e i n t h e K-M model and t h e e c o n o m e t r i c t e c h n i q u e s t o p e r f o r m a l m o s t 2 3 i d e n t i c a l t e s t s f o r c o r p o r a t i o n s i n Canada , West Germany , and 4 I nd i a . The r e s u l t s f rom t h e s e t e s t s con fo rmed w i t h t h e K-M f i n d i n g s o f o v e r - s h i f t i n g o f t h e t a x . O t h e r e c o n o m i s t s d i d no t 5 s h a r e t h i s o p t i m i s m i n t h e model s used and t h e f i n d i n g s ; . R. Goode , R. S l i t o r 6 , and c o l l e c t i v e l y J . C r a g g , A. H a r b e r g e r , and P. M i e z o w s k i 7 , d e m o n s t r a t e d t h e s u s c e p t i b i l i t y o f t h e s h i f t i n g measure t o changes i n g t h e s p e c i f i c a t i o n o f t h e e s t i m a t i n g e q u a t i o n s . R. Gordon , s p e c i f y i n g h i s own model and e q u a t i o n s , found a r e s u l t f o r s h o r t - r u n s h i f t i n g e n t i r e l y c o n t r a r y t o t h e K-M f i n d i n g s . A summary o f t h e s t u d i e s , t e c h n i q u e s u s e d , and r e s u l t s f o r s h o r t - r u n s h i f t i n g i s g i v e n i n T a b l e I. CHAPTER I I RETURNS TO INVESTMENT, THE NATURE OF PROFITS, AND THE TAX - 2 -As can be seen t h e f i n d i n g s h a r d l y d i s p l a y u n a n i m i t y , and a l t h o u g h , t h e K-M s t u d y has been s u b j e c t t o damaging c r i t i c i s m , t h e c o n c l u s i o n must be t h a t no c l e a r con sen su s emerges f rom t h e l i t e r a t u r e . D i s -c u s s i o n o f t h e v a r i o u s e c o n o m e t r i c t e c h n i q u e s used s h o u l d , and u n d o u b t e d l y w i l l c o n t i n u e , but i t a ppea r s t h a t a more s u b s t a n t i a l r e v i e w i s c a l l e d f o r . T h e r e f o r e , in t h i s paper a r e - e x a m i n a t i o n i s made o f t h e t h e o r y o f t a x i n c i d e n c e and o f t h e p r e d i c t i o n s t h a t can be d e r i v e d f rom t h e same. F o l l o w i n g t h i s p a r t o f t h e p a p e r , c o n s i d e r a t i o n i s g i v e n t o t h e o p e r a t i o n a l p rob lems i n t e s t i n g t h e body o f p r e d i c t i o n s ; t h e n , h a v i n g s e t o u t a m e t h o d -o l o g i c a l f r amework , t h e v a r i o u s s t u d i e s d e s i g n e d t o measure s h i f t i n g a r e e v a l u a t e d i n t h e l i g h t o f t h i s f r amework . I K r z y z a n i a k , M. and Musg rave , R.A. The S h i f t i n g o f t h e C o r p o r a t i o n  Income Tax . B a l t i m o r e : Johns Hopk i n s P r e s s , 1963. 2 , S p e n c e r , B.G. "The S h i f t i n g o f t h e C o r p o r a t i o n Income Tax i n Canada " C a n a d i a n J o u r n a l o f Economics V o l . 2 , No. I, Feb. 1969. 3 Roskamp, K a r l "The S h i f t i n g o f Taxes on B u s i n e s s Income: The Case o f West German C o r p o r a t i o n s " The N a t i o n a l Tax J o u r n a l V o l . 18, No. 3, S e p t . 1965. 4 Lammas, G u r c h u r a n , S. The S h i f t i n g o f t h e C o r p o r a t e Income Tax - A.': S tudy w i t h R e f e r e n c e t o I n d i an C o r p o r a t i o n s " Pub I i c F i nance V o l . 2 1 , No. 4 . 5 Goode, R i c h a r d . " R a t e s o f R e t u r n , Income S h a r e s , and C o r p o r a t e Tax I n c i d e n c e " , i n M . K r z y z a n i a k ( e d . ) E f f e c t s o f C o r p o r a t i o n Income Tax D e t r o i t : Wayne S t a t e U n i v e r s i t y P r e s s , 1966. 6 S l i t o r , R i c h a r d . " C o r p o r a t e Tax I n c i d e n c e : Economic A d j u s t m e n t s t o D i f f e r e n t i a l s under a T w o - T i e r Tax S t r u c t u r e " , i n M . K r z y z a n i a k (ed.) E f f e c t s Of C o r p o r a t i o n Income Tax . D e t r o i t : Wayne S t a t e U n i v . P r e s s 1966. 7 C r a g g , John G; H a r b e r g e r , A r n o l d C; and M i e z o w s k i , P e t e r . " E m p i r i c a l E v i d e n c e on t h e I n c i d e n c e o f t h e C o r p o r a t i o n Income T a x " , J o u r n a l o f  Po l i t i c a l Economy, V o l . 75 , No. 6, December 1967. 8 Go rdon , R o b e r t J . "The I n c i d e n c e o f t h e C o r p o r a t i o n Income Tax In U.S. M a n u f a c t u r i n g 1925 -62 " , A m e r i c a n Economic Rev i ew, V o l . 57, No. 5, September 1967. A u t h o r ( s ) A p p r o x i m a t e R e s u I t f o r S h i f t i n g E c o n o m e t r i c T e c h n i q u e Dependent V a r i a b l e s Independent V a r i a b l e s K r z y z a n i a k , M. and Musgrave, R.A. 150$ Hal I , C A . J r . 0$ Ki l p a t r i c k , R . W . 50-80$. Roskairtp,.. K» - ,1.08$,., S l i t o r , R. 80$ C r a g g , H a r b e r g e r 0$ M i e z o w s k i Gordon, R. J . 0$ T.S.R.E. f o r 1935-1.942 and 1948-1959. I n s t r u m e n t a l v a r i a b l e s . T.S.R.E. O.L.S.-1919-1950 C r o s s S e c t i o n Re-g r e s s i o n E q u a t i o n s O.L.S. T.S.RiE: f o r p o s t -war German C o r p o r -a t i o n s . Instrument-aI v a r i a b l e s . . •-/ T.S.R.E. 1942 and O.L.S.' f o r 1935-1948-1959 T.S.R.E. f o r 1935- -1942 and 1948-1959 I n s t r u m e n t a l v a r -i a b l e s . T.S.R.E. f o r I 926-1962. War y e a r s n o t i n c l u d e d . I t e r a t i v e t e c h n i q u e . G r o s s r a t e o f r e t u r n on c a p i t a l f o r manu-f a c t u r i n g (' y<^  ) P r o f i t s s h a r e i n ' N a t i o n a I J ncome Change i n W<j between two p e r i o d s AC-k - i : change f r o m y e a r k - z t o y e a r k - i i n r a t i o o f c o n s u m p t i o n t o c ^ P V t - i : r a t i o o f i n v e n t o r i e s t o s a l e s i n n s n u f -a c t u r i n g i n y e a r b- i 3fc : r a t i o o f t a x a c c r u a l s ( o t h e r t h a n c o r p o r -a t e income t a x ) minus government t r a n s f e r s t o in y e a r t L-t. : r a t i o o f c o r p o r a t i o n income t a x l i a b i l i t -i e s t o t o t a l c a p i t a l s t o c k i n y e a r £ ( o r e f f e c t i v e t a x r a t e ) , V a r i o u s , b u t i n c l u d i n g a measure o f c o n c e n t r a t i o n | " p r e s s u r e " v a r i a b l e , t h e employment r a t e and P t and war dummy Wt and £t C u r r e n t p r i c e , o u t p u t , changes i n same, p r o d -u c t i v i t y change t e r m , c a p a c i t y u t i l i s a t i o n v a r i a b l e , and t a x v a r i a b l e . TABLE I (continued) Author(s) Approximate Resu1t f o r S h i f t i n g Econometri c Technique . Dependent V a r i a b l e s Independent V a r i a b l e s Spencer, E.G. 130$ T.S.R.E. post-war f o r Canada. 1nstr-umenta1 v a r i a b l e s . Lammas, G.S. 113.5* T.S.R.E. 1950-62 f o r India. I n s t r -umental v a r i a b l e s . • • • " ' • ' • . KEY: T.S.R.E. : Time S e r i e s Regression Equations . ••, O.L.S. : Ordinary Least Squares ' . ' SOURCES: ... /" ',• '. * ' ..' . • . ". " .1. Krzyzaniak, M. and Musgrave, R.A. op. c i t . 2. H a l l , C.A. J r . ^ " D i r e c t S h i f f i n g of the Corporation Income Tax in Manufacturing" American Economic Review Proceedings V o l . 54, May 1964. ( f o r a damaging c r i t i q u e of t h i s study see Musgrave, R.A. " D i s c u s s i o n on Problems of T a x a t i o n " in the same '• volume, p. 300-302 3. K i l p a t r i c k , R.W. "Short-Run Forward S h i f t i n g of the C o r p o r a t i o n Income Tax" Yale Economic Essays, Vol . 5, No. 2, F a l l 1965.. .. j . •'• ' _ / . • _ — " \. 4. Roskamp, Karl W. op. c i t . 5. S l i t o r , R i c h a r d , op. - c i t . •', 6. Cragg, J . , Harberger, A. and Miezowski, P. op. c i t . , ; . 7. Gordon, Robert J . op. c i t . • "*...'•.••„' . ..' 8. Spencer, B.G. op. c i t . • -'' -,. ""' 9. Lammas, Gurchuran S. op. c i t . '' ".. . .' 4 One o f t h e p r i n c i p a l d i f f i c u l t i e s t h a t a r i s e i n d i s c u s s i o n s o f t h e t a x i n c i d e n c e i s t h a t p a r t i a l e q u i l i b r i u m a n a l y s i s imposes l i i m i t a t i o n s . O the r t h i n g s c a n n o t be e x p e c t e d t o rema in equa l i n r e s p o n s e t o a ma jo r s h i f t i n t h e t a x s t r u c -t u r e ; an a n a l y s i s o f such a s h i f t would r e q u i r e e x a m i n a t i o n o f a comp lex dynamic s y s t e m , f o r any ma jo r change i n t h e t a x p r o v i s i o n s w i l l have r e p e r c u s s i o n s on t h e c a p i t a l m a r k e t s , t h e f i n a l demand f o r goods and s e r v i c e s , t h e p a t t e r n s t h e r e o f , t h e i n d u s t r i a l s t r u c t u r e , and t h e i n t e r n a t i o n a l payments p o s i t i o n . S i m i l a r l y , a d j u s t m e n t s may be made s i m u l t a n e o u s l y t o o t h e r t a x r a t e s , p a t t e r n s , and amounts o f government s p e n d i n g wh i ch would have t o be t a k e n i n t o a c c o u n t when a s s e s s i n g t h e o v e r a l l and d e t a i l e d e f f e c t s o f a ma jo r t a x s h i f t . ; T h e r e f o r e , in t h e f o l l o w i n g a n a l y s i s , c e r t a i n a s s u m p t i o n s w i l l be made: ( i ) t h e change i n t h e t a x p r o v i s i o n s e n v i s a g e d i s c o n f i n e d t o t h e r a t e o f b u s i n e s s income t a x , and i s s u f f i c i e n t l y s m a l l t h a t p a r t i a l e q u i l i b r i u m a n a l y s i s can be used i n t h e o r -e t i c a l mode l s ; t h e r e p e r c u s s i o n s s u g g e s t e d 1 See f o r example t h e a s s e s smen t o f t h e C a r t e r Commis s ion R e p o r t by v a r i o u s a u t h o r s i n t h e C a n a d i a n J o u r n a l o f E conom i c s . Supp lement No. I, Feb . 1968. - 5 -above a r e assumed t o be such as t o no t s e r i o u s l y e f f e c t t h e v a l i d i t y o f t h e p r e d i c t i o n s . In a l a t e r s e c t i o n t h e impo r t ance o f r e l a x i n g t h e s e a s s u m p t i o n s i s c o n s i d e r e d . . ( i i ) i n o r d e r t o i s o l a t e t h e o r e t i c a l l y t h e e f f e c t s o f t h e t a x i m p o s i t i o n , i t i s assumed t h a t government e x p e n d i t u r e s a r e f i x e d in amount i ndependen t o f t h e b u s i n e s s income t a x r a t e s . In s p e c i f i c t e rms we assume a l l demand and s u p p l y c u r v e s i n t h e economy f i x e d , e x c e p t in so f a r as d e r i v e d demands and s u p p l y p r i c e s o f i n p u t s a r e a l t e r e d by t h e e f f e c t s o f s p e c i f i e d changes i n b u s i n e s s income t a x r a t e s a t o t h e r l e v e l s o f p r o d -u c t i o n and d i s t r i b u t i o n . ( i i i ) t h e b u s i n e s s income t a x i s assumed t o be g e n e r a l and a p p l i c a b l e t o r e t u r n s y i e l d e d f rom a l l fo rms o f a s s e t s . G i v e n t h e s e a s s u m p t i o n s , we t u r n t o an e x a m i n a t i o n o f t h e e f f e c t s o f t h e t a x on t h e r e t u r n s s t r eams o f i n d i v i d u a l f i r m s both w i th -r e g a r d t o e x i s t i n g and f u t u r e i n v e s t m e n t p r o j e c t s . The e x a m i n a t i o n - 6 -i s u s e f u l both f o r a n a l y s i n g t h e long and s h o r t - r u n e f f e c t s o f t h e t a x . G r o s s r e t u r n s i n any p e r i o d b e f o r e d e p r e c i a t i o n and t a x payments may be e x p r e s s e d as f o l l o w s f o r t h e i t h f i r m : -St - Pt*t -K - M s t - T w L t where ^ J t ~ g r o s s r e t u r n s i n t h p e r i o d o f t h e i t h f i r m j>£ = p r i c e pe r u n i t o f o u t p u t " " " " = o u t p u t s o l d (assumed equa l t o p r o d u c t i on ) o f t h e i t h f i r m = wage b i l l o f t h e i t h f i rm M^ . = m a t e r i a l s b i l l o f t h e i t h f i r m = i n d i r e c t b u s i n e s s t a x payments o f t h e i t h f i r m Under t h e income t a x p r o v i s i o n s i n o p e r a t i o n , i n t e r e s t on bond c a p i t a l , and r e n t a l payments a r e l e g i t i m a t e d e d u c t i o n s ; t h e s e e l e m e n t s o f d i s c r i m i n a t i o n a g a i n s t some fo rms o f c a p i t a l s o u r c e s w i l l e n c o u r a g e , c e t e r i s par ibus s u b s t i t u t i o n - t o w a r d s i n v e s t m e n t f i n a n c i n g by deb t c a p i t a l . Fo r t h e pu rpo se s h e r e , however , i t i s assumed t h a t no d i s c r i m i n a t i o n e x i s t s , hence a s s u m p t i o n ( i i i ) a bove . The d e f i n i t i o n t h e r e f o r e s t a n d s as s t a t e d . However, t h e r e t u r n s e v a l u a t e d i n an i n v e s t m e n t programme o r p r o j e c t w h i c h e v e r e v a l u a t i o n c r i t e r i o n used by t h e f i r m , a r e no t h e l d w i t h c e r t a i n t y ; t h e v a r i a b l e s in t h e f u t u r e income s t r e a m have outcomes t h a t c a n n o t be p r e d i c t e d w i t h c o m p l e t e c e r t a i n t y . The e n t r e p r e n e u r o r management g roup may be v i ewed as making d e c i s i o n s i n t h e f a c e o f u n c e r t a i n t y on t h e b a s i s o f p r o b a b i l i s t i c e x p e c -t a t i o n s abou t f u t u r e ou t comes . The p r o b a b i l i t y d e n s i t y f u n c t i o n s - 7 -o f t h e r e t u r n s w.i I I h a v e r c e r t a i n p r o p e r t i e s wh i ch w i l l be v a l u e d by t h e d e c i s i o n - m a k e r , who may be v i ewed as b a l a n c i n g t h e v a r i o u s moments o f t h e p r o b a b i l i t y f u n c t i o n on t h e b a s i s o f h i s u t i l i t y f u n c t i o n . Fo r e xamp le , f o r a g i v e n mean v a l u e , i n c r e a s i n g v a r i a n c e w i l l y i e l d d e c r e a s i n g e x p e c t e d u t i l i t y t o r i s k a v e r s e f i r m s ; however skewness may have a c o m p e n s a t i n g i n f l u e n c e i f p o s i t i v e , i . e . t h e p r o b a b i l i t y o f low e a r n i n g s i s s m a l l . I t i s no t t h e pu rpose h e r e ' t o i n -c o r p o r a t e t h e s e v i t a l e l e m e n t s cau sed by u n c e r t a i n t y on t h e i n v e s t m e n t p r o c e s s r i g o u r o u s l y i n t o t h e a n a l y s i s , bu t o n l y t o s t r e s s t h e i r i m p o r t a n c e ; one o f t h e ways t h a t b u s i n e s s income t a x a t i o n may e f f e c t t h e i n v e s t m e n t p r o c e s s i s i t s e f f e c t on t h e c e r t a i n t y w i t h wh i ch f u t u r e v a l u e s o f . v a r i a b l e s i n t h e g r o s s r e t u r n s s t r e a m a r e h e l d . There a r e s e v e r a l d e c i s i o n c r i t e r i a used i n i n v e s t m e n t e v a l u -a t i o n , namely t h e p r e s e n t v a l u e p u l e , t h e p a y - o f f r u l e , t h e g r o s s r e t u r n s r u l e and n e t r e t u r n s r u l e , t h e a c c o u n t i n g r a t e o f p r o f i t r u l e , t h e i n t e r n a l r a t e o f r e t u r n r u l e , e t c . C o n s i d e r -2 a t i o n t o a l l t h e s e r u l e s can no t be g i v e n ; we r e s t r i c t o u r a t t e n t i o n h e r e t o t h e l a s t m e n t i o n e d , t h e i n t e r n a l r a t e o f r e t u r n r u l e , wh i ch has c e r t a i n ad van t a ge s f o r t h e pu rpo se s o f d i s c u s s i o n . In a t a x l e s s w o r l d , f i r m s a c c o r d i n g t o t h i s r u l e choose c a p i t a l i s a maximum, where 0 i s t h e i n t e r n a l r a t e o f r e t u r n . When t h e 2 C o n s i d e r a t i o n o f t h e c a p i t a l b u d g e t t i n g d e c i s i o n under v a r i o u s r u l e s and t h e t a x can be found i n H a r c o u r t , C M . " I n v e s t m e n t - D e c i s i o n C r i t e r i a , I nves tment I n c e n t i v e s , and t h e C h o i c e o f T e c h n i q u e " . Economic J o u r n a l . V o l . 78 , No. 309, March 1968. expenditures Kj such that in the expression - 8 -t a x i s i n t r o d u c e d i t i s a l s o n e c e s s a r y t o c o n s i d e r t h e s t a t u t o r y p r o v i s i o n s f o r d e p r e c i a t i o n , wh i ch d e t e r m i n e t h e e f f e c t i v e r a t e o f t a x , t h e e x t e n t o f t h e t a x b u r d e n , and b i a s i n t h e t a x s y s t e m . I f , f o r e xamp le , a l l o w a b l e d e p r e c i a t i o n i s i n s t a n t a n e o u s a t t i m e o f t h e a s s e t pu r cha se and b e f o r e income y i e l d , and immediate f u l l l o s s o f f s e t p r o v i s i o n s a r e i n f o r c e , t h e n t h e l o s s i s r e f u n d e d by t h e t a x a u t h o r i t i e s wh i ch t h e n can be r e i n v e s t e d , r e g i s t e r e d as a l o s s , r e f u n d e d , e t c . If we assumed c o n s t a n t r e t u r n s t o i n v e s t m e n t and a l l f u r t h e r income were s u b j e c t t o t h e r a t e o f t a x , t h e i n t e r n a l r a t e o f r e t u r n on c a p i t a l i n v e s t e d w i l l r ema in a t t h e l e v e l a t t a i n e d i n t h e t a x l e s s w o r l d , and t h e s i t u a t i o n i s e q u i v a l e n t t o a z e r o p r o f i t s t a x ? Now t h e c a s e where i n s t a n t a n e o u s d e -p r e c i a t i o n i s no t p e r m i t t e d w i l l be c o n s i d e r e d . Under c u r r e n t d e p r e c i a t i o n p r o v i s i o n s , t h r e e main methods can be u s e d ; t h e s e a r e t h e s t r a i g h t l i n e b a s i s , and t h e two a c c e l e r a t e d schemes, t h e sum o f t h e y e a r ' s d i g i t s , and t h e d o u b l e d e c l i n i n g b a l a n c e method . The p r e s e n t v a l u e o f d e d u c t i o n s under t h e l a t t e r schemes a r e h i g h e r t h a n t h e s t r a i g h t l i n e scheme; i n f a c t i t has been shown e l s e w h e r e t h a t f o r many p I a u s i b I e . v a I u e s o f mach ine l i f e and i n t e r e s t r a t e s , t h a t t h e sum o f t h e y e a r ' s d i g i t s method predomi n a t e s ..4 The t i m i n g o f i n t r o d u c t i o n and e x t e n t o f a p p l i c a t i o n o f changes i n t h e p r o v i s i o n s can be 3 Musg rave , R.A. P u b l i c F i n a n c e . M c G r a w - H i l l Book Company, New Y o r k 1959. pp. 343 4 See , f o r e xamp le , H a l l , R.E. and J o r g e n s o n , D.W. " Tax P o l i c y and I nves tment B e h a v i o u r " Ame r i c an Economic Rev iew, V o l . 57, June 1967, p. 394. - 9 -c a l c u l a t e d t o change t h e e f f e c t i v e t a x r a t e by s i g n i f i c a n t amounts w h i l e t h e s t a t u t o r y r a t e s a r e c o n s t a n t . Wi'th s e t d e p r e c i a t i o n p r o v i s i o n s , t h e i n t e r n a l r a t e o f r e t u r n r u l e i s now s t a t e d a s : - choose c a p i t a l e x p e n d i t u r e s Kjsuch t h a t ^ i n t h e e x p r e s s i o n : -y <VtQ -c)+ci>'y - KJ * o i s a maximum where ^ i s t h e i n t e r n a l r a t e o f r e t u r n , and c i s t h e t a x r a t e . Two c a s e s p r e s e n t t h e m s e l v e s f o r c o n s i d e r -a t i o n ; f i r s t l y , t h e e f f e c t o f t h e t a x on e x i s t i n g p r o j e c t s , c a p i t a l e x p e n d i t u r e s a l r e a d y h a v i n g been made; s e c o n d l y , t h e e f f e c t on i n v e s t m e n t p r o j e c t s under c o n s i d e r a t i o n f o r f u t u r e c a p i t a l e x p e n d i t u r e s . (A) E x i s t i n g p r o j e c t s and t h e Tax Fo r e x i s t i n g p r o j e c t s , t h e t a x has t h e e f f e c t o f r e d u c i n g t h e a t t a i n a b l e maxima under v a r i o u s d e c i s i o n r u l e s ; i n o u r i l l u s -t r a t i v e r u l e i s r e d u c e d . The ne t r a t e o f r e t u r n on c a p i t a l i s r e d u c e d , bu t w i l l n o t e f f e c t t h e p r i c e and o u t p u t s i n c e was a l r e a d y b e i n g m a x i m i s e d ; t h i s w i l l be so f o r a l l f i r m s w h a t e v e r i n d u s t r i a l s t r u c t u r e t h e y a r e o p e r a t i n g i n u n l e s s t h e t a x changes t h e c o n s t r a i n t s w i t h i n wh i ch m a x i m i s a t i o n t a k e s p l a c e . In pu re c o m p e t i t i o n , f i r m s have no d i s c r e t i o n a r y power o v e r p r i c e , bu t a r e p r i c e t a k e r s , and a r e assumed t o pu r sue s h o r t -run p r o f i t m a x i m i s a t i o n as a p r e r e q u i s i t e t o l o n g - r u n p r o f i t o p t i m i s a t i o n . In i m p e r f e c t l y c o m p e t i t i v e i n d u s t r i e s , f i r m s a r e 10 -assumed t o max im i se p r o f i t s w i t h i n c o n s t r a i n t s ; t h e r e f o r e , i f t h e t a x makes a c o n s t r a i n t i n o p e r a t i v e , ^ t m a y be a v a r i a b l e t h a t can be e f f e c t e d by t h e f i r m , e i t h e r as a s o l e member o f t h e i n d u s t r y o r as p a r t o f a c o l l u s i v e o r m u t u a l l y i n t e r d e p e n d e n t g roup o f f i r m s . In t e rms o f t h e i n t e r n a l r e t u r n r u l e , ^ wh ich was d e p r e s s e d c e t e r i s pa r i bu s by t h e t a x may be pushed t o w a r d s t h e o r i g i n a l ^ v a l u e b e f o r e t h e t a x . If t h i s c a n n o t be done, t h e r a t e o f r e t u r n s w i l l f a l l ; t h e o n l y remedy ing a c t i o n t h a t can be t a k e n i f t h e t a x r a t e change i s e x p e c t e d t o be t e m p o r a r y i s t o max im i s e c u r r e n t t a x d e d u c t i o n s . A t t h i s s t a g e i n t h e d i s c u s s i o n n o t h i n g more can be s a i d w i t h o u t c o n s i d e r i n g i n f u l l e r d e t a i I . t h e v a r i o u s model s o f i n d u s t r i a l s t r u c t u r e ; t h i s i s u n d e r t a k e n i n t h e two f o l l o w i n g c h a p t e r s . (B) I nves tment E x p e n d i t u r e s under c o n s i d e r a t i o n f o r t h e f u t u r e W i t h t h e knowledge o f t h e t a x change and e x p e c t a t i o n s as t o t h e l e n g t h o f t i m e f o r wh i ch t h e r a t e ( s ) i s e x p e c t e d t o a p p l y , f i r m s can i n c o r p o r a t e t h e r a t e s and d e p r e c i a t i o n p r o v i s i o n s ex a n t e i n t o t h e e v a l u a t i o n c r i t e r i a . Here agaim t h e a t t a i n a b l e maxima w i l l be reduced f o r t h e v a r i o u s c r i t e r i a ; t h e r e f o r e i s a g a i n r e d u c e d . The e x p e c t e d r a t e o f r e t u r n on c a p i t a l f a l l s f r om f u t u r e i n v e s t m e n t e x p e n d i t u r e s , u n l e s s s i m i l a r l y t o t h e above , ^ can be pushed up a g a i n because c o n s t r a i n t s on p r o f i t ' m a x i m i s a t i on a r e changed by t h e t a x ; even so s i n c e t h i s n e c e s s i t a t e s an i n -c r e a s e i n p r i c e and a r e d u c t i o n i n o u t p u t , t h e r e f o r e t h e p r o s p e c t i v e need f o r a d d i t i o n a l c a p a c i t y i s r educed w i t h c o n s e q u e n t e f f e c t s on i n v e s t m e n t . 5 See L i n t n e r , J . "The e f f e c t s o f a S h i f t e d C o r p o r a t e Income Tax on Real I n v e s t m e n t " , N a t i o n a l Tax J o u r n a l , V o l . 8, S e p t . 1955. p .235 . - 11 -In l o n g - r u n e q u i l i b r i u m , the r a t e o f r e t u r n on c a p i t a l i n each f i r m has components which v a r y among i n d u s t r i e s ; above i n t e r e s t r a t e c o s t , r e t u r n s a r e i n c l u d e d f o r u n c e r t a i n t y b e a r i n g , e n t r e -p r e n e u r i a l a b i l i t y , and o t h e r economic r e n t s i n o r d e r t o i n d u c e i n v e s t m e n t o f c a p i t a l i n t o t h e i n d u s t r y . These elements combined w i t h the i n t e r e s t r a t e c o s t d e t e r m i n e t h e c o n c e p t o f a 'normal' r a t e f o r an i n d u s t r y ; a d d i t i o n a l r e t u r n s due t o monopoly power may be i n c l u d e d i n some i n d u s t r i e s . Thus f o r p u r e l y c o m p e t i t i v e i n d u s t r i e s , t he r a t e o f r e t u r n ^ => + (T + 8J , where T i s the i n t e r e s t r a t e c o s t a p p r o x i m a t e d to the y i e l d on government bonds, (T i s the reward f o r b e a r i n g u n c e r t a i n t y , and 6 a r e r e n t s . S i m i l a r l y , f o r monopoly power e x e r c i se ^  =(**+ <T+B -t-TfM) where T l M a r e t h e s e monopoly r e t u r n s . With the t a x , the r a t e o f r e t u r n i s reduced from ^ t o , where C. i s the e f f e c t i v e t a x r a t e ; meanwhile the y i e l d on government bonds f a l l s from T t o ( - i — c ) r , r Under the a s s u m p t i o n t h a t government pursues a monetary p o l i c y k e e p i n g the bond r a t e c o n s t a n t , the e f f e c t on r e a l i n v e s t m e n t and the r a t e o f r e t u r n can be i s o l a t e d . In the c o m p e t i t i v e c a s e , the d e p r e s s e d r a t e o f r e t u r n w i t h ! the t a x wi11 not c o v e r t h e new 'normal' p r o f i t r a t e , i .e.^ =|(i-c,£r+e) -t-dj ; r e a l r e s o u r c e s w i l l t h e r e f o r e l e a v e the i n d u s t r y . In the monopoly c a s e , r e a l r e s o u r -c e s w i l l l e a v e t h i s i n d u s t r y o n l y on the f o l l o w i n g c o n d i t i o n : -t h a t the t a x r a t e i s such t h a t ^ r + tf+e+TTM)(i-C.) ^ ^i - c j(r-i-e) + ( f j I f t h i s c o n d i t i o n i s f u l f i l l e d , the t a x r a t e f u l l y e l i m i n a t e s monopoly 12 -p r o f i t s and imp inges on normal p r o f i t s . If t h e c o n d i t i o n i s no t f u l f i l l e d , t h e t a x d e p r e s s e s t h e r a t e o f r e t u r n w i t h o u t c a u s i n g r e s o u r c e s t o move o u t o f t h e i n d u s t r y . The r e - e s t a b -l i s h e d l e v e l o f ' n o r m a l ' p r o f i t s w i l l n a tu r a I I y - r e f I e c t t h e a d j u s t m e n t s o f t h e s u p p l y o f f u n d s , t h e bond, r a t e , and t h o s e s e c t o r s i n t h e economy wh i ch a r e i n f a c t no t s u b j e c t t o t h e b u s i n e s s income t a x . We now t u r n t o a m o r e - d e t a i I e d - e x a m i n -a t i o n o f model s o f i n d u s t r i a l b e h a v i o u r . CHAPTER I I I INDUSTRIAL STRUCTURE AND TAX EFFECTS - 13 " We he re g i v e b r i e f c o n s i d e r a t i o n a g a i n t o t h e p o l a r model s o f pu re c o m p e t i t i o n and pu re monopo ly ; a c o n s i d e r a b l e p a r t o f t h e a n a l y s i s f o r t h e s e model s was c a r r i e d o u t i n t h e p r e v i o u s c h a p t e r . The c o n s i d e r a t i o n i s b r i e f a l s o s i n c e , u n l i k e o l i g o p o l y mode l s , t h e y draw upon a l a r g e measure o f a c c e p t a n c e f rom e c o n -o m i s t s , and a r e i n c l u d e d in most e c o n o m i s t s ' box o f a n a l y t i c a l t o o l s ; i n a d d i t i o n i t i s a p p a r e n t i n t h e l i t e r a t u r e t h a t i t i s t h e c o n s i d e r a t i o n o f o l i g o p o l y and i t s e x t e n t w i t h i n any g i v e n economy t h a t has been one o f t h e c au se s o f t h e g r a v e s t t h e o r e t i c a l d i f f i c u l t i e s and t h e a t t e n d a n t p rob lems o f s p e c i f y i n g an e m p i r i c a l f r amework . ( I ) P u r e C o m p e t i t i o n F i rms a r e assumed t o max im i se s h o r t - r u n p r o f i t s , and t h e p r o f i t m a x i m i s i n g o u t p u t i s a t t a i n e d where p r i c e e q u a l s m a r g i n a l c o s t . We he re r e c a l l t h e i d e n t i t y f o r b u s i n e s s income o f t h e i t h f i r m i n the^ fc th p e r i o d , b e f o r e t a x payments and d e p r e c i a t i o n , and a b -s t r a c t i n g f rom i n d i r e c t b u s i n e s s t a x e s : -If we assume c o n s t a n t m a r g i n a l and a v e r a g e v a r i a b l e c o s t s up t o some c a p a c i t y l i m i t t h e n t h e p r o f i t m a x i m i s i n g c o n d i t i o n can be e x p r e s s e d i n t h e fo rm o f p r i c e s b e i n g marked-up by some 1 f a c t o r C< o v e r u n i t v a r i a b l e c o s t s : -P r i c e w i l l be t h e same between f i r m s but CK may v a r y a t any g i v e n 2 t i m e due t o i n t e r - f i r m d i f f e r e n c e s i n u n i t v a r i a b l e c o s t s . C< t h e mark-up f a c t o r i s l e f t i n t h e s h o r t - r u n t o c o v e r u n i t f i x e d c o s t s : i t , in f a c t , may o r may no t do s o , b u t as long asQC2>0the f i r m w i l l c o n t i n u e o p e r a t i n g i n t h e s h o r t - r u n . The' f i r m ' s p o s i t i o n i s i l l u s t r a t e d b e l o w : -In t h e s h o r t - r u n , e q u i l i b r i u m i s a t t a i n e d a t o u t p u t Xt where t h e i n d u s t r y p r i c e i s p. The i m p o s i t i o n o f t h e t a x does no t a f f e c t s h o r t - r u n m a r g i n a l c o s t l e a v i n g t h e f i r m ' s o u t p u t unchanged and t h e i n d u s t r y p r i c e rema in s a t p. i s unchanged so t h a t b u s i n e s s income r e c e i v e d by t h e f i r m i s unchanged, i . e . t h e g r o s s r a t e o f r e t u r n on c a p i t a l i s u n -changed ; w i t h t h e t a x on b u s i n e s s income t h e ne t r a t e o f r e t u r n on c a p i t a l f a l l s . In l o n g - r u n e q u i l i b r i u m ' n o r m a l ' p r o f i t s w i l l 1 The t h e o r y i s t h e r e f o r e q u i t e c o m p a t i b l e w i t h mark-up b e h a v i o u r p r o f e s s e d by b u s i n e s s men. 2 New p l a n t s o r mach ine s r e f l e c t c u r r e n t knowledge , t e c h n o l o g y , and f a c t o r p r i c e s ; however , t h e c o s t s t r u c t u r e o f any i n d u s t r y i n any g i v e n t i m e p e r i o d depends upon t h e p a s t e v o l u t i o n o f i t s g r o s s i n v e s t m e n t , i t s t e c h n o l o g y , and f a c t o r p r i c e s . be ea rned by a l l f i r m s i n t h e i n d u s t r y ; economic l o s s e s and pu re p r o f i t s wh i ch may e x i s t i n t h e s h o r t - r u n w i l l be e l i m i n a t e d . The t a x wh i ch i s imposed on b u s i n e s s income imposes on ' n o r m a l ' r a t e s o f p r o f i t i n c o m p e t i t i v e i n d u s t r i e s , l e a d i n g t o e x i t o f c a p i t a l r e s o u r c e s ; as e x i t c o n t i n u e s t h e s u p p l y c u r v e o f t h e i n d u s t r y s h i f t s I e f t w a r d s r a i s i n g p r i c e , and w i l l c o n t i n u e u n t i l ' n o r m a l ' r a t e s o f p r o f i t a r e r e - e s t a b l i s h e d i n t h e i n d u s t r y . (i i) Pu re Monopoly In t h i s c a s e a l s o p r o f i t m a x i m i s a t i o n r ema in s t h e assumed g o a l , and t h e m o n o p o l i s t e q u a t e s m a r g i n a l r evenue t o m a r g i n a l c o s t t o d e t e r m i n e p r i c e and o u t p u t o f t h e i n d u s t r y ; t h i s , t o o , can be e x p r e s s e d as p r i c e s b e i n g marked-up by a f a c t o r K o v e r u n i t v a r i a b l e c o s t s . In t h e s h o r t - r u n t h e r a t e o f r e t u r n i s d e p r e s s e d , p r i c e and o u t p u t rema i n i ng;;unchanged. In t h e l o n g - r u n , as long as t h e t a x does no t imp inge on t h e e l e m e n t s i n t h e p r o f i t r a t e o t h e r t h a n monopoly r e t u r n s , t h e r a t e o f r e t u r n i s d e p r e s s e d i n t h e l o n g - r u n w i t h o u t o u t p u t o r p r i c e change . In t h i s pu re c a s e , t h e monopoly power i s g i v e n by l o n g - r u n c o n t r o l o v e r i n d u s t r y s u p p l y t h r o u g h t h e a b i l i t y t o ba r e n t r y ; t h e key f e a t u r e o f t h i s model t h a t d i f f e r e n t i a t e s i t f r om t h e o l i g o p o l y mode l s t o be c o n -s i d e r e d i s t h a t t h e m o n o p o l i s t ' s a c t i o n s a r e no t c o n s t r a i n e d by t h e r e c o g n . i t i o n o f i n t e r d e p e n d e n c e between p r o d u c e r s t o any s u b -s t a n t i a l deg ree a f f e c t i n g b e h a v i o u r . To some e x t e n t a l l p r o d u c e r s a r e c o m p e t i n g f o r t h e consumer d o l l a r , and t h e d i s t i n c t i o n no ted 16 -l a c k s p r e c i s i o n , bu t once i n t e r d e p e n d e n c e becomes an i m p o r t a n t f e a t u r e e f f e c t i n g b e h a v i o u r t h e c o n s t r a i n t s on t h e e x e r c i s e o f monopoly power must be p r e c i s e l y s t a t e d , and i s b e s t done in t h e c o n s i d e r a t i o n o f o l i g o p o l y m o d e l s . In c o n t r a s t t o t h e c l a s s i c a l - t h e o r i e s o f pu re c o m p e t i t i o n and pu re monopo ly , t h e o r i e s o f o l i g o p o l i s t i c b e h a v i o u r f i n d no such g e n e r a l a c c e p t a n c e by e c o n o m i s t s . The pu re monopoly model i s o f l i m i t e d a p p l i c a b i l i t y s i n c e such s i t u a t i o n s a r e found but r a r e l y , p r i m a r i l y because s i n g l e f i r m s r a r e l y have t h e a b i l i t y t o p r e v e n t e n t r y and e x t r a c t monopoly r e t u r n s o v e r a l ong p e r i o d o f t i m e w i t h o u t a t t r a c t i n g c a p i t a l r e s o u r c e s i n t o • t h e i n d u s t r y ; more g e n e r a l l y p r o d u c e r i n t e r d e p e n d e n c e i s t h e v i t a l f a c t o r i n f l u e n c i n g b e h a v i o u r . Even i f t h e r e i s a s o l e p r o d u c e r o f a p r o d u c t f a c i n g a n e g a t i v e l y s l o p e d demand c u r v e f o r t h i s p r o d u c t and t h e r e e x i s t s u b s t i t u t e s , t h e n t h e p r o d u c e r w i l l have t o t a k e i n t o a c c o u n t t h e e f f e c t o f h i s a c t i o n s on t h e b e h a v i o u r o f p r o d u c e r s m a r k e t i n g s u b s t i t u t e s . In f o rma l t e r m s , among t h e c e t e r i s p a r i b u s d e t e r m i n i n g t h e p o s i t i o n o f t h e demand c u r v e w i l l be t h e p r i c e s o f t h e s u b s t i t u t e s , and i f t h e m o n o p o l i s t changes h i s p r i c e i t i s u n l i k e l y t h a t t h e c e t e r i s p a r i b u s w i l l h o l d . An example o f t h i s i s t h e s o f t - d r i n k i n d u s t r y where s e v e r a l o f t h e main p r o d u c e r s have p a t e n t e d d r i n k s w i t h d i s t i n c t i v e p r o p e r t i e s ; t h e monopoly w i l l t h e r e f o r e be l i m i t e d , and c o n s t r a i n e d by t h e n a t u r e o f i n t e r d e p e n d e n c e o f ma jo r d e c i s i o n v a r i a b l e s . As has 17 been s t a t e d i t i s unusua l f o r pu re monopoly t o c o n t i n u e o v e r t i m e ; even i f t h e r e a r e no c l o s e s u b s t i t u t e s a t any g i v e n t i m e , t h e p o s s i b i l i t y o f such deve l opment and e n t r y may w e l l i n f l u e n c e t h e b e h a v i o u r o f t h e m o n o p o l i s t . T h e r e f o r e , i n t e r -dependence o f p r o d u c e r s , i . e . an o l i g o p o l y s i t u a t i o n , i s l i k e l y t o be more common t h a n pu re monopo ly , and i n most modern c a p i t -a l i s t economies o l i g o p o l y i s a w i d e s p r e a d fo rm o f ma r ke t s t r u c t u r e , and t h u s n e c e s s i t a t e s c o n s i d e r a t i o n i n t h e a n a l y s i s o f t a x e f f e c t s . However, t h e r e i s no s i m p l e s e t o f r u l e s f o r t h e e q u i l i b r i u m e i t h e r o f t h e f i r m o r t h e group o f f i r m s t h a t c o n s t i t u t e t h e i n d u s t r y ; n e i t h e r i s t h e r e a s e t of s i m p l e p r e d i c t i o n s a s t o how f i r m s w i l l r e a c t , e i t h e r i n d i v i d u a l l y ' o r c o l l e c t i v e l y , t o v a r i o u s changes i n t a x e s , c o s t s , and demand. A l l depends on t h e p o l i c y t h a t t h e f i r m p u r s u e s , on t h e p o l i c i e s i t s c o m p e t i t o r s p u r s u e , on how each r e a c t s t o t h e o t h e r ' s change s , and on how each f i r m t h i n k s t h e o t h e r w i l l r e a c t . S i n c e f i r m s can be assumed t o a c t , r e a c t , and i n -t e r a c t i n many ways, t h e c h o i c e must be r e s t r i c t e d t o a s e l e c t e d few m o d e l s . One method o f a t t a c k i n g t h e o l i g o p o l y p r ob l em i s t o d e v e l o p a s e r i e s o f t h e o r e t i c a l model s a s suming t h a t i n d i v i d u a l f i r m s r e a c t i n p a r t -i c u l a r ways, and t h e n t o see what f o l l o w s f r om t h e a s s u m p t i o n s . T h i s app roach i s u n s a t i s f a c t o r y on two main g r o u n d s . F i r s t l y , t h e number o f a s s u m p t i o n s t h a t c o u l d be made abou t b e h a v i o u r i s v e r y l a r g e , and t h e number o f p o s s i b l e c a s e s t h a t c o u l d be examined 18 -i s l a r g e and u n w i e l d y . The second o b j e c t i o n i s more fundamenta l and i t i s t h a t a s a t i s f a c t o r y t h e o r y ( o r more l i k e l y g roup o f t h e o r i e s ) o f o l i g o p o l y c a n n o t b e g i n w i t h a s s u m p t i o n s c o n c e r n i n g t h e way i n wh ich i n t e r d e p e n d e n c e w i t h i t s r i v a l s i s c o n s i d e r e d by t h e f i r m ; i f we r e t a i n t h e p r o f i t m a x i m i s i n g p o s t u l a t e o f t r a d i t i o n a l p r i c e t h e o r y , t hen b e h a v i o u r i s no l o n g e r s ometh i ng t o be assumed, but r a t h e r s ometh i ng t o be deduced . The app roach adop ted h e r e , t h e r e f o r e , i s t o r e t a i n t h i s p o s t u l a t e o f p r o f i t m a x i m i s i n g and t o s p e c i f y t h e n a t u r e o f t h e c o n s t r a i n t s o p e r a t i n g i n v a r i o u s o l i g o p o l i s t i c e n v i r o n m e n t s , t h u s d e d u c i n g b e h a v i o u r and how t h i s b e h a v i o u r may be a f f e c t e d by t h e i m p o s i t i o n o f t h e t a x . A l l f i r m s i n an o l i g o p o l y a r e by d e f i n i t i o n m u t u a l l y dependen t ; how-e v e r , t h e a b i l i t y t o s e c u r e f o r t h e o l i g o p o l y , e l e m e n t s o f monopoly r e t u r n s on t h e b a s i s o f r e c o g n i t i o n o f mutual dependence w i l l depend, as i n t h e pu re monopoly c a s e , o h t h e a b i l i t y t o p r e v e n t o r d i s c o u r a g e new f i r m s e n t e r i n g t h e i n d u s t r y . Thus i f e n t r y i s r e l a t i v e l y easy i n t o an i n d u s t r y , t h e n r e c o g n i t i o n o f mutual dependence t o c o l l u d e t o max im i se i n d u s t r y p r o f i t s by a c t i n g as a monopoly w i l l n o t s e c u r e f o r t h e o l i g o p o l i s t s h i g h r a t e s o f r e t u r n i n t h e l o n g - r u n . However, o l i g o p o l i s t s , whose j o i n t - m o n o p o l y p o s i t i o n i s p r o t e c t e d by e n t r y b a r r i e r s , w i l l be a b l e t o r e c o g n i s e t h e i r dependence and a l s o adop t b e h a v i o u r and measures t h a t w i l l p r o t e c t t h e i r monopoly p o s i t i o n . 19 -We now t u r n t o a more d e t a i l e d e x a m i n a t i o n o f t h e s e m o d e l s , t h e o l i g o p o l i s t s ' o p t i m a l b e h a v i o u r , and an e x a m i n a t i o n o f whe the r t h e t a x w i l l change such b e h a v i o u r . The t a x o n o m i c app roach i s c o n t i n u e d h e r e . ( i i i ) O l i g o p o l y w i t h B a r r i e r s t o E n t r y and Homogeneous P r o d u c t The i n d u s t r i e s c o n s i d e r e d i n t h i s ' c I a s s i f i c a t i on c o n s i s t o f t h o s e i n wh i ch t h e minimum economic p l a n t s i z e i s a b s o l u t e l y l a r g e , and r e q u i r e s l a r g e amounts o f c a p i t a l . Each marke t f o r the-p r o d u c t i s s e r v e d by a few f i r m s , and t h e p r o d u c t i s homogeneous; t h i s l a t t e r f e a t u r e has i m p o r t a n t e f f e c t s on b e h a v i o u r . W i th t h e homogeneous p r o d u c t , buye r s c a n n o t be i nduced t o p r e f e r one m a k e r ' s p r o d u c t o v e r a n o t h e r ' s o f s i m i l a r q u a l i t y i f a p o s i t i v e p r i c e d i f f e r e n t i a l e x i s t s ; we may go f u r t h e r and say t h a t a t t e m p t s t o d i f f e r e n t i a t e t h e p r o d u c t would be i r r e l e v a n t i n t h e marke t c o n c e r n e d s i n c e buye r s ape so w e l l i n f o rmed as t o t h e a v a i l a b l e p r i c e s and q u a n t i t i e s , t h a t monetary e x p e n d i t u r e s t o p r o v i d e i n f o r m a t i o n t o i nduce l a r g e r s a l e s t o any p a r t i c u l a r company a r e p o i n t l e s s . O l i g o p o l i s t s i n such p o s i t i o n s a r e no t g e n e r a l l y s e i I i n g t o t h e g e n e r a l p u b l i c . T h i s may be c o n t r a s t e d w i t h some i n d u s t r i e s where p r o d u c t s a r e o f t e n p h y s i c a l l y i d e n t i c a l and i n wh i ch p r i c e s o f t h e v a r i o u s compan ie s p r o d u c t s a r e common y e t brand a l l e g i a n c e s can be formed and changed by i n f o r m a t i o n a l e x p e n d i t u r e s , and t h u s i n c r e a s e s a l e s t o p a r t i c u l a r c o m p a n i e s . An example o f t h i s i s g a s o l i n e m a r k e t i n g by t h e ma jo r o i l c ompan i e s . - 20 -Now t h e combined p r o f i t s o f t h e f i r m s i n an i n d u s t r y a r e max im i sed when t h e y a c t t o g e t h e r as a m o n o p o l i s t ; - t h e o p t i m a l p o l i c y f o r t h e f i r m s i n an o l i g o p o l y i s t o r e c o g -n i s e t h e i r mutua l dependence and a c h i e v e j o i n t - p r o f i t m a x i m i s a t i o n . D e p a r t u r e s f rom t r y i n g t o a t t a i n t h i s maximum in an o l i g o p o l y p r o t e c t e d by b a r r i e r s t o e n t r y have a low p r o b a b i l i t y , s i n c e a t t e m p t s a t p r i c e c h i s e l i n g by any one f i r m a r e u n l i k e l y t o go u n n o t i c e d by t h e o t h e r s . I f n o t i c e d t h e y w i l l be matched by p r i c e c u t s f r om t h e r i v a l s ; t h e s i t u a t i o n becomes u n s t a b l e and i f t h e p r i c e c u t i s no t w i t h d r a w n p r i c e wars b reak o u t wh i ch a r e d i s a s t r o u s f o r i n -d i v i d u a l f i r m s and i n d u s t r y p r o f i t s . In an o p t i m a l p o l i c y t h e f i r m s r e a l i s e t h e i r mutual dependence and a c t on t h i s r e c o g n i t i o n ; i n such i n d u s t r i e s p r i c e c o m p e t i t i o n , i n t h e sense o f d e l i b e r a t e l y l o w e r i n g p r i c e t o a t t r a c t a d d i t i o n a l s a l e s , w i l l be suspended and p r i c e l e a d e r s h i p w i l l p r e v a i l . ^ Fo r t h e s e i n d u s t r i e s , t h e c a p i t a l r e q u i r e m e n t s n e c e s s i t a t e d by t h e a b s o l u t e l y l a r g e s i z e o f minimum e f f i c i e n t s c a l e o f p l a n t p r e s e n t f o r m i d a b l e b a r r i e r s t o t h e p o t e n t i a l e n t r a n t a t t r a c t e d by t h e monopoly r e t u r n s b e i n g made; t h e p o s i t i o n o f o l i g o p o l i s t s c o n f e r s on them t h e e x e r c i s e o f c o n s i d e r a b l e I The c l a s s i c c a s e o f t h i s i s t h e A m e r i c a n S t e e l I n d u s t r y where p r i c e l e a d e r s h i p i s g e n e r a l l y p r o v i d e d by t h e U.S. S t e e l Company. 9 monopoly power. The o l i g o p o l i s t s , t h e r e f o r e , h a v i n g s u s -pended p r i c e c o m p e t i t i o n i n o r d e r t o j o i n t - p r o f i t m a x i m i s e , i n f u r t h e r p u r s u i n g t h e o p t i m a l p o l i c y must a d o p t t a c t i c s t o p r e s e r v e t h e i r ma r ke t power and p r e v e n t decay i n t h e i r s h a r e s o f monopoly p r o f i t s and o u t p u t . The dange r s have two ma jo r s o u r c e s ; namely t h o s e a r i s i n g b e -cau se of. a c t i o n s o r p o t e n t i a l a c t i o n s w i t h i n t h e group wh ich may endange r t h e m a t u r i t y o f t h e mutual dependence r e c o g n i t i o n , and t h o s e a r i s i n g e x t e r n a l l y f r om t h e group t h r o u g h movements f r om p o t e n t i a l d o m e s t i c and i n t e r n a t i o n a l e n t r a n t s . As such t h e o p t i m a l p o l i c y o f t h e o l i g o p o l i s t s i n f a c e o f t h e s e c o n -s t r a i n t s may g i v e r i s e t o d e p a r t u r e s f r om t h o s e p r i c e s wh i ch w i l l max im i se p r o f i t s o v e r a s h o r t p e r i o d o f t i m e . T h i s may be c o n -t r a s t e d w i t h t h e pu re c o m p e t i t i o n model where s h o r t - r u n p r o f i t m a x i m i s a t i o n i s a p r e r e q u i s i t e o f l o n g - r u n p r o f i t o p t i m i s a t i o n . We p r o c e e d t o s p e c i f y t h e s e c o n s t r a i n t s l e a d i n g t o such d e p a r t u r e s ; we t h e n c o n s i d e r whethe r t h e c o n s t r a i n t s a r e changed by t h e t a x . (a) The c o n s t r a i n t imposed by p o t e n t i a l d o m e s t i c e n t r y : The monopoly r e t u r n s i n t h e p r o f i t r a t e a r e a t t r a c t i v e t o p o t e n t i a l e n t r a n t s w i t h i n t h e economy, and i f e n t r y o c c u r s each f i r m ' s s h a r e o f monopoly p r o f i t s w i l l d e c l i n e , and may even g i v e r i s e t o m a t u r i t y b r e a k i n g down a l t h o u g h t h i s seems an u n l i k e l y p o s s i b i l i t y i n t h e h i g h c o n c e n t r a t i o n i n d u s t r i e s e n v i s a g e d . Op t ima l p o l i c y - 22 -w i l l be t h e r e f o r e t o seek t o d i s c o u r a g e e n t r y . I t has been, s u g ge s t ed t h a t o l i g o p o l i s t s can b l o c k e n t r y by p u r s u i n g an o v e r a l l l e s s t h a n monopoly p r i c e p o l i c y i n a l l m a r k e t s . A t t h i s p r i c e , e n t r y a t e f f i c i e n t s c a l e w i l l d e p r e s s p r i c e ( j f t h e o l i g o p o l i s t s do no t c u t o u t p u t ^ s o t h a t t h e e n t r a n t w i l l n o t a c h i e v e a c o m p e t i t i v e r a t e o f r e t u r n ; - i n t h i s way e n t r y i s d i s c o u r a g e d and t h e o l i g o p o l i s t s r e c e i v e a r a t e o f r e t u r n above t h e c o m p e t i t i v e r a t e . However, t h e p o t e n t i a l e n t r a n t w i l l a s s e s s t h e i n v e s t m e n t a t t h e p o s t e n t r y p r i c e and a f t e r t h e i n i t i a l p e r i o d o f l o s s e s , and a s t r o n g o b j e c t i o n t o t h e l i m i t p r i c e a n a l y s i s i s t h e a s s u m p t i o n t h a t t h e o l i g o p -o l i s t s do no t accommodate t h e e n t r a n t . An e n t r a n t d e t e r m i n e d enough c o u l d s t i l l e n t e r on t h e e x p e c t a t i o n t h a t t h e o l i g o p o l i s t s accommodate t h e move t o a v o i d impos ing l o s s e s on a l l , and s h a r e t h e monopoly p r o f i t s . An e x c e p t i o n t o t h i s however may o c c u r , bu t t h e c i r c u m s t a n c e s and c a s u a l i n s p e c t i o n o f t h e e m p i r i c a l d a t a s u g g e s t t h i s i s l i k e l y t o be u n u s u a l . T h i s .is where t h e e x i s t i n g f i r m s i n t h e i n d u s t r y a r e a l l a t t h e minimum e f f i c i e n t s c a l e . o f p l a n t but do no t have c a p a c i t y above t h i s ; p r o d u c t i o n a t t h i s c a p a c i t y does no t meet demand a t t h e c o m p e t i t i v e p r i c e , bu t does no t a l l o w s u f f i c i e n t o u t p u t f o r an a d d i t i o n a l p l a n t o f e f f i c i e n t s c a l e , and y i e l d s e l e m e n t s o f monopoly r e t u r n s t o t h e e x i s t i n g p r o d u c e r s . E n t r y o f a n o t h e r p l a n t a t o p t i m a l s c a l e w i l l 2 B a i n , J o e . S, B a r r i e r s t o New C o m p e t i t i o n . Cambr i dge , M a s s : H a r v a r d U n i v e r s i t y P r e s s , 1956. - 23. -d e p r e s s p r i c e ; bu t even i f accommodat ing move was made t o t r y and m a i n t a i n p r i c e s above t h e o r i g i n a l c o m p e t i t i v e l e v e l t h i s w i l l r educe each f i r m s s h a r e o f o u t p u t such t h a t none can o p e r a t e a t minimum e f f i c i e n t s c a l e . The d a t a s u g g e s t t h a t i n most i n d u s t r i e s w i t h economies o f s c a l e , p l a n t c a p a c i t y i s above t h e minimum, and t h u s under t h e o r i g i n a l h y p o t h e s i s accommodat ing moves c o u l d be made w i t h o u t i m p i n g i n g upon minimum e f f i c i e n t p l a n t c a p a c i t y . More g e n e r a l l y t h e r e f o r e i t seems u n l i k e l y t h a t o l i g o p o l i s t s can p r e v e n t e n t r y by an o v e r a l l low p r i c e p o l i c y , o r by s h o r t -run h a r a s s i n g t a c t i c s . P a sh i g i j an has s t a t e d t h e p rob l em i n t h e f o l l o w i n g w a y : - " I n p r a c t i c e , t h e r a t e o f decay o f ma rke t s h a r e w i l l depend on a number o f v a r i a b l e s , o n l y a few o f wh ich a r e under t h e f i r m s c o n t r o l . To a c o n s i d e r a b l e e x t e n t , t h i s i s an a r e a o f i g n o r a n c e . Very l i t t l e i s known abou t t h e c a u s e s o f d i f f e r e n c e s between i n d u s t r i e s in t h e r a t e a t wh i ch t h e marke t s h a r e o f t h e m o n o p o l i s t w i l l d e c l i n e r a p i d l y i f t h e monopoly p r i c e i s c h a r g e d . " ~* In t h e o l i g o p o l i e s w i t h homogeneous p r o d u c t , c i r c u m s t a n c e s may e x i s t however whereby p r i c e p o l i c y can be used t o p r e v e n t e n t r y . These c i r c u m s t a n c e s a r e p r e s e n t where e n t r y o c c u r s i n s u b - m a r k e t s o r i n s p e c i f i c c l a s s e s o f p r o d u c t s , t h e r e b y f u l f i l l i n g a n e c e s s a r y c o n d i t i o n f o r p r i c e 3 P a s h i g i a n , B. P e t e r , " L i m i t P r i c e and t h e M a r k e t Share o f t h e L e a d i n g F i r m " , J o u r n a l o f I n d u s t r i a l E conom i c s . V o l . 16, No. 3, J u l y 1968, pp. 173. - 24 -d i s c r i m i n a t i o n t o be f e a s i b l e ; he re p r i c e s can be a p p l i e d such t h a t t h e e n t r a n t i s f o r c e d o u t o f b u s i n e s s by s u b s t a n t i a l and consuming l o s s e s . T h i s w i l l d i s c o u r a g e o t h e r s f rom a t t e m p t i n g e n t r y , and t h e p o l i c y a l s o m i n i m i s e s t h e e f f e c t on t o t a l p r o f i t s . (b) The c o n s t r a i n t imposed by p o t e n t i a l e n t r a n t s f rom a b r o a d : The o l i g o p o l i s t s monopoly power i n t h e d o m e s t i c ma rke t i s g a i n e d by t h e f a c t t h a t p r i c e s a r e below f o r e i g n p r i c e s , o r i f t h e i n d u s t r y i s p r o t e c t e d , t h e f o r e i g n p r i c e p l u s t h e t a r i f f . The i n d u s t r y must o p e r a t e w i t h i n t h i s c o n s t r a i n t . S h o r t - r u n p r o f i t m a x i m i s i n g i m p l i e s t h a t t empo ra r y upward f l u c t u a t i o n s i n demand, o r s h o r t a g e s c r e a t e d b e f o r e a d d i t i o n a l c a p a c i t y can be a d d e d , w i l l be met by p r i c e changes t o e x t r a c t f u l l s h o r t - r u n monopoly r e t u r n s . T h e r e f o r e , i f r a t i o n i n g by p r i c e was implemented i n such s i t u a t i o n s t h e d o m e s t i c p r i c e c o u l d app roach t h e e x t e r n a l p r i c e l i m i t ; however o l i g o p o l i s t s have been o b s e r v e d t o use p h y s i c a l r a t i o n i n g d e v i c e s such as w a i t i n g l i s t s i n t i m e s o f s h o r t a g e s . E x t r a c t i o n o f s h o r t - r u n monopoly p r o f i t s i s n o t c o m p l e t e d s i n c e o p t i m i s a t i o n o f p r o f i t s o v e r a l o n g e r t i m e span may a d v e r s e l y be e f f e c t e d by such a c t i o n . The buye r s o f t h e i n d u s t r y ' s p r o d u c t i f t h e p r i c e goes up i n t h e s h o r t - r u n w i l l f a c e h i g h e r c o s t s and t h u s f a c e r e l a t i v e l y l owered p r o f i t - m a r g i n s ; as s u c h , t h e n , when t h e s h o r t a g e s d i s a p p e a r , t h e y w i l l be e n -cou raged t o t r y and e n s u r e such s i t u a t i o n s do no t o c c u r a g a i n by - 25 -e n c o u r a g i n g s u p p l i e s f rom ab road and r e - s p e c i f i c a t i o n o r r e -a l l o c a t i o n o f l o n g - r u n s u p p l y c o n t r a c t s e i t h e r ab road o r by i n t e g r a t i n g s t a g e s o f p r o d u c t i o n d o m e s t i c a l l y . W i t h i n such a f r amework , o p t i m i s a t i o n o f p r o f i t s o v e r a l o n g e r p e r i o d may r e q u i r e t h e o l i g o p o l i s t s depart!-.from . s h o r t - r u n max im-i s a t i o n . ( c ) C o n s t r a i n t s imposed by i n t e r n a l d i s c i p l i n a r y p r o b l e m s : D i s a g r eemen t may a r i s e w i t h i n t h e o l i g o p o l y as t o t h e n a t u r e o f demand change s ; t h u s some f i r m s may r e g a r d some demand changes as permanent whereas o t h e r s may c o n s i d e r t h e change t e m p o r a r y o r r e g a r d t h e change t o be o f l e s s e r e x t e n t . S i n c e a l l p r i c e i n c r e a s e s must be ag reed on and v a l i d a t e d by t h e p r i c e l e a d e r , s i g n a l l i n g by o t h e r members o f t h e o l i g o p o l y f o r p r i c e i n c r e a s e s may no t be v a l i d a t e d by t h e l e s s o p t i m i s t i c o r more c l e a r l y s i g h t e d p r i c e l e a d e r , even though such i n c r e a s e s would e x t r a c t s h o r t - r u n monopoly r e t u r n s . If t h e p r i c e l e a d e r v a l i d a t e d such a change , t h e more o p t i m i s t i c may add p l a n t c a p a c i t y wh i ch would f a i l t o be used s u f f i c i e n t l y t o g e n e r a t e t h e n e c e s s a r y r e t u r n s ; p r i c e c h i s e l i n g m i gh t o c c u r i n such s i t u a t i o n s e n d a n g e r i n g t h e j o i n t - m o n o p o l y p o s i t i o n . A n o t h e r p r ob l em a r i s i n g i n t e r n a l l y i s t h e danger o f s m a l l e r f i r m s i n e x p a n d i n g under t h e p r i c e u m b r e l l a making i n r o a d s i n t o t h e ma r ke t s h a r e s o f t h e l a r g e r c o m p a n i e s . Here a g a i n i f t h e company can be i s o l a t e d i n a m a r k e t , t h e o l i g o p o l i s t s w i l l a t t e m p t t o d i s c o u r a g e f u t u r e a t t e m p t s o f - 26 -s i m i l a r compan ies by f o r c i n g l o s s e s on t h e smaI I : company . Now we c o n s i d e r t h e i m p o s i t i o n o f a t a x on p r o f i t s f o r t h i s c l a s s i f i c a t i o n o f o l i g o p o l i s t s ; t h e key q u e s t i o n i s t o a sk whethe r t he ' t a x changes t h e b e h a v i o u r o f t h e g r o u p . A t any g i v e n t i m e t h e o l i g o p o l i s t s may e x t r a c t l e s s t h a n f u l l s h o r t -run i n d u s t r y monopoly p r o f i t s f o r t h e r ea s on s g i v e n above . The s i t u a t i o n f o r t h e i n d u s t r y a t any g i v e n t i m e i s i l l u s t r a t e d be low where OlTc a r e 0 o' i n d u s t r y c o m p e t i t i v e p r o f i t s , whereas OTTM a r e maximum s h o r t - r u n i n -d u s t r y p r o f i t s . The o l i g o p o l i s t s may a t t h i s t i m e be making l e s s t h a n O'TTM i n t h e i n t e r e s t o f l o n g - r u n p r o f i t o p t i m i s a t i o n , e.g.lTa The t a x r educe s 0TTc and o'lt^ t o OTTc and O'TTM r e s p e c t i v e l y ; i n t h e s h o r t - r u n t h e r e f o r e a move t o w a r d s e x t r a c t i n g f u l l monopoly r e t u r n s c o u l d be made by t h e o l i g o p o l i s t s so t h a t p a r t o r a l l o f t h e t a x m i g h t be s h i f t e d . However, t h i s s h o r t - r u n l e s s t h a n f u l l e x t r a c t i o n o f monopoly p r o f i t s i s t h a t p o l i c y wh i ch ex a n t e max im i se s e x p e c t e d p r o f i t s o v e r a l o n g e r p e r i o d o f t i m e , so t h a t u n l e s s t h e c o n s t r a i n t s a r e changed by t h e t a x t h e o p t i m a l p o l i c y i s n o t changed and t h e r a t e o f r e t u r n on c a p i t a l i n t h e i n d u s t r y i s d e p r e s s e d by t h e t a x , o u t p u t and p r i c e r e m a i n i n g unchanged. C e t e r i s p a r i b u s , - 27 t a x does n o t change t h e c o n s t r a i n t s enumerated a b o v e . In t h e l o n g - r u n as long as t h e t a x does no t impinge on ' n o r m a l ' p r o f i t s , t h e t a x f a l l s on t h e monopoly r e t u r n s w i t h o u t c h a n g i n g o u t p u t and p r i c e . ( i v ) O l i g o p o l y w i t h B a r r i e r s t o E n t r y p r o d u c i n g He te rogeneou s  P r o d u c t s T h i s model d i s p l a y s s i m i l a r i t i e s t o t h a t above i n t h a t c o n s i d e r a b l e c a p i t a l i s r e q u i r e d t o b u i l d p l a n t o f o p t i m a l s c a l e ; s i m i l a r l y , o u t b r e a k s o f open p r i c e c o m p e t i t i o n w i l l be a v o i d e d due t o r e c o g -n i t i o n o f mutual dependence . However, t h e p r o d u c t s , a l t h o u g h c l o s e s u b s t i t u t e s , can be d i f f e r e n t i a t e d and brand a l l e g i a n c e s can be i nduced and changed by v a r i o u s methods; t h e s e methods o f com-p e t i n g a r e a c c e p t e d by c o n v e n t i o n i n such i n d u s t r i e s a s l e g i t i m a t e fo rms o f c o m p e t i t i o n s i n c e t h e y a v o i d t h e dange r s o f open p r i c e c o m p e t i t i o n . These c o n d i t i o n s o f t e n a r i s e i n consumer r a t h e r t han t r a d e m a r k e t s where i n f o r m a t i o n i s l e s s t h a n p e r f e c t , but i n such i n d u s t r i e s s a l e s r e s i s t a n c e i s o f t e n q u i t e s u b s t a n t i a l due t o p a s t s a l e s p r o m o t i o n a c t i v i t i e s . The f i r m s , w i t h t h e e s t a b l i s h m e n t o f a s y s t em o f p r i c e s on t h e r e c o g n i t i o n o f mutual dependence , m a x i -m i se p r o f i t s w i t h r e c o u r s e t o t h e n o n - p r i c e c o m p e t i t i o n o f a d v e r t i s -i n g , s a l e s p r o m o t i o n g i m m i c k s , t empo ra r y s m a l l v a l u e d i s c o u n t s , v o u c h e r schemes, e t c . The f a c t t h a t t h e p r o d u c t d i f f e r e n t i a t i o n can be pur sued c r e a t e s w i d e r s cope t o d i s c o u r a g e e n t r y . In t h e homogeneous p r o d u c t c a s e , t h e i n v a r i a n t b a r r i e r o f c a p i t a l i s p r i n c i p a l l y caused by t e c h n o l o g i c a l f a c t o r s ; w i t h he te rogeneneou s - 28. -p r o d u c t s , t h e p r o l i f e r a t i o n o f a d v e r t i s i n g e x p e n d i t u r e s 4 c r e a t e n e c e s s a r y a d d i t i o n a l c o s t s f o r e n t r a n t s . These i n d u s t r i e s may o f t e n r e s o r t t o l e g a l means t o make e n t r y more d i f f i c u l t by p a t e n t i n g and t r a d e - m a r k i n g p r o d u c t s . A n o t h e r t a c t i c employed in some i n d u s t r i e s i s t h e d i f f e r -e n t i a t i o n and p r o l i f e r a t i o n o f b rands t h a t a r e p h y s i c a l l y i d e n t i c a l i n most r e s p e c t s , mak ing t h e s a l e s o f an e n t r a n t l a u n c h i n g a new brand s m a l l e r , and i n c r e a s i n g a d v e r t i s i n g 1 c o s t s . T h i s has been o b s e r v e d i n i n d u s t r i e s where brand s w i t c h i n g i s i m p o r t a n t , such as t h e soap and t o b a c c o i n d u s -t r i e s . W h i l e i f e n t r y does o c c u r , n o n - p r i c e c o m p e t i t i o n can a l s o be used t o t r y and f o r c e l o s s e s on e n t r a n t s , . a s w e l l a s p r i c e d i s c r i m i n a t i o n i f t h i s i s f e a s i b l e . W i t h t h e s e i n d u s t r i e s , c o n t r o l o v e r s u p p l y i s o f t e n e x t ended f r om p r o d u c t i o n t o w h o l e s a l i n g f u n c t i o n s t o c o n t r o l p o t e n t i a l p r i c e c u t t i n g , o r i n t o t h e r e t a i l l e v e l by f u l l y i n t e g r a t i n g a l l m a r k e t i n g p r o c e s s e s , u s i n g f r a n c h i s e s , a g e n c i e s , and r e t a i l p r i c e m a i n t e n a n c e . T h i s t y p e o f i n d u s t r y i s l a r g e l y o r i e n t e d t o w a r d s t h e p u b l i c ; i n Canada t h i s t y p e o f i n d u s t r i a l s t r u c t u r e o f t e n p r e d o m i n a t e s due t o t h e t a r i f f p r o t e c t e d s m a l l s i z e d market-f o r consumer goods . J o i n t - p r o f i t m a x i m i s a t i o n must t a k e p l a c e w i t h i n s i m i l a r c o n s t r a i n t s t o t h e homogeneous p r o d u c t c a s e ; p r i c e s in such i n d u s t r i e s must be under t h e f o r e i g n p r i c e p l u s t h e t a r i f f , t h e e x t e n t t o wh i ch depend ing on c o s t and demand 4 A d v e r t i s i n g i s a f i x e d c o s t pe r u n i t o f o u t p u t , t h u s as a r e c -t a n g u l a r h y p e r b o l a i n t h e t r a d i t i o n a l c o s t - o u t p u t p l a n e t h i s has t h e e f f e c t o f s h i f t i n g t h e minimum p o i n t on t h e l o n g - r u n c o s t c u r v e upward and t o t h e r i g h t . - 29 -c o n d i t i o n s i n t h e d o m e s t i c m a r k e t . As such w i t h t h e t a r i f f s unchanged and e x t e r n a l p r o d u c e r s ' c o s t s unchanged , -t h e i m p o s i t i o n o f t h e t a x does no t e f f e c t t h e o t h e r c o n -s t r a i n t s d e t e r m i n i n g t h e d e p a r t u r e s f r om p r i c i n g p o l i c i e s t h a t w i l l e x t r a c t f u l l s h o r t - r u n monopoly p r o f i t s ; c o n s e q u e n t l y t h e r a t e o f r e t u r n d e c l i 'nes, w i t h no p r i c e and o u t p u t changes i n t h e s h o r t - r u n , o r t h e l o n g - r u n , c e t e r i s p a r i b u s h o l d i n g . (v ) I n t e r n a t i o n a l O l i g o p o l i e s R a t h e r t h a n b e i n g i m p o r t - c o m p e t i n g i n t h e d o m e s t i c market, " some o l i g o p o l i e s , g e n e r a l l y t h o s e p r o d u c i n g homogeneous goods f o r f u r t h e r p r o c e s s i n g , a r e e x p o r t i n d u s t r i e s , and as such t h e p o l i c i e s o f f o r e i g n compan ie s must be t a k e n i n t o c o n s i d e r a t i o n i n d e t e r m i n i n g o p t i m a l p r i c e p o l i c y . O f t e n i n f a c t t h e o l i g o p o l y i s a p r i c e t a k e r i n t h e e x p o r t marke t due t o t h e f a c t t h a t t h e i r s u p p l y i n t h e i n t e r n a t i o n a l marke t i s no t dom inan t ; i n wh i ch c a s e t h e i m p o s i t i o n o f t h e t a x c a n n o t be s h i f t e d i n t h e s h o r t - r u n w i t h -o u t s i m i l a r moves by compan ie s i n o t h e r c o u n t r i e s . Even i f t h e s h a r e o f t h e marke t o f t h e o l i g o p o l i s t s i s s i g n i f i c a n t , u n l e s s o t h e r f i r m s f rom o t h e r c o u n t r i e s can be r e c o g n i z e d as f o l l o w e r s o f p r i c e i n c r e a s e s , t h e n t a x s h i f t i n g w i l l no t o c c u r ; so u n l e s s t a x r a t e s change s i m i l a r l y i n o t h e r c o u n t r i e s such t h a t a l l f a v o u r a p r i c e r i s e , t h e o l i g o p o l y must a c c e p t a l ower r a t e o f r e t u r n . S i n c e , however , Canad i an and U.S. r a t e s have u s u a l l y moved t o g e t h e r 5 P r o f i t m a x i m i s a t i o n does no t r e q u i r e such p r i c e s be j u s t below t h e p o r t o f e n t r y p r i c e s i n c e t h e demand and c o s t c o n d i t i o n s may d e t e r m i n e t h e p r o f i t m a x i m i s i n g p r i c e t o be s u b s t a n t i a l l y below t h e p o r t o f e n t r y p r i c e . - 30 -f i r m s i n both c o u n t r i e s w i l l f a v o u r a r a i s e i n t h e p r i c e i n a j o i n t - m a r k e t t o a v o i d a d e p r e s s i o n i n t h e r a t e o f r e t u r n , i.-and s h o r t - r u n s h i f t i n g w i l l o c c u r . ( v i ) O l i g o p o l y w i t h Ease o f E n t r y Nex t i n t h e c l a s s i f i c a t i o n a r e i n d u s t r i e s i n wh i ch f i r m s a r e i n t e r d e p e n d e n t , bu t c a n n o t e x e r c i s e l o n g - r u n c o n t r o l o v e r s u p p l y because e n t r y i s ea sy i n t o t h e i n d u s t r y . T h i s t y p e o f s t r u c t u r e i s o f t e n found i n r e t a i l i n g and s e r v i c e i n d u s t r i e s where s u b - m a r k e t s a r e m a i n t a i n e d by s p a t i a l f a c t o r s ; i t i s a l s o found i n m a n u f a c t u r i n g where t h e marke t i s a b s o l u t e l y s m a l l and few f i r m s a c h i e v i n g minimum e f f i c i e n t s c a l e o f p l a n t p o p u l a t e t h e i n d u s t r y . R e c o g n i t i o n o f mutual dependence and a c h i e v i n g monopoly i n d u s t r y p r o f i t s w i l l n o t p r o t e c t t h e r e t u r n s o f t h e o l i g o p o l i s t s because o f easy e n t r y ; e n t r a n t s may a c c e p t t h e monopoly p r i c e , but i n t h i s c a s e each f i r m ' s s h a r e o f monopoly p r o f i t s d e c l i n e s . The c o n v e n t i o n o f no p r i c e c o m p e t i t i o n i s a c c e p t e d i n t h i s c a s e , bu t t h e p o p u l a t i o n o f t h e i n d u s t r y has grown l e a d i n g t o e x c e s s c a p a c i t y ; s i n c e p r i c e c o m p e t i t i o n i s b a r r e d , c o m p e t i t i o n among t h e f i r m s i n t h e i n d u s t r y f o r t h e l i m i t e d numbers o f c u s t o m e r s t a k e s t h e fo rm o f c o m p e t i n g on c o s t i n c r e a s i n g and p r o f i - t ' d e c r e a s i n g n o n - p r i c e c o m p e t i t i o n , such as s e r v i c e p a c k a g e s . ' N o r m a l ' p r o f i t s w i l l be ea rned i n t h e i n d u s t r y . The i m p o s i t i o n o f t h e t a x d e p r e s s e s 6 T h i s i s 1 i k e I y t o be v e r y i m p o r t a n t i n t h e Canad i an c a s e where t h e ma jo r o l i g o p o l i e s p roduce homogeneous p r o d u c t s f o r s a l e i n t h e i n t e r n a t i o n a l and U.S. m a r k e t s , e . g . n e w s p r i n t . r e t u r n s be low ' n o r m a l ' , but monopoly p r i c e and o u t p u t a r e unchanged; e x i t f rom t h e i n d u s t r y o c c u r s u n t i l t h e s h a r e o f monopoly p r o f i t s t o each f i r m is. s u f f i c i e n t t o c o v e r ' n o r m a l ' p r o f i t s a g a i n . E n t r a n t s may no t a c c e p t t h e p r i c e s however , and a c t i v e p r i c e c o m p e t i t i o n may b reak o u t d e s p i t e t h e i n t e r d e p e n d e n c e o f p r o d -u c e r s s i n c e new e n t r a n t s must a t t r a c t b u s i n e s s t o t h e i r e n t e r -p r i s e s ; i n t h i s c a s e , p r i c e s and p r o f i t s a r e d r i v e n down t o c o m p e t i t i v e l e v e l s ; The s i t u a t i o n t e n d s t o be u n s t a b l e due t o t h e p e r i o d i c p r i c e b r e a k s . W i th t h e t a x and w i t h o u t p r i c e l e a d e r s h i p no f i r m can r a i s e i t s p r i c e s u n l e s s i t can be s u r e o f b e i n g f o l l o w e d ; i n wh i ch c a s e t h e p r o f i t s a r e d e p r e s s e d and e x i t w i l l o c c u r f rom t h e i n d u s t r y i n t h e l o n g - r u n . In t h e mode l s p r e s e n t e d above on i m p e r f e c t m a r k e t s , i t i s p r e -d i c t e d t h a t f o r f i r m s e x e r c i s i n g j o i n t - c o n t r o l o v e r p r i c e t h e n i f s h o r t - r u n s h i f t i n g does no t o c c u r t h e n n e i t h e r w i l l l o n g - r u n s h i f t i n g , as long as monopoly e l e m e n t s make up t h e r a t e o f r e t u r n on c a p i t a l . On a g g r e g r a t e , t h e t a x can o n l y be s h o r t - r u n s h i f t e d on t h i s a n a l y s i s i f t h e economy i s composed e n t i r e l y o f i n d u s t r i e s i n wh i ch t h e t a x removes a c o n s t r a i n t wh i ch had p r e v i o u s l y made f u l l e x t r a c t i o n o f monopoly r e t u r n s a t any g i v e n t i m e n o n - o p t i m a l and n o n - o p e r a t i o n a l . The p o i n t can be i l l u s t r a t e d i n t h e f o l l o w -ing d i a g r am wh i ch shows t h e a g g r e g a t e ' r a t e o f r e t u r n and t h e c a p i t a l s t o c k a t a g i v e n i n s t a n t o f t i m e : - 32 -Fi',.3. i j >v j N. j \ M E C Z 0 K* K J u s t p r i o r t o t h e t a x i m p o s i t i o n w i t h c a p i t a l s t o c k O K , t h e r a t e o f r e t u r n g i v e n by t h e m a r g i n a l e f f i c i e n c y o f c a p i t a l s c h e d u l e MEFC,, g i v e s as t h e a g g r e g a t e r a t e o f r e t u r n . The immediate e f f e c t o f t h e t a x i s t o s h i f t i nwards t h e M E C t o M E C 2 r e d u c i n g t h e n e t r a t e o f r e t u r n on c a p i t a l t o ^ i - c ) ; t h u s / u n l e s s a l l f i r m s a c t s i m i l a r l y and manage t o s h o r t - r u n s h i f t t h e t a x , t h u s p u s h i n g t h e MEC back t o M6C|, t h e ne t r a t e o f r e t u r n a f t e r t h e t a x must be reduced below ^, . CHAPTER IV TESTING HYPOTHESES AND THE EMPIRICAL EVIDENCE - 33 -S e l e c t e d t h e o r e t i c a l model s o f i n d u s t r i a l b e h a v i o u r have been s p e c i f i e d i n c l u d i n g a more e x t e n s i v e t h e o r e t i c a l t r e a t m e n t o f i m p e r f e c t c o m p e t i t i o n t h a n i s u sua l i n t h e l i t e r a t u r e on t a x i n c i d e n c e . W i th t h e i m p o s i t i o n o f t h e b u s i n e s s income t a x under c e t e r i s p a r i b u s a s s u m p t i o n s , t h e model s y i e l d e d a s e r i e s o f p r o p o s i t i o n s as t o t h e e f f e c t o f t h e t a x i n t h e long and s h o r t - r u n on t h e r a t e o f r e t u r n on c a p i t a l , p r i c e and o u t p u t . In t h e n o n - s t a t i o n a r y s t a t e and in an o p e r a t i o n a l f ramework t h e p r e d i c t i o n s o f t h e model a r e r e l a t i v e ; t h u s f o r a z e r o s h o r t -run s h i f t i n g p r o p o s i t i o n y i e l d e d by a s p e c i f i c m o d e l , t h e . . p r e d i c t i o n becomes t h a t p r i c e and o u t p u t a r e unchanged w h i l e t h e ne t r a t e o f r e t u r n f a l l s r e l a t i v e t o what would have been r eached i n t h e ab sence o f t h e t a x . S i m i l a r l y , f o r model s y i e l d i n g s h o r t - r u n s h i f t i n g p r o p o s i t i o n s , t h e p r e d i c t i o n s a r e t h a t o u t p u t f a l l s , p r i c e r i s e s , and t h e r a t e o f r e t u r n i s m a i n -t a i n e d o r f a l l s by l e s s t h a n t h e amount o f t a x , r e l a t i v e t o v a l u e s t h a t would have been reached w i t h o u t t h e t a x . The p r e d i c t i o n s o f t h e model s s p e c i f i e d have been e x p r e s s e d w i t h r e s p e c t t o t h e r a t e o f r e t u r n on c a p i t a l , and i n s p e c i f y i n g an - 34 -o p e r a t i o n a l f ramework f o r t h e h ypo the se s and i n c o n s i d e r i n g t h e e m p i r i c a l e v i d e n c e , t h i s app roach o n l y w i l l be a c c e p t e d . Some e m p i r i c i s t s have a t t e m p t e d t o measure s h i f t i n g o f t h e t a x by c o n s i d e r i n g changes i n t h e s h a r e o f n a t i o n a l income g o i n g t o c o r p o r a t e e n t e r p r i s e a s p r o f i t s . However, t h e r e i s no r e a l l y s a t i s f a c t o r y t h e o r y c o n c e r n i n g t h e s e s h a r e s , and l i t t l e can be done t o w a r d s e x p l a i n i n g p a s t b e h a v i o u r o f t h e s e s h a r e s , no r i s t h e r e a body o f p r e d i c t i o n s abou t t h e e f f e c t on t h e s e s h a r e s o f o c c u r r e n c e s such as t h e r i s e o f u n i o n s , p r i c e and wage c o n t r o l s , wage f r e e z e s , p r o f i t s t a x e s , e t c . • Re sea r ch i s needed i n t h i s s u b j e c t but u n t i I t h e r e emerges a more s u b s t a n t i v e body o f t h e o r y , e m p i r i c a l s t u d i e s p u r p o r t i n g t o t e s t f o r s h i f t i n g t h r o u g h an exam-i n a t i o n o f changes i n f a c t o r s h a r e s c a n n o t be a c c e p t e d . S i n c e t h e I 9 2 0 ' s t h e r e has been a s u b s t a n t i a l s h i f t ' i n t h e t a x s t r u c t u r e i n bo th t h e U n i t e d S t a t e s and Canada; t h o s e e a r l y y e a r s were c h a r a c t e r i s e d by low t a x r a t e s , whereas i n t h e l a s t t w e n t y - f i v e y e a r s t h e r a t e o f t a x has been abou t f i f t y p e r c e n t . The re have been s u b s t a n t i a l changes i n t h e g e n e r a l economic e n v i r o n -ment o v e r t h e p e r i o d ; s e v e r e d e p r e s s i o n f o l l o w e d t h e g e n e r a l l y p r o s p e r o u s 1920 ' s t o be f o l l o w e d by w a r t i m e , d e m o b i l i s a t i o n , t h e i n f l a t i o n a r y s i t u a t i o n o f K o r e a , and t h e n t h e r e t u r n t o n o r m a l i t y and p r o s p e r i t y o f t h e m i d d l e and l a t e 1 9 5 0 ' s . If we assume t h a t t h e economy had a d j u s t e d t o low r a t e s o f t a x a t i o n d u r i n g t h e l a t t e r - 35 -h a l f o f t h e I 9 2 0 ' s , and t h a t a l s o by t h e 1950 ' s t h e economy had a d j u s t e d t o t h e f a c t o f h i g h c o r p o r a t i o n t a x r a t e s , t h e n t h e r a t e s o f r e t u r n can be compared . Two p e r i o d s when g e n e r a l c o n d i t i o n s were s i m i l a r can be s i n g l e d o u t , one c h a r a c t e r i s e d by t h e low r a t e s , t h e o t h e r by h i g h r a t e s o f t a x . The p e r i o d s 1926-29 and 1954-58 both f o l l o w e d a c y c l i c a l u p s w i n g , and both had a g g r e g a t e c a p a c i t y u t i l i s a t i o n and unemployment f i g u r e s a p p r o x i m a t e l y c o m p a r a b l e . The d a t a i s . a s f o l l o w s : -Table 2 Ra te s o f R e t u r n on Book V a l u e s i n M a n u f a c t u r i n g B e f o r e Tax A f t e r Tax S t a t u t o r y Tax Ra te 1^926-29 7 ' 5 8 ^ 6-68$ \2% ?954 -58 l 2 ' 0 6 ^ 6 , 2 4 ^ ° 5 2 $ S o u r c e : S t i g l e r , G . J . " C a p i t a l and Ra te s o f R e t u r n i n M a n u f a c t u r i n g " P r i n c e t o n : P r i n c e t o n U n i v e r s i t y P r e s s , 1963. The c o n c l u s i o n t o be i n f e r r e d i s t h a t d e s p i t e t h e q u a d r u p l i n g o f t h e s t a t u t o r y t a x r a t e , t h e ne t r a t e o f r e t u r n f o r c o r p o r a t e m a n u f a c t u r i n g as a who le has no t been i m p a i r e d . D u r i n g t h e l a s t t w e n t y - f i v e y e a r s s i n c e r e c o v e r y f rom t h e d e p r e s s i o n y e a r s , c o r p o r a t i o n s have managed t o s h i f t t h e t a x in t h e sense o f m a i n t a i n i n g t h e i r n e t r e t u r n on c a p i t a l . The o b j e c t i v e t h e r e f o r e i s t o e x p l a i n how t h i s came a b o u t ; whe the r by s h o r t - r u n s h i f t i n g o r by l o n g - r u n a d j u s t m e n t s i n t h e c a p i t a l s t o c k . T h i s i s what t h e r e c e n t s t u d i e s have a t t e m p t e d t o do by t e s t i n g f o r s h o r t - r u n s h i f t i n g . The h ypo the se s pu t f o r w a r d i n t h i s paper on s h o r t - r u n s h i f t i n g can be - 36 -t e s t e d by e c o n o m e t r i c i a n s by u s i n g d a t a on p r o f i t s , p r i c e s and o u t p u t b e f o r e and a f t e r t h e t a x change , i s o l a t i n g t h e e f f e c t o f t h e t a x change f rom o t h e r f a c t o r s o p e r a t i n g t o change t h e r a t e o f r e t u r n both c y c l i c a l l y and s e c u l a r l y . Thus f o l l o w i n g a t a x change , e v i d e n c e c o n s i s t e n t w i t h z e r o s h o r t - r u n s h i f t i n g a s s o c - ' i a t e s a p o s i t i v e change i n t h e t a x r a t e w i t h a n e g a t i v e change i n t h e ne t o f t a x r a t e o f r e t u r n ( z e r o j c h a n g e i n t h e g r o s s r a t e ) and z e r o change i n p r i c e and o u t p u t , a f t e r a l l o w a n c e f o r r e s pon se s 1 t o o t h e r s h o r t - t e r m demand and c o s t c h a n g e s . However, i f p a r t i a l s h i f t i n g o c c u r s , i . e . some i n d u s t r i e s a r e a b l e t o s h i f t t h e t a x i n t h e s h o r t - r u n , t h e n on a g g r e g a t e t h e p r e d i c t i o n t o be t e s t e d i s t h a t r e l a t i v e l y t h e ne t r a t e o f r e t u r n f a l l s , bu t a g g r e g a t e o u t p u t f a l l s and p r i c e s r i s e . T y p i c a l l y t h e e m p i r i c a l i n v e s t i g a t o r s have used t i m e s e r i e s r e g r e s s i o n a n a l y s i s t o p r e d i c t t h e g r o s s r e t u r n on c a p i t a l on a g g r e g a t e by a number o f e x p l a n a t o r y v a r i a b l e s i n c l u d i n g t h e t a x r a t e . F o r such t e s t s t o be a c c e p t e d , t h e e m p i r i c a l s t u d i e s must s a t i s f y t h e f o i l o w -ing : -i . R e g r e s s i o n e q u a t i o n s d e s i g n e d t o i s o l a t e t h e t a x e f f e c t must be d e r i v e d f rom an a r t i c u l a t e d and s p e c i f i e d economic m o d e l , i i . In t h e s p e c i f i c a t i o n o f such mode l s , a u t h o r s a r e r e q u i r e d t o g i v e q u a l i t a t i v e p r e d i c t i o n s as t o t h e e x p e c t e d p a r t i a l r e g r e s s i o n c o e f f i c i e n t s o f t h e o t h e r e x p I a n a t o r y v a r i a b I e s . I These change s , i f t h e y do o c c u r , w i l l be l i k e l y t o be e f f e c t e d by an o l i g o p o l y i n a s h o r t p e r i o d o f t i m e . - 37 -i i i . In t h e r e g r e s s i o n a n a l y s i s we must be s a t i s f i e d t h a t m u 1 1 i - c o I I i n e a r i t y between i ndependen t v a r i a b l e s i s no t p r e s e n t , and t h a t s p u r i o u s c o r r e l a t i o n between i ndependen t and dependent v a r i a b l e s has been a v o i d e d , i v . If t h e d e r i v e d model i s mac ro -econom ic i n app r oach t h e n c o n f i d e n c e must be h e l d t h a t such a model i s a p p l i c a b l e o v e r .the who le d a t a p e r i o d u s e d , v . • If t h e e s t i m a t i n g e q u a t i o n s a r e d e r i v e d f rom a model o f t h e f i r m i t must be s t a t e d whe the r t h e p r e d i c t i o n s can be e x p e c t e d t o ho'l'd f o r a 11 ma rke t s t r u c t u r e s and v a r i o u s economic c o n d i t i o n s o r whe the r c o n s i d e r a b l e d i f f e r e n c e s i n magn i tude o r s i g n can be e x p e c t e d depend i ng on whethe r t h e marke t s t r u c t u r e i s c o m p e t i t i v e , o l i g o p o l i s t i c , o r m o n o p o l i s t i c , and whethe r t h e economy i s i n a d e p r e s s e d o r i n f l a t i o n a r y s i t u a t i o n . v i . Such e s t i m a t i n g e q u a t i o n s must e x p l a i n s h o r t -t e rm changes i n t h e r a t e o f r e t u r n i n r e s p o n s e t o demand, c o s t and t a x changes r a t h e r t h a n i n c l u d i n g a d j u s t m e n t s t o t h a t r a t e due t o l o n g -run f o r c e s . T h i s l a s t r e q u i r e m e n t a p p e a r s t o p l a c e c o n s i d e r a b l e d i f f i c u l t i e s i n - 38 -t h e f a c e o f t i m e s e r i e s a n a l y s t s who have used d a t a f rom o v e r t h e l a s t f o r t y y e a r s , where s u f f i c i e n t t i m e has e l a p s e d f o r c o n s i d e r a b l e changes i n t h e c a p i t a l s t o c k . In e f f e c t what t h e s e t i m e s e r i e s a n a l y s e s have done i s t o compare l e v e l s o f t h e v a r -i a b l e s a t each o b s e r v a t i o n w i t h t h o s e o f e v e r y o t h e r o b s e r v a t i o n i n t h e s a m p l e . R e f e r r i n g a g a i n t o t h e f i g u r e s on t h e r a t e o f r e t u r n f o r t h e 1920 ' s and t oward t h e end o f t h e t i m e s e r i e s i n t h e I 9 5 0 ' s and t h e accompany ing t a x r a t e s , i t can be seen t h a t bo th l e v e l s o f t h e v a r i a b l e s have i n c r e a s e d o v e r t h e p e r i o d . C o n s i d e r a g a i n t h e movement o f t h e t a x r a t e d u r i n g t h e p e r i o d o f t h e t i m e s e r i e s ; t h e movement i t s e l f has come i n s t a g e s , mov ing f r om low r a t e s d u r i n g t h e I 9 2 0 ' s and e a r l y and mid 1 9 3 0 ' s , t h e n d r i f t i n g upwards d u r i n g t h e r e c o v e r y t o a peak d u r i n g w a r t i m e , f a l l i n g o f f i n t h e I a t e f o r t i e s , p e a k i n g a g a i n i n t h e Korean War y e a r s , and t h e n s t a b i l i s i n g i n t h e I 9 5 0 ' s . C r a g g , H a r b e r g e r , and M i e zowsk i have s t a t e d t h e p r ob l em t h u s : " G i v e n t h i s t y p e o f movement, t h e d i f f e r e n t phases £o f t h e t a x b e i n g a s s o c i a t e d w i t h r a d i c a l l y d i f f e r e n t t y p e s o f economic e n v i r o n m e n t , one runs t h e r i s k o f m i s t a k i n g a s s o c i a t i o n f o r c a u s -a t i o n i n any e m p i r i c a l a t t e m p t t o a s s e s t h e impact o f changes in 2 t h e t a x " . Now c o n s i d e r what t h e e m p i r i c a l s t u d i e s a r e a t t e m p t -ing t o do t o t e s t f o r s h o r t - t e r m s h i f t i n g ; t h e y a r e t r y i n g t o e s -'I t i m a t e t h e s h o r t - t e r m d i f f e r e n c e cau sed by t h e t a x r a t e on t h e r a t e o f r e t u r n f r om what would have o c c u r r e d i n t h e ab sence o f t h e p r o f i t s 2 C r a g g , J . H a r b e r g e r , A. & M i e z o w s k i , P. " E m p i r i c a l E v i d e n c e on t h e I n c i d e n c e o f t h e C o r p o r a t i o n Income T a x " , Jou rna I o f P o I i t i c a 1  Economy, V o l . 7 5 , No. 6, December 1967, p.81 I - 39 -t a x . Thus i f by t h e l a t e 1920 ' s t h e economy had a d j u s t e d t o low r a t e s o f t a x , and by t h e 1950 ' s had a d j u s t e d s i m i l a r l y f o r t h e h i g h r a t e s , ^ t h e n such t i m e s e r i e s r e g r e s s i o n s o v e r t h e span o f f o r t y y e a r s run t h e ex t r eme danger o f no t s u c c e e d -ing i n i s o l a t i n g s h o r t - t e r m changes f rom l o n g - r u n a d j u s t m e n t s i n t h e c a p i t a l s t o c k , a p a r t f r om t h e p rob lems o f a c c o u n t i n g f o r c y c l i c a l v a r i a b i l i t y . F u r t h e r m o r e , i n a g r o w i n g economy i ndependen t v a r i a b l e s a p a r t f rom t h e t a x r a t e wh i ch a r e i n c l u d e d i n r e g r e s s i o n s t o i s o l a t e and e x p l a i n o s c i l l a t i o n s i n t h e r a t e o f r e t u r n , a r e l i k e l y t o be c o l l i n e a r o v e r t h e who le p e r i o d even i f f o l l o w i n g d i f f e r e n t s h o r t - r u n c y c l i c a l p a t t e r n s . Time s e r i e s e m p i r i c a l s t u d i e s f a c e ex t reme d i f f i c u l t i e s , t h e r e -f o r e , wh i ch w i l l no t e a s i l y be ove rcome. A f u r t h e r p o i n t c l o s e Iy c o n n e c t e d w i t h t h e l a s t i s t h e r e l e v a n c e o f t h e d a t a used i n t h e t i m e s e r i e s o v e r t h e who le o f t h e l a s t f o r t y y e a r s f o r e m p i r i c a l t e s t i n g o f t h e h ypo the se s s t a t e d h e r e . These h ypo the se s were p u t f o r w a r d abou t t h e b e h a v i o u r o f f i r m s i n a ' n o r m a l ' e n v i r o n m e n t i n v a r i o u s ma rke t s i t u a t i o n s ; t h e y t h u s a b s t r a c t f r om abnormal c o n d i t i o n s such as s e v e r e d e p r e s s i o n and w a r t i m e . S e ve r e d e p r e s s i o n came t o t h e No r t h Ame r i c an Economy i n 1930 and c o n t i n u e d t h r o u g h o u t t h e I 9 3 0 ' s w i t h s e v e r e u n d e r - u t i I i s -a t i o n o f c a p i t a l and manpower; i n v e s t m e n t e x p e n d i t u r e s c o l l a p s e d t o a l e v e l c l o s e t o z e r o i n 1932-33. I n t e r n a t i o n a l t r a d e s h a r p l y d e -c l i n e d and t a r i f f p r o t e c t i o n i n c r e a s e d . GNP i n t h e U n i t e d S t a t e s d i d no t r e c o v e r i t s 1929 v a l u e u n t i l 1938, and f u l l employment was 3 We assume t h e c a p i t a l ma r ke t s t o be a l l o c a t i n g t h e f l o w o f f und s such t h a t ne t o f t a x r e t u r n s t o c a p i t a l a r e t e n d i n g t o e q u a l i t y ; i n v e s t m e n t w i l l l e a v e t h o s e c o r p o r a t e i n d u s t r i e s whose r a t e o f r e t u r n i s r educed by t h e t a x below t h e c o m p e t i t i v e l e v e l , and move i n t o a l t e r n a t i v e a s s e t s . The t a x s y s tem has been a p p l y i n g a d i f f e r e n t i a I o v e r t h e t i m e p e r i o d c o n -s i d e r e d , and t h u s t h e e v i d e n c e i s q u i t e c o n s i s t e n t w i t h t h e d i s c u s s i o n o f l o n g - r u n a d j u s t m e n t i n t h i s a n a l y s i s wh i ch was c o n d u c t e d w i t h i n a p a r t i a l equ i I i b r i urn s e t t i ng . - 40 -a t t a i n e d a g a i n o n l y under heavy government e x p e n d i t u r e s and t h e s t i m u l u s o f m o b i l i s a t i o n . The model s s p e c i f i c a l l y a b s t r a c t e d f rom such abnormal s i t u a t i o n s . Thus t h e t i m e s e r i e s a n a l y s t s e q u a t i o n s have t o e x p l a i n a d e q u a t e l y t h e p r e s s u r e s on t h e g r o s s r a t e o f r e t u r n i n t h e d e p r e s s e d 1930 ' s and t h e more p r o s p e r o u s 1950 ' s; y e t t h e main i n c r e a s e s i n t h e r a t e o f t a x o c c u r r e d o u t s i d e o f t h e I 9 3 0 ' s i n t h e p e r i o d 1940 onwa rd s , i . e . t h a t p e r i o d a s i d e f r om t h e war y e a r s f o r wh i ch t h e mode l s p r e s e n t e d he re a r e d e s i g n e d t o a n a l y s e . T h e r e f o r e , t h e s e f a c t o r s p o i n t t o t e s t i n g t h e p r e d i c t i o n s by i n d u s t r y , and w i t h d a t a drawn f r om a sample wh i ch does no t i n c l u d e t h e d e p r e s s i o n o r war y e a r s , i . e . w i t h d a t a drawn f rom t h e p o s t - w a r p e r i o d . T h i s p r o c e d u r e a v o i d s " t he d a t a p e r i o d i n wh i ch s u b s t a n t i a l e n v i r o n m e n t a l change was o c c u r r i n g and i n w h i c h i t a p p e a r s f a c t o r s a f f e c t i n g t h e e q u i l i b r i u m com-p o s i t i o n and s i z e o f t h e c a p i t a l s t o c k were c h a n g i n g most r a p i d l y . P r e s e n t knowledge o f t h e c a u s e s o f changes i n t h e s e f a c t o r s , such as t h e r e l a t i v e p r i c e s o f c a p i t a l g ood s , t h e r a t e and b i a s o f t e c h n o l o g i c a l change , e t c . have no t been f u l l y i n v e s t i g a t e d . D e s p i t e t h e s e a r gumen t s , K r z y z a n i a k and Musgrave (K-M) pe r f o rmed r e g r e s s i o n a n a l y s i s f o r t h e U n i t e d S t a t e s u s i n g d a t a f rom 1935-42 and 1948-59 and c o n c l u d e d t h a t t h e c o r p o r a t e income t a x was f u l l y s h i f t e d i n t h e s h o r t ^ r u n and indeed more so s i n c e c a p i t a l owners a c t u a l l y g a i n e d i n a f t e r - t a x income as a con sequence o f t h e t a x change 4 . K r z y z a n i a k , M. and Musg rave, 'R . . The S h i f t i n g o f t h e C o r p o r a t e  Income Tax , B a I t i m o r e : J o h n s Hopk in s U n i v e r s i t y P r e s s , 1963. S t u d i e s f o r Canada, West Germany, and I nd i a u s i n g an a l m o s t i d e n t i c a l r e g r e s s i o n f o r m u l a t i o n found s i m i l a r e v i d e n c e t h a t t h e t a x had been o v e r s h i f t e d on a g g r e g a t e f o r m a n u f a c t u r i n g . The b a s i s o f t h e r e g r e s s i o n e q u a t i o n s used by K-M were d e r i v e d i n an ad hoc f a s h i o n f rom an e i g h t e q u a t i o n m a c r o -. mode l ; t h e y s t a t e " i t c a n n o t be o u r pu rpo se he re t o d e v e l o p a g e n e r a l mac ro -mode ] , bu t t h e t y p e o f s y s tem may be  s k e t c h e d " ["my i t a l i c s ] . 5 No f u r t h e r e x p l a n a t i o n i s o f f e r e d . They c o n t i n u e : " The model has been w r i t t e n t n a s u f f i c i e n t l y g e n e r a l f o rm t o a v o i d any dogmat i sm between K e y n e s i a n v e r s u s • C l a s s i c a l s y s tems o r c o m p e t i t i v e v e r s u s i m p e r f e c t l y c o m p e t i t i v e s y s t e m s . " W h i l e dogma i s t o be a v o i d e d n a t u r a l l y , t h e me thod -o l o g i c a l c o n c e p t f a i l s t o q u a l i f y under t h e l i s t e d r e q u i r e m e n t s , o f an e m p i r i c a l s t u d y . S e v e r a l a u t h o r s have c r i t i c i s e d t h e K-M s t u d y , and by a s s o c i a t i o n t h e o t h e r t h r e e s t u d i e s done i n a s i m i l a r v e i n . The main c r i t i -c i s m i s d i r e c t e d t owa rd s t h e s p e c i f i c a t i o n o f t h e e s t i m a t i n g e q u a t i o n used by K-M. The C r a g g , H a r b e r g e r and M i e z o w s k i s t u d y t a k e s as i t s s t a r t i n g p o i n t t h a t t h e K-M e q u a t i o n has i n a d e q u a t e l y c o r r e c t e d f o r t h e " s p u r i o u s c o r r e l a t i o n between t h e c o r p o r a t e t a x r a t e and g r o s s - o f - t a x r a t e o f r e t u r n on c o r p o r a t e c a p i t a l i n m a n u f a c t u r i n g in t h e t i m e s e r i e s f o r 1935-42 and 1948-59. O p e r a t i n g w i t h i n t h e K-M .framework t h e y add two a d d i t i o n a l v a r i a b l e s namely t h e employment r a t e and a dummy f o r t h e Korean 5 K r z y z a n i a k and Musg rave , o p . c i t . pp. 33 6 C r a g g , J . , H a r b e r g e r , A. and M i e z o w s k i , P . , o p . c i t . pp. 812 - 42 -War e p i s o d e ; t h e s e v a r i a b l e s r educe t h e p r e v i o u s l y p o s i t i v e s i g n i f i c a n t s i g n on t h e t a x v a r i a b l e t o i n s i g n i f i c a n c e . E x p e r i m e n t a t i o n by S l i t o r a l s o led t o s i m i l a r c o n c l u s i o n s abou t t h e s u s c e p t i b i l i t y o f t h e K-M r e s u l t t o r e - s p e c i f i c a t i o n w i t h i n t h e o r i g i n a l f r a m e w o r k . 7 T h i s r e s u l t , however , does no t change t h e f a c t t h a t t h e o r i g i n a l f ramework and ' m o d e l ' i s w o e f u l l y i n a d e q u a t e . C o n s i d e r t h e v a r i a b l e s used t o e x p l a i n t h e g r o s s r a t e o f r e t u r n ; t h e e q u a t i o n i s : -^3t = *• + *, A c k . , + ** v fc- i • K i ^ t + o ^ q t + « s ' where Mjj^  = t h e g r o s s r a t e o f r e t u r n on c o r p o r a t e c a p i t a l i n m a n u f a c t u r i n g AC(._, = t h e change f r om y e a r t - 2+0 y e a r b - i i n t h e r a t i o o f c o n s u m p t i o n t o GNP Vfc-i = t h e r a t i o o f i n v e n t o r i e s t o s a l e s i n m a n u f a c t u r i n g i n y e a r t-1 = t h e r a t i o o f t a x a c c r u a l s ( o t h e r t h a n c o r p o r a t e income t a x e s ) minus government t r a n s f e r s t o GNP i n y e a r t = r a t i o o f government p u r c h a s e s o f goods and s e r v i c e s t o GNP i n y e a r t A r e q u i r e m e n t t h a t has been s p e c i f i e d i s t h a t t h e a u t h o r s p r o v i d e d us w i t h q u a l i t a t i v e p r e d i c t i o n s as t o Dil , <XZ ,<U3 : t h i s K-M f a i l t o do o r g i v e an a d e q u a t e r a t i o n a l e f o r t h e v a r i a b l e s i n c l u d e d . In t h e r e s u l t s <X\7& ; t h i s may be t h e r e s u l t o f d i v e r s e c a u s e s such as r e d u c t i o n i n p e r s o n a l t a x e s o r a d e c r e a s e i n p r i v a t e i n v e s t m e n t . I t m i g h t be s ugge s ted t h a t t h e v a r i a b l e i n c o r p o r a t e t h e n o t i o n o f a 7 S l i t o r , R. " C o r p o r a t e Tax I n c i d e n c e : Economic A d j u s t m e n t s t o D i f f e r e n t i a l s under a T w o - T i e r Tax S t r u c t u r e " i n M. K r z y z a n i a k ( e d . ) E f f e c t s o f C o r p o r a t i o n Income Tax , D e t r o i t : W a y n e S t a t e U n i v e r s i t y P r e s s , 1966. - 43 -f o rm o f a c c e l e r a t o r f a c t o r ; i f t h i s was so o t h e r v a r i a b l e s m i g h t be e x p e c t e d t o r e p r e s e n t t h i s f a c t o r b e t t e r . Gordon has a rgued t h a t t h e p o s i t i v e c o e f f i c i e n t a r i s e s f r om h i s t o r i c a l c o i n c i d e n c e ; on modern t h e o r i e s o f t h e c o n s u m p t i o n f u n c t i o n . ACfc. t e n d s t o be p o s i t i v e i n r e c e s s i o n s , and s i n c e p r o f i t s t e n d t o be h i g h i n t h e f i r s t p o s t - r e c e s s i o n y e a r , t h e c o e f f i c -g i e n t on ACfcH t end s t o be p o s i t i v e . Bu t t h e p o s i t i v e c o r r e l a t i o n i s j u s t a c o i n c i d e n c e owing t o t h e f a c t t h a t p o s t -war r e c e s s i o n s have l a s t e d o n l y one y e a r . vt^ i s found n e g a t i v e ; a p o s i t i v e change i n un lagged i n v e n t o r i e s can be e x p e c t e d t o lower t h e r a t e o f r e t u r n , bu t l a g g i n g has no a p p a r -e n t r a t i o n a l e . o£j i s n e g a t i v e ; 0^ 4. i s n e g a t i v e and i n s i g -n i f i c a n t and i s d ropped f rom t h e K-M p r e f e r r e d equa t i on s . , a l t h o u g h c e t e r i s p a r i b u s t h e e x p e c t e d s i g n would be o p p o s i t e t o 0/3 .. No p r i o r i n f o r m a t i o n i s p r e s e n t e d i n t h e K-M s t u d y , no r i s t h e e q u a t i o n d e r i v e d f rom a s t a t e d s e t o f h ypo the se s abou t p r o f i t b e h a v i o u r . T h i s i s no t an a c c e p t a b l e a p p r o a c h f o r an e m p i r i c a l s t u d y . K i l p a t r i c k r e c o g n i s i n g some o f t h e p rob lems a s s o c i a t e d w i t h t h e use o f t i m e s e r i e s o v e r a long p e r i o d t o p r e d i c t s h o r t - t e r m changes i n t h e r a t e o f r e t u r n adop ted a l e s s d i r e c t method o f 9 t e s t i n g t h r o u g h t h e use o f a c r o s s - s e c t i o n a n a l y s i s . He h y p o t h e s i s e d t h a t ma r ke t power i s a n e c e s s a r y c o n d i t i o n f o r 8 Go rdon , R . J . "The I n c i d e n c e o f t h e C o r p o r a t i o n Income Tax i n U,S, M a n u f a c t u r i n g |.925r-62" A m e r i c a n Economic Rev i ew, V o l . 57, No. 4, September 1967. 9 K i l p a t r i c k , R.W. "The S h o r t - R u n Forward S h i f t i n g o f t h e C o r p o r -a t i o n Income T a x " Y a l e Economic E s s a y s , V o l . 5, No. 2, F a l l 1965. - 44 s h o r t - r u n s h i f t i n g o f t h e t a x . T h e r e f o r e , i f between two p e r i o d s w i t h d i f f e r e n t t a x r a t e s t h e r e i s a s i g n i f i c a n t c r o s s - s e c t i o n c o r r e l a t i o n between an i n d u s t r y ' s c o n c e n -O t h e r e x p l a n a t o r y v a r i a b l e s were i n c l u d e d i n t h e r e g r e s s i o n t o a s s i s t e x p l a n a t i o n o f t h e change o f p r o f i t r a t e . The z e r o , ct = I and z e r o s h o r t - r u n s h i f t i n g t o o k p l a c e . A s i g -n i f i c a n t - r e g r e s s i o n c o e f f i c i e n t was found on t h e Ci t e r m , and t h u s on t h e b a s i s o f t h e a s s u m p t i o n , K i l p a t r i c k a c c e p t e d t h e h y p o t h e s i s o f 50-80$ s h o r t - r u n s h i f t i n g i n m a n u f a c t u r i n g . However, t h i s r e l a t i o n s h i p may w e l l be found even i f t a x r a t e s d i d no t change o v e r t h e i n t e r v a l ; i n e f f e c t i t may be e x p e c t e d t h a t c o n c e n t r a t e d i n d u s t r i e s e x e r c i s i n g monopoly power o v e r p r i c e a n d ' p r o t e c t e d by b a r r i e r s t o e n t r y a r e b e t t e r a b l e t o p r o t e c t o r improve t h e i r r a t e s o f r e t u r n o v e r an i n t e r v a l o f t i m e , whereas i n c o m p e t i t i v e i n d u s t r i e s t h e r a t e s o f r e t u r n a r e s u b -j e c t t o the. d e p r e s s i n g e f f e c t s o f easy e n t r y . The s i g n i f i c a n t c o e f f i c i e n t on t h e c o n c e n t r a t i o n r a t i o c a n n o t t h e r e f o r e be a c c e p t e d as s u f f i c i e n t e v i d e n c e o f s h o r t - r u n f o r w a r d ; s h i f t i n g . G o r d o n ' s a n a l y s i s uses s i m i l a r t o o l s t o t h e K-M s t udy i n t h a t t r a t i o n r a t i o C't and t h e change i n i t s p r o f i t r a t e (^ si / );; o v e r t h e i n t e r v a l f r om K t o j t h e n t h i s was de f a c t o e v i d e n c e o f t a x s h i f t i n g . The model t e s t e d w a s : -h y p o t h e s i s assumed t h a t when \Qi^ = 0 i . e . monopoly power was - 45 -t i m e - s e r i e s r e g r e s s i o n e q u a t i o n s a r e s p e c i f i e d i n wh i ch t h e c o r p o r a t e p r o f i t r a t e i s t h e dependent v a r i a b l e . ' ^ The d a t a u s e d , however , c o v e r s a l o n g e r p e r i o d f rom 1925-1962; t h e a n a l y s i s i s open t h e r e f o r e t o t h e same o b j e c t i o n s as t o t h e use o f t h i s t i m e s e r i e s and t h e ex t reme d i f f i c u l t i e s o f i s o l a t i n g t h e t a x e f f e c t i n t h e s h o r t - t e r m as i s t h e K-M s t u d y . The model o f p r o f i t b e h a v i o u r i s d e v e l o p e d f rom a model o f t h e f i r m p r a c t i s i n g a mark-up p r i c i n g p o l i c y o v e r a v e r a g e c o s t . i a t c a p a c i t y o u t p u t . As such t h i s g i v e s no o b j e c t i o n , bu t t h e a s s u m p t i o n i ! i s made t h a t a l l m a n u f a c t u r i n g f i r m s f o l l o w p r i c i n g p r a c t i c e s s i m i l a r t o t h e r e p r e s e n t a t i v e f i r m and s e c o n d l y i t i s assumed t h a t t h e mark-up p r o f i t s e q u a t i o n r e p r e s e n t s p r o f i t b e h a v i o u r i n e v e r y m a n u f a c t u r i n g i n d u s t r y . E s t i m a t i o n o f t h e e q u a t i o n d e r i v e d f rom t h e s e a s s u m p t i o n s w i t h a g g r e g a t e d a t a l e a d s Gordon t o c o n c l u d e t h a t t h e t a x i s no t s h i f t e d i n t h e 11 s h o r t - r u n . On t h e b a s i s o f a p p l y i n g t h e same e s t i m a t i n g e q u a t i o n t o i n d u s t r y d a t a , he a l s o found however t h a t t h e t a x was s h i f t e d i n t h e P a p e r , C h e m i c a l s and P e t r o l e u m , Rubber and S t one i n d u s t r i e s , and was n e g a t i v e Iy s h o r t - r u n s h i f t e d i n t h e P r i n t i n g i n d u s t r y . A l t h o u g h we c o n s i d e r e d t h e p o s s i b i l i t y o f s h o r t - r u n p o s i t i v e s h i f t i n g i n o u r t h e o r e t i c a l a n a l y s i s , t h e l a t t e r r e s u l t was no t c o n s i d e r e d . T h i s s u g g e s t s t h a t t h e e s t i m a t i n g 10 Go rdon , R . J . o p . c i t . .1] ' G o r d o n , R . J . o p . c i t . p. 743. - 46 -e q u a t i o n s a r e no t i s o l a t i n g o t h e r f a c t o r s e f f e c t i n g s h o r t -t e r m changes on t h e r a t e o f r e t u r n because t h e same s p e c i f i c -a t i o n i s used f o r a l l i n d u s t r i e s , where i n v f a c t we m i g h t e x p e c t d i f f e r e n t v a r i a b l e s t o have d i f f e r i n g e f f e c t s on t h e r a t e o f r e t u r n i n v a r i o u s i n d u s t r i e s . C o n s i d e r how an i n -c r e a s e i n t h e a v e r a g e p r o d u c t i v i t y o f l a b o u r , wh i ch Gordon c l a i m s t o i n c l u d e i n h i s r e g r e s s i o n e q u a t i o n , m i gh t i n f l u e n c e i n d u s t r y p r o f i t s , h o l d i n g c o n s t a n t , wages o f l a b o u r f o r e x p o s -i t o r y p u r p o s e s . In pu re c o m p e t i t i o n , f i r m s f u l l y pass on t o p u r c h a s e r s t h e i n c r e a s e i n l a b o u r p r o d u c t i v i t y : c o n s i d e r i f t h e demand f o r t h e i n d u s t r y p r o d u c t i s i n e l a s t i c , t h e n p r o f i t s o f t h e i n d u s t r y w i l l f a l l . However, i n o I i g o p o I i s t i c i n d u s t r i e s i f l a b o u r p r o d u c t i v i t y i n c r e a s e s and f i r m s do no t change p r i c e , t h e n f i r m s w i l l keep t h e e x t r a s a v i n g s , and i n d u s t r y p r o f i t s w i l l i n c r e a s e . T h e r e f o r e , i f t h e e q u a t i o n s do no t f u l l y c a p t u r e t h e s e i n f l u e n c e s t h e n i t i s q u i t e p o s s i b l e t h a t t h e a s s o c i a t i o n s found and a t t r i b -u ted by Gordon t o t h e income t a x a r e , i n f a c t , due t o o t h e r f a c t o r s wh i ch h i s e s t i m a t i n g e q u a t i o n s d e r i v e d f o r a r e p r e s e n t a t i v e f i r m c a n n o t a d e q u a t e l y c a p t u r e due t o i n t e r - i n d u s t r y d i f f e r e n c e s . T h e r e f o r e , i n c o n c l u s i o n , i t must be s t a t e d t h a t t h e e m p i r i c a l s t u d i e s have no t a d e q u a t e l y t e s t e d f o r s h o r t - r u n s h i f t i n g . P r i c e changes i n r e s p o n s e t o t h e t a x , i f t h e y o c c u r , a r e l i k e l y t o o c c u r w i t h i n a s h o r t - p e r i o d o f t i m e a f t e r t h e t a x change , and t h e e f f e c t - k7 -on g r o s s p r o f i t s i n a s i m i l a r s h o r t p e r i o d o f time g i v e n an o l i g o p o l i s t i c s i t u a t i o n . S i n c e , however, t h e l a r g e s t changes i n the t a x r a t e have taken p l a c e d u r i n g w a r t i m e , and subsequent changes i n the e f f e c t i v e t a x r a t e have been s m a l l d u r i n g normal economic c o n d i t i o n s , i t must be c o n c l u d e d t h a t - t h e methodology adopted by r e c e n t e m p i r i -c a l s t u d i e s has not l e d t o an i n c r e a s e i n the u n d e r s t a n d i n g o f the e f f e c t s o f the t a x . - 48 -BIBLIOGRAPHY B a i n , Joe S. B a r r i e r s t o New C o m p e t i t i o n , Cambr i d ge , Mass: H a r v a r d U n i v e r s i t y P r e s s 1956. 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