An Application of the Scholes and Wolfson Model to Examine the Relation between Implicit and Explicit Taxes and Firm Market Structure

A taxpayer can take advantage of preferential tax provisions to lower its explicit tax burden. In the absence of market frictions, this differential tax treatment gives rise to differences in pre-tax rate of returns across investments, defined as an implicit tax (Scholes and Wolfson 1992). Market structures that are other than perfectly competitive can impede the realization of implicit taxes (which represent lower pre-tax rate of returns) by allowing firms to earn extra-normal after-tax returns (Wilkie, 1992). This study estimates implicit tax rates and investigates the relation between a firm?s implicit tax rate and two factors: 1) the pre-tax rate of return, and, 2) the potential market power of the firm, which could provide the opportunity to shift implicit (and explicit) tax burdens from the firm to consumers or labor. The results indicate that implicit taxes are significantly negatively related to the pre-tax rate of return and firm market structure characteristics. The interaction of pre-tax rate of returns and firm market structure characteristics is positively related to implicit taxes, indicating that firm market structure leads to a weakening of the strict negative relation between implicit taxes and pre-tax rate of returns