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nd

PAPERS

CountryEconomisDepartment TheWorldBank

April1989

WPS178

113 00

TaxHolidays

andInvestment

Jack M. Mintz

The tx holiday-designed to encouragecapitalinves*ments- actuallypenalizes long-term investmentsin somecountries with high inflation rates and relatively fast writeoffs for depreciable capital.

PPRWolkiDgPapustodisseminatethefindingsof winkinprogess nd to

ettawge

theanteM relletteonly

author'own.TheyhoWdnotbeaunbtedtotheWorldBank.itsBoad ofDiuctors,itsmnagetmen.orany ofitsmembercautries.

tieFol iy. Plani

nd Rearch C<pkx

datuiba

theeacang

cf idea amongBankstaffandaflotheenin td

tbeirviews,and houldbe

indevelopuentiues.

Thesepapen cany thenamesof

and enclsiom anrete

usedandcitedaccordingly.Thefindings,ierautios.

The tax holiday - an incentive frequently used in developing countuiesto encourage capital

investments -

investments but could in fact penalize long-term

offers benefits for short-term

capital investments.

not indexed for inflation -

the true economic cost of depreciation.

may be lower than

For another, the tax benefit of nominal

interest deductions associated with debt

ing of capital are of no value to the firm during

fnanc-

For some countries with high inflation rates the holiday - whereas after the holiday they and relatively fast writeoffs for depreciable may be quite beneficial. capital, the effective tax rate on long-term

investments is higher during the tax holiday th after.

After estimating the effective tax rates on capital for holiday and post-holiday investments, the author concludes that for some countries the effective tax rate on long-term capital is highter dtuing the holiday than after.

For one thing, the tay law may require assets to be depreciated during the holiday. If so, the

value of tax depreciation writeoffs -

which is

This paper is a product of the Public Economics Division, Country Economics Department Copies are available free from the World Bank, 1818 H Street NW, WashingtonDC 20433. Pleasecontact Ann BhaUa,roomN1O-061,extension 60359.

The PPRWorkingPaperSeriesdissemintesthe findingsah ofworkunderwry in theBank'sPolicy,Plarming,

Research

Complex. An objective of the series is to got these fuuings out quicldy, even if presentations are less than fuOypolished. 'Me fmdings, interpretations, and conclusions in ffiese papers do not necessarily represent ofricial policy of the Bank.

Produced at the PPR DissenminaionCenter

TaxHolidays

andInvestment

Jk

by

M.Mintz

TableofCoolants

I.

Intduction

2

I. A Deaied Decrpio ofTaxHolidays . 4

A.TaxHolidayProvisions B.Post-TaxHoidayP vision

.9

m.

TheoretcalAnalysis

.

.

10

A.Th BasicTheoord Model.11

 

B. SomeComnpliCaius.19

 

i

DeferalofDepreciation.20

ii,

Associed Non-TaxHolidayFrms.22

 

iii.PemsonalTaxationandDebtPolicy.26

 

IV. EmpiricalAnalysis.32

 

V. Conclusins.38

Biblioahy

 

41

1. INTMODUCTION

The corporateincometax holidayis a tax incentivefrequentlyused

by less developedcountries(LDCs)to promotecapitalinvestment.The usual

form of the holidayis to allow a 'pioneer"firm operatingin a designated

industryto be fully or partly exeomptfrom corporatetaxationduring its

formativeyearswith fulltaxationapplyingafterthe holidayperiod. Of the

54 LDC tax systemsdescribedin a PriceWaterhousesurvey(19861,27 of these

include tax holidays of one form or another. Althoughtax holidaysare

prevalentin LDC's,it is not difficultto find examplesof holidaysused in

developed countries such as Franceand Belgium.

Much of the currentliteratureon capitalformationand effectivetax

ratesl has concentratedon investmenttax credits,accelerateddepreciation,

and statutorytax rate abatementsas tax incentives(see,for example, King

and Fullerton (1984]and Boadway, bruce and Mintz [1984]). These tax

incentivesare not particularlydifficultto analyzesince it can be assumed

that the firm anticipates the tax system to be unchanging overtime. With

additionalassumptions,timeinvarianteffectivetax ratesare derivedthatare

usefulfor describingthe long run impactof the tax systemon capital. For

example,the usual assumptionsincludethe following: (i) real capitalgood

prices increase at a constant rate over time, (ii) capital depreciates

1/ The notionsof the effectivetax rate and the costof capitalare fairly well knownnow in the literatureso theyare onlybrieflydefinedhere. The user cost of capital is depreciationand financingcosts,adjustedfor taxes,that are incurredby the firm whenholdingcapital. Effectivetax rates are conventionallydefinedas the differencebetweenthe marginal gross-of-taxrate of return(theuser cost of capitalnet of depreciation costs)and the net-of-taArateof returnthatsaversearnwhen investingin the firm'scapital. This differencemay be dividedby the gross-of-taxor net-of-taxmarginalratesof return.

-2-

exponentiallyat a constantrate and (lii) the real net-of-taxdiscountrate of

the firm is time invariant. The steady-statecondition in a dynamic perfect

foresight model without adjustment costs implies that the firm's capital

decision is determinedat the point where the value of marginal product per

dollar of capital is equal to the tax-adjustedannual cost of depreciationand

financing(see Boadway and Bruce [19791). With this type of model, the cost of

capitaland effectivetax rate facedby the firm is independentof time.

With

tax

holidays,

the

firm

anticipates

the

tax

system

to

be

changing

over time. In particular, the cc.-porate tax rate rises after the holiday is

finished. This implies that the cost of capital is no longer time invariant,

making the tax holiday problem more difficult to analyze compared to other tax

incentivesthat have been treated in the literature. The scant literature on

this subjecthas concentratedon issues relatedto the reasonswhy tax holidays

may be used as an incentivewithout trying to derive the effectivetax rate on

capital during a holiday (Bond and Samuelson [1986] and Doyle and van

Wijnbergen (1984]).2 The task of this paper is quite different. The user

cost of capital, which varies over timil,is derived for a firm that correctly

anticipatesthe length of the holiday and the tax regime that exists after the

holiday. The time consistencyof tax policy is not an issuehere.

2 Two papers that also try to answer this question are by Agell (1982] and Bond [1981]. Each measures the effective tax rate by taking into account that income earned by capital during the holiday is taxed at the end of the holiday with the value of marginal product constant over the tax holiday period. As shown in this paper, this assumption,implyingthe capital stock is constant until the end of the holiday, is incorrect. Tax depreciation allowancesare also modelled incorrectly.

-3-

If c±e firm is fully exempt from corporateincome taxationduring the

holiday, what is its effective tax rate? A first response would be that

capitalbears no tax at all. This would be correct for short term capital that

fully depreciatesbefore the end of the holiday. However, as shown later, the

effectivetax rate on long term holiday investmentsdependson the relationship

between tax depreciationand true economicdepreciation. Even though the firm

is tax exempt during the holiday, it must pay taxes on income generated by

holiday investmentsonce the holiday is finished. If the firm must write down

the value of its assets for tax purposes during the tax holiday, the tax

depreciationwriteoffs after the tax holiday may be inadequaterelative to the

true cost of depreciation. For example, suppose capital is written off at a

100% rate of tax purposes but has an economic life that goes well beyond the

holiday period. A firm that undertakesan investmentduring the holiday must

expense the capital for tax purposes,yet pay taxes on profits generatedby the

remaining capital after the holiday period. In fact, the "rule" can be

describedas follows: the effectivetax rate on depreciablecapitalduring the

holiday is positive [negative]if the tax depreciationrate (plus inflation

rate with historicalcost valuation of capital) is more [less) than the true

economic depreciationrate. 3 Indeed, it is possible, in the case of long

term depreciablecapital, that the tax holiday may be no holiday at all in that

the effectivetax rate on investmentsduring the holiday is higher than that on

i/ This rule applieswhen the firm cannot defer its tax depreciationwriteoffs. As we review in the next section, some countriesallow tax depreciationto be deferred until after the holiday. We show that capital is generally subsidizedwhen income is fully ei.emptfrom taxation in the holiday period and firms are allowed to defer depreciationdeductions.

-4-

investuentsafterthe holidayl Thisdoesnot implythatthe tax holidmyis of no value to the firm. Short term investmentsand labor (compensatedby profits)bearno tax duringthe tax holiday. It is onlylongterminvestments thatmay be penalizedby the tax holiday. The remainderof the paper is dividedas follows. In SectionII, details regarding the tax law for five countries that use tax holiday incentivesare surveyed. SectionIII presentsthe theoryused to derivethe cost of capitaland the effectivetax rateon capitalfor eachyear duringand aftera tax holiday. SectionIV presentssome effectivetax comparisonsfor the countriessurveyedin SectionII. SectionV concludeswith a discussionof the distortionsthatarisefromtaxholidays.

II. A DETAILEDDESCRIPTIONOF TAX HOLIDAYS

This sectiondescribesthe detailsof the corporateincometax law that is relevantto tax holidaysused in five countries:Bangladesh,C6te dl'Ivoire, Malaysia,Moroccoand Thai1lnd. Table 1 providesa summaryof varioustax provisionsin each country. Insteadof describingthe tax regimesin each country,I shall outlinethe generalfeaturesof the tax law that applyto qualifyingholidayinvestments. Manycountriesgiveotherformsof tax relief duringtheholidaysuchas a remissionof importdutieson inputs,exporttaxes

on goods, sales taxes,and personaltaxes on dividends. Since this paper concentrateson the firm'sinvestmentdecision,only the remissionof import dutieson capitalgoodsand dividendtaxesare considered.

-5-

A. Tax Holiday Provision

In the five countrieslisted in Table 1, tax holidays officiallylast

from 3 to 14 years dependingon the law. In general, the firm is fully exempt

from corporate income taxes during the holiday although this is not always

true. C6te d'Ivoire only partly exempts the firm during the last three years

of the holiday while certain Ho",eco investments are given only a 50S

exemption. In each of the countries,firms must apply for a tax holiday status

and not all firms qualify. 4

The tax heliday provisions for the treatment of depreciable assets

vary considerablyacross countries. Morocco and Thailand requireassets to be

depreciated for tax purposes during the holiday while Malaysia explicitly

permits the firm to depreciate assets after the holiday. Depreciation

deductions in C6te dllvoire are not mandatory-these can be deferred

indefinitely. Thus, a C6te d'Ivoire firm during the tax hofiday may elect to

defer its depreciationallowancesuntil after the holiday. Bangladeshrequires

that depreciationdeductionsbe claimed in the year but unused deductionsmay

be carried forward indefinitely. 5

As shown later in the theoreticalsection,

the deferral of depreciation deductions makes the tax holiday much more

generousto the firm.

i/ Morocco grants tax holidays only for Zone III (50% exemption)and Zone IV investments(!00% exemption)that are situated in rural areas. The length of Cote d'Ivoire tax holidays depend on region that the firm operates in. Most countries do not allow tax holiday firm to claim other tax incentives (Bangladesh,Malaysia,Cote d'Ivoire).

j/

during the holiday, I interpretthe rules

to imply that these depreciationdeductionsduring the holiday are fully

If the firm earns

taxable

profits

used and thus not carried forward.

Table I:

Tax HolidayProvision

Irndutrial

Enterprise

 

Bangladesh

Cst. d'Ivoir.

P

riod

4-12yrn

7-11yrsn-10

Malaysia

Morocco

Thailand

yrs

10-14 yrn

i-S

yro

*

yrs

(optioml)

Exemption

100X

Treatmentof

Unue m*ndatory

D Dr eintlon

deductionscarried foruard

100Xfor4,6,or S yrs dependingon region 755Ord lastyer 60X 2nd lastyear

255 lastyer

1ox

10oozono IV

10o0

s0X Zo

III

S05for five

 

additionalyrs

Depreciation

DOpreiati"o

mandatory-

mandatory

carried

forward

In

loesperiods

 

only

Straightline:

Straightline:

Depreciationdeductions Depreciationdelayed

notmandatory-canbe deferred Indefinitely

untilend of holiday

nat"e of

0oereciatioa

DecliningBalance: Straightline:

Sauldiag

15X

Machinery us

Building SS

Machinery 10-- X.

Straightline:

Buildings25

Conformitywith

Conformitywith

Machinery 125 (average)

beek

book

Initial

Allowoac:

Buildings20S

 

Machinery 205

Mandatory dedection

Four yrs

Pioner

and

of

associated

non-

pionoer

lone only carried forward lidefinitely

lose-plonr

carry forward

associatedno_-

piopeer

Income ad

ltos

ggregoted

Dividens

exempt

free

persoal

tax

 

In3tial

Alloance:

Building10X

Machinery 20X

Treamnt

of

Not carried

tJn"

tforwardafter

holiday

Other Features

C-05Oof Incom

of Holidays

Invested

In govt.

bonds.

Dividentsof

Carried

8

yers

forward

National Invest ment Diridwnd

*xmpt from

Fund levy -

10Xtax

personal

tax

fully recoverable at a

ratethatverie

publicfirmexempt accordingto typeof

freepersonaltox

Investment

Bangladesh

Post-,

iday

Tax Provisions

 

Corporate Tax

401

(Public)

Rate

41

(Private)

Doprociatlon

Sameas above

Rat"

Recapturerulae

apply

Other Tax

Incentives

- avallablo

Inveetmet

afterholiday

allowance251.

Depreciationbee

not adjuste

- not avallablo Acceloratedat 1005

for holiday

or

s0o s

201

CSte d'Ivoire

4011+

OX (NIF)

Sameas above

No

Accelerated at twice

the

er_s rate

 

Malaysia

Morocco

Thailnd

43X leam5X

49*.X

3OX(Public)

abatement

351 (Privat)

Sa

as abov

Sameas aove

Sameso above

Recapture

rules apply

Recapturerues

 

Wly

No

lb

No

Accelerated at 401

lIveetmeet

None

IvestmSttTax

Allowancof 1001

11_e"'

of prof Itsa'*I

-

101

up to

I Westmont

OXof

-8-

 

If

the firm

is

granted a

hollday,

it

usually

does

not

quallfy

for

other

tax

lncentives

such

as

accelerated

depreciation.

Depreclatlon,

except

in

Bangladesh,

is

based

on the

straLghtline

methods unlndexed

for

inflation.

In

some

countries

such

as

Bangladesh and

Malaysla,

an

lnltial

allowance

is

given. Morocco and Thailand require

 

tax

depreciatlon

to

conform

with

accounting

depreciation.

These

rates

of

depreciation

are

applied

to

assets

purchased

both

during

and after

the

hollday

period.

Table

1 provides

the

rates

of

depreciation

 

and

lnitialdepreciatlon

 

or

investment allowances.

In

most

cases,

annual

tax

depreciation

is

based

on the

original

cost

of

asset

without

writingdown the asset base by the lnitial

allowance.

Ignoring

inflation.

ax

depreciation

rates

seem

to

be

higher

than

economic

depreciation

 

zes

particularly

for

buLldings

and machinery in

Bangladesh,

and,

as

a result

of

the

initial

allowances,

buildings

and machinery in

Malaysia.

 

Another

important

provision

regarding

tax

holidays

is

the

treatment

of tax

losses.

Thailand

requires

losses

incurred

by

a

pioneer

firm

to

be

written

off

against

income of

a related

non-pioneer

company.

The same applies

to

the

tax

losses

of

the

non-pioneer

buwiness-it

must

be set

off

against

the

income of

the

pioneer

firm. Malaysia also requires

losses

of

associated

non-

pioneer

firms

to

be

written

off

the

income

of

pioneer

firms,

but

unlike

Thailand,

not

the

converse

(the

pioneer

firm

tax

losses

sre

carried

forward

indefinitely).

Bangladesh

does

not

allow

tax

losses

of

holiday

firms

to

be

carried

forward

after

the holiday while in

C6te

d'Ivoire

and Morocco there

is

a limit

on the

time

permitted

for

losses

to

be

carried

forward.

In the

case

of

C6te d'Ivolre,

depreciation

deductions

can

be

deferred

indefinitely

so it

is

unlikely

that

the

restriction

on

the

carry

forward

of

losses

is

binding

for

many firms. 6

i/

Canada,

deductions.

during

similar

to

For

the

seven

C6te

this

d'Ivoire,

reason,

allows

most reported

the

year

maximumperiod

in

Canada.

firm

tax

to

losses

defer

are

depreciation

written

off

See Mintz

(19881.

-9-

There are a few other featuresthat apply to tax holidays. In Bangladesh,a certainpercentageof incomeearnedduringthe holidaymust be investedin governmentbonds (theratevariesfrom5 to 30% accordingto the

region in which the investmentis located). If the governmentbond rate is

below the market ra,,',an "implicit* tax is imposed on the firm. C6te

d'Ivoire has a similar provision associatedwith the National InvestmentFund

(this fund is financed by taxes levied on companies and the taxes are

recoverable if the firm purchases governmentbonds or undertakes sufficient

levels of investment). The rate of corporateincome tax is 10% and the rate of

recoverydepends on the region in which the investmentis located. 7

Another feature of tax holiday is that dividendspaid by a firm to

its shareholders may be exempt at the personal level during the holiday.

Thailand fully exempt dividends while Bangladesh only exempts

Malaysia and

dividends of holiday firms listed on the stock exchange. How dividend

taxation affects the marginal investmentdecision of the holiday firm is an

issue left for later analysispresentedin Section III.

B. Post-TaxHolidav Provisions

When the holiday is terminated,the firm must pay corporate income

taxes accordingthe normal tax code provisions. The statutorytax rate imposed

in the five countries currentlyvaries from 30% in Thailand (publicfirms) to

about 50% in Morocco.

/ I have not been able to determineif the firm must pay the NIF tax during the holiday. I assume, if it does, that the tax does not affect the marginal investment decision since the funds can be fully recovered by investingin qualifyingcapital.

-10-

Tax depreciationrules, after the hollUay is terminated,are the same

as those described in the previous section. In general, the rates of

depreciation do not change except for the case of C6te d'Ivoire where

accelerated depreciation (twice the normal rate) might be available for

qualifyingcapital after the holiday period (for later analysis,I assume that

post-holIday investments do not qualify for accelerated depreciation). An

investmentallowancenot availableto firmsduring a holiday is availableafter

the holiday in Bangladesh. Otherwise,accelerateddepreciationand investment

allowance incentivesare generally not available after the holiday period in

most of the countries.

The corporate tax law reviewed above and outlined in Table I is the

basis for modelling in the next sectionand for estimatingeffectivetax rates

in Section IV. The informationon the tax provisionswere taken from published

sources so it is quite possible that the tax law has been misinterpretedin

some cases.

III. THEORETICALANALYSIS

In this section, the impact of tax holidays on the investment

decisions of price-takingfirms is analyzed. The analysis is simplified by

assuming that there are no costs incurred by firm in adjusting its capital

stock. 8

In addition,the firm, when undertakinginvestments,anticipatesno

L/ It is straightforward to include adjustment costs so long as they are current and fully deductiblefrom the corporate tax. If adjustmentcosts are capital in nature, the analysis is more complicatedbut adds little in theory to the model. For a discussionon effectivetax rates and adjustment costs, see Boadway (1988].

-11-

changes in the tax provisions that are applied during and after the holiday period. Personal taxation and debt finance are ignored, at least initially. These assumptionsimply that the firm uses a time invariantdiscount rate (the opportunitycost of shareholderfunds) both during and after the holidayperiod to value its cash flows. Otherwise,in the presence of varying personal tax

discount

rates and financing policies, the

rate, would be different during and after holiday period. Time varying discountrates are consideredat the end of this section. The first part of this section is devoted to the simplest model that can be formulated to evaluate the impact of tax holidays on investment. In this part, it is assumed that holiday firm is not associatedwith a non-tax

firm's cost of finance, hence its

holiday firm, its depreciationdeductionscannot be deferred and that the firm has no accumulatedlosses at the end of the holiday period, thus being fully

taxable when the holiday is finished. In the second part of this section, three complications are considered. The first is the possibility that depreciationdeductionsmay be deferred. The second is the tax treatmentof

associatedholiday and non-holidayfirms. The third is incorporationof both

debt and personal t-xation in the model.

A. The Basic TheoreticalModel

A competitivefirm uses capital in each period with the objective of

maximizingthe value of shareholders'equity. With no debt, the payment made

to shareholders is equal to the cash flow of the firm: revenues net of

expenditures on gross investment and corporate taxes. Labor inputs are ignored

since

there

are

no

tax

consequences

associated

with

the use of current inputs

(as wages are fully deductiblefrom the corporatetax base).

-12-

In each year, the firm earns nominal revenues equal to (l+r)tF[Kt] where w is the rate of inflationand Kt 1i capital stock. Real revenues are thus output which is representedby a strictly concave production function. The revenues are distributedss dividendsto the shareholderor used for gross

investment. Capital good prices rise with the general inflationrate, and the

price is equal to unity. Real gross investment,It, is physical depreciation (which is assumed to be of the decliningbalance form)plus new investment:

It

-

(6Kt + Kt+l

-

Kt)

(1)

Corporatetaxes paid by the firm in each period depends on whether tho

firm is operating during the tax holiday period or not. Let t-O be the time when the firm starts up and t-t* be the time at which the tax holiday ends and

t*-l), the firm's

taxable profits, revenues net of mandatory depreciationdeductions,are taxed

the firm becomes fully taxable. Prior to t*, (t- 0

at the rate uo and, for t 2 t*, at the rate ul with ul > uo.

The net-of-tax

real revenues of the firm are thus equal to F[KtJ(1-uo) and the real expenditureon gross investmentnet of the present value of tax allowancesis

equal to It(l-At). During the holiday, the tax value of depreciation allowancesper dollar of gross investment(At) varies at each point of time

which is shown subsequently.

When the firm invests in capital at time t < t*, it writes off its

gross investmentat the initial allowancerate of P.

An annual depreciation

allowance is also given based on the undepreciatedcapital cost base (UCC) which is increasedat time t, in real terms, by the amount (l-f)It, with f. denoting the proportion of the initial allowance that is written off the UCC base. If there is full adjustment,f-1 and if no adjustmentf-0. At each

-13-

point of time the annual allowance rate is a which is assumed to be of the

decliningbalance form and based on the original purchase price of capital. 9

Thus at time s > t, the annuaw allowance deducted from profits is equal to

a(l-a)5 t(1-fp)(l+ir)t,in nominal terms. Prior to t*, the initial and annual

allowancesare written off at the rate uo and after t*, the remainingannual

allowanceon the investmentsmade prior to the terminationof the tax holiday

is written off at the rate ul. Since these tax depreciationwriteoffs are

valued in nominal terms, they are discountedat the nominal interest rate i.

Deflating by the price index at time t, the real value of tax depreciation

allowances,At, are computed as follows:

At - uop +(l-ff)

t*-l

E auo5

s-O

+

+s u [a

s-t

s-t

s-t*

l+

(2)

Equation (2) yields a simplerexpressionfor At which is the following:

At - uop + Z (uo + (ul uo)[(l.a)/(l+i)]t* t)

for t < t*.

(3)

and Z - (1-f)(l+i)c/(o+i). The tax value of depreciationwriteoffsare thus

equal to the value of initial allowance (uop) plus the present value of the

annual allowanceswritten off during and after the holidays. Given ul > uo,

the firm is given an additional tax benefit arising from the deduction of

2/ The theory is easier to present with declining balance tax depreciation. Straight line depreciationis more common, as discussed in Section II, so depreciationrates were adjusted for the empiricalwork presentedin Section

-14-

depreciation allowances after the holiday.

However, the value of the

deduction is lower the earlier that the investment takes place during the

holiday since [((-a)/(l+i)]t*-tis lower in value for t<t+l. For investmentsundertaken after the holiday period is terminated, real revenues are equal to F[KtJ(l-ul) and the real cost of investment expenditureis It(l-At)with

At - ulf + (l-fp) |

ua

S1-

u)up

+ Z) for t ; t*.

(4)

After the holiday is finishedthe presentvalue of tax depreciationallowances is time invariantsince 8 and Z are independentof t. This is the usual case found in the tax literature (note if P-O, At- ula(l+i)/(a+i)which is the

presentvalue of annual tax depreciationon a decliningbalancebasis). Given the above description of cash flows, the value maximization problem is formulated. Let the real discount rate of the firm be l+r which is equal to (l+i)/(l+s). Shareholders'equity is the discountedvalue of real

cash flows earned during and after the holiday period:

V -

.1

t-o (l+r)t

F[Kt](l-ut)

-

(6Kt

+ Kt+l

-

Kt)(l

-

At)

(5)

with At definedby equations(3) and (4) and ut denoting time varying corporate

tax rates. For convenience,let At - A for t 2 t* since the present value of tax depreciationallowanceson gross investmentis shown to be time invariant

after the tax ho'iday. The firm maximizes its value choosing Kt in each period. The first

order conditionsare of three types:

For t < t*:

a3L

1 t F(J-uo) - (6-l)(l-At)l-

l

1l-At-l1- 0

(6.1)

For t - t*:

-15-

V- 1 [F(1-u1) - (6-1)(1-A)J

aKt* (l+r)t

t

For t > t*:

aKtt1+r)tt(I+r)t-l

AL. -

I

IF

(lvl

-

(6-1)(1-A)]

- L

(1l-At*l]- 0

11-Al

-

0

(6.2)

(6.3)

Equation (6.1) to (6.3)are rearrangedusing the expressionsfor At so

that the familiar user cost of capital is derived as described below.

Intuitively, the firm equates the discountedmarginal value of capital in

period t with purchase cost of acquiringcapital in period t-1. The discounted

marginalvalue of capital is net-of-taxmarginal revenues,Fj(l-ut)/(l+r),plus

the discountedresale value of capital net of the tax value of depreciation

allowances that would be lost to the firm if capital is sold in period t:

(l-6)(l-At)/(l+r). The cost of buying capital in period t-l is its purchase

cost (net of tax depreciationallowances),l-At.l. Each of the three cases are

describedaccordingto when the investmenttakesplace.

InvestmentsDuring the HolidayPeriot:

When t < t*, the user cost obtained from equation (6.1) is

Fs

($+r)(l-At)+ (1+r)(At-At-1)

t

(l-uo)

(1-uo)

_ ($+r)(l-At)

(1-uO)

+ (ul-uO)(l-fP)e(l+r)

(i-Uo)

(l-a't*-t

Ll+iJ

(7.1)

-16-

The user cost of capital during the tax holiday is composed of two parts as shown in the first line of equation (7.1). The first expression is quite familiar: the costs of holding a unit of capital are depreciationand financing costs adjusted for taxes. The expression (1-At) is the real purchase cost of capital net of the tax value of depreciationand investment

allowancesat time t*. The expressionis also dividedby (1-uO) since marginal

the rate uo. The second

part of the expression (7.1) in the first line is the cost to the firm of purchasingcapital in period t-l rather than t. Since depreciationwriteoffs increase in value over time, the firm is better off waiting one period. The expression of equation (3) is substituted into (7.1) and rearranged by combiningterms, yieldingthe second term of the right hand side in line two of equatluA (7.1). This expressionis interpretedas the tax depreciationpenalty

revenues (gross of depreciationcosts) are taxed at

of investingin assets during the holiday rather than waiting until the holiday

terminates. In most cases, 100% of the firm's profits are exempt from taxation.

This implies that uo-O and that the present value of tax depreciation

allowancesare based on writeoffsmade after the tax holiday is completed: At- ulZ((l-a)/(l+i))t*-t (the value of tax depreciation allowances after the

holiday is terminated). With a full exemption, the user cost of capital in

equation (7.1)becomes the following:

Ft - 6 + r - [6(1+w) - (a+1)]ulZf(l-o)/(l+i)]t* t/(l+s)

t

(7.1')

Let 6ff * 0. During the tax holiday, the user cost of capital is equal to the cost of depreciationand finance less the gain to firm in tax depreciation

allowancesafter the holiday is terminated. The interpretationof this formula

is straightforward. By investingin capital in period t-l (yieldingincome in

period t), the firm replaces 6 units of capital in period t. This generates

tax depreciation

allowances

-17-

per

dollar of capital equal

to ul Z

[(l-*)/(l+i)lt*tafrer the period. However, the firm, by investingin capital

in period t-l rather than in t, loses in present value terms, tax depreciation

that

multiplied by the present value of tax depreciation allowance later eariied by

would

be

based

on

higher

capital

good

prices.

This

is

the

term

a+w

the

firm.

Equation

(7.1')

leads

to

the

following

conclusionregardinga tax

holiday

were equal to the tax deRreciationrate Rlus inflation,the caRital good would

be exemRt from cgRital taxation during the holiday. 10 If, however, economic

that

fully

exempts

a

firm:

if

the

firm's

economic

deRreciation

rate

depreciationwere more (less) than tax depreciation plus inflation,capital

during the holidaywould be subsidized(taxed).

The user cost of capital in (7.1) and (7.1') also shows that there

are other distortions associatedwith tax holidays. Non-depreciableassets

such as land and inventoriesare fully exempt from taxationduring the holiday

(sinceZ-0). If depreciableassets are written off quicklyor if there is high

inflation,the non-depreciableassets are favouredby the tax holiday. Also,

for a given tax depreciationrate, durableassets are favored less compared to

non-durableassets during the tax holiday. It also easy to determinethat the

cost of capital during the tax holiday when profits are fully exempt rises

(falls)continuouslyif I+w> 6 (< 6).

lQ/ If the tax depreciationallowanceswere indexedfor inflation,the inflation term would drop out and all that would matter would be the relationship between economicdepreciationand tax depreciation.

-18-

Investmentat the End of the Holiday Period:

When t-t*,

the

tax holiday ends and the firm becomes fully taxable.

Its income, however, is based on its capital stock held in period t* but determinedby the new investmentdecisiontaken in the previousperiod when the holiday was operating. Thus, the present value of tax depreciationallowances ls in part influencedby investmentdecisionstaken in period t*-l even though the its income generatedin period t* is fully taxed. All this is determined

by equation (6.2)which is rearrangedwith substitutionsmade for At using the expressionsin equations(3) nd (4). The cost of capitalfor this case is the

following:

F-

(6+r) fl-Al+ (l+r) (ul-uO)[B+(l-fB)c]

(7.2)

(1-ul)

A - ul( + Z].

(1-ul)

Intuitively,the user cost of capital stock for period t* is equal to

the cost of depreciationand finance adjusted for taxes in two ways. First, the corporate tax levied on revenuesearned after the holiday is based on the

post-holidaystatutorytax rate. Second,the purchase cost of holding capital

is adjusted for the present value of tax depreciationallowances (A) that are incurredby the firm wtienreplacingcapital at time t*. However, because the capitalstock decision at time t* is determinedin the period before the end of

holiday, a correctionmust be made for the loss in the tax value of initialand

annual allowancesarising from investing too early in period t*-l. This tax

penalty is capturedby the second term of equation (7.2).

.19-

InvestmentsMade After the Tax Holidav:

When t > t*, the firm is fully taxed both at the time of investment

and when income is generated. In this case, the familiaruser cost of capital

formula for a firm is derived:

F' - (6+r) (1-A)

t

(1-ul)

for t > t*.

(7.3)

The post-holiday user cost of capital is adjusted for the full

statutory corporate tax rate and the tax value

are availableafter the holiday period. 11

of investmentallowancesthat

Note that the cost of capitalafter

period t* is time invariant.

B. Some Comolications

The above theory can be extended in three directions to take

int'.account various complicationsin tax codes that are relevant to the

impact of tax holidays on investment. The complications that are to be

considered are the following: (i) the deferral of depreciationdeductions

until after the tax holiday: (ii) the treatmentof associatedtax holiday

(pioneer) and non-pioneerfirms; and (iii) financialpolicy and time varying

personal tax rates.

11/ Some tax holidayprovisionsalso exempt the firm from paying sales taxes and import duties on their capitalgood purchases. If taxes are paid on capital goods, the price of capital in real term is (1+r) instead of 1 dollar (letterr be the sale tax or import duty rate). The cost of capital is thus adjustedby multiplyingthe term [1-Alby (l+r) in expression(7.1) to 7.3) where applicable,assuming that depreciationis based on the tax inclusive price of the asset.

-20-

(i) Deferralof Deprociatton

When depreciationis deferreduntil after the holiday, the firm

deductsthe allowancesfrom taxableincomeat the post-holidaycorporatetax

;ate. This could cause the firm to be non-taxpayingfor a lengthytime if

unusedholidaydepreciationallowancesare largerelativeto post-holidaynet

revenues. For convenience,it is assumedthatthe firm is taxpayingafterthe

holidayso deductionsare used immediately,beginningat timet*.

If deferral does arise, the present value of tax depreciation

allowAncesare calculatedbeginningin periodt as follows. At time*-t* (ie:

when the holidayis over),the firmdeductsthe initialallowanceat the value

ulP or in present value terms at time s-t,

expenditurein periodt alsoadds1-fpdollarsof investmentexpenditureto the

UCC basewhichis usedto calculatethe annualallowancegivenat the ratea on

a decliningbalancebasis. 12

the holidayis finished(s2t*). The deductionfor the annualallowanceis

equal to the nominalvalue ula(l-a)st* in each post-holidayperiod. In

presentvalueterms,at timet, thisis equalto ula(la)s-t*(l+i)-(s-t*).The

ulp(l+i](t*t). Investment

The firmdeductsan annualallowanceonlyafter

taxbenefitof depreciationallowancesis thusequalto the following:

30 s-t* At - [ulp+ (l-ff)(E ula [(l-a)/(l+i)J )| (1+i)

.(t*-t)

t-t*

(8)

-(t*-t)

- ul[#+Zj(l+i)

for t s t*.

1/ In some cases, the total amount of depreciationundeclaredduring the

holidaymay be expensedat the end of theholidayratherthanwrittenoff

in

the post-holidayperiodat the ratea. This practicedoesnot seem to followedin the countriesthatare dealtwith in thispaper.

be

21-

The cost of capital is derived followingthe samemethodologyas

beforeexceptfor the use of equation(8). The threeexpressionsfor the user

cost of capitalare the following:

HolidaYPeriod (t < t*):

PI

- (6+r) [1-ul(B+Z)(l+i)-(t*-t)I+ ul(B+Z)(l+i)-(t*-t) (9.1)

(1-uo)

(l-uO)(l+*)

End of Holdax (t - t*)

PI - (6+r) (1-ul(#+Z)]+ iul(O+Z)

(1-ul)

(l-u 1 )(l+*)

-ostHolidZy(t > t*):

F' - (6+r)(l-A)

(1-u

l )

(9.2)

(9.3)

Equations(9.1)and (9.2)are similarto (7.1)and (7.2)respectively

except for the treatmentof the value of tax depreciationallowances. The

valueof tax depreciationallowancesfor investmentsduringthe holidayperiod

are the discountedvalue of writeoffs that begin after the holiday is

completed.This is quiteunlikethe case (equation(7.1)when the firmmust

writeoffcapital during the holiday(and thus 'as only ( 1 -*)t*'tunits of

capitalinvestedat time t to writeoff).The secendterm in equations(9.1)

and (9.2)are also similarin interpretation.Ther'denotethe tax penaltyof

investingin capitalprior to the end of the holidayand takingdepreciation

allowancesafterwards.If the firmcouldcarryforwardits tax deductionsat a

rate of interest,thenthis secondtermwoulddisappear.Equations(9.3)and

(7.3)are identicalas one wouldexpect.

-22-

If the firm is able to defer its tax depreciationuntil after the holiday is completed,capital investmentmay be subsidizedespeciallyif the firm is fully exempt (uo - 0). For example in the first term of equation (9.1) the firm is able to deduct its depreciationallowancesat the rate ul which is higher than the tax on revenues (uo). The only cost to the firm of investing

in capital at time t (< t*) is the loss in the present value of tax depreciationallowancesby investingin capital as captured by the second term

in equations(9.1) and (9.2) respectively. In some countries,such as C6te d'Ivoire,the firm may choose whether to deduct or not its depreciationallowancesduring the holiday period. The choice made by the firm is determinedby comparing the present value of tax depreciationallowancesfor each strategy. Under deferral, the present value of tax depreciation(denote Ad) is equal to that shown in equation (8) and

under no deferral, the present value (And) is that shown in equation (3). Deferral is preferred if Ad - And > 0, implying ul(#+Z) - uoZ[l-a]t*-t> 0.

Given that ul > uo, 8 2 0 and (1-a) < 1, it is clear that deferral is always preferred. This is a useful result for empiricalwork presentedlater in that

it can be assumed that a C6te d'Ivoire firm that is given only a partial exemption during the last three years of the holiday, would still prefer to defer its depreciationdeductions.

(ii) AssociatedNon-TaxHoliday Firms

Tax holidays in many countriesare given to designatedfirms that may be owned in associationwith other taxpaying firms. As result, there is a

clear incentive for owners to shift income from taxpaying into tax holiday entities and similarly, shift tax deductible costs from tax holiday to

taxpaying firms to minimize corporate tax payments. For example, one strategy would involve intercorporatetransferpricing. Transactedprices of goods and

-23-

services sold by a tax holiday firm to a taxpayingone can be overstated,thus

allowing the firms to pass taxable income from the taxpaying firm to the tax

holiday one (and vice versa if goods and services are sold from the associated

taxpayingcompany to the tax holiday firm).

Unless tax administrators institute and enforce "tax-avoidance"

rules, tax holidays provide significantadvantagesfor investmentsundertaken

by associated taxpaying firms. This argument can be elaborated upon by

consideringthe followingcase which assumes that the post-tax holiday regime

is the same that applying to all taxpayingfirms.1 3

Suppose that the proportion, ec,of net revenues is shifted from

taxpaying to non-taxpaying firms (but not so much that the taxpaying firm

becmes a tax loss company). This implies that the effective statutory tax

rate t-hatis applied to the net revenuesearned by

the taxpayingcompany is p -

ecuo+(l-x)ul. Since tax depreciationis deductibleat the rate ul, the present

value of tax allowancesfor the taxpayingfirm is A- ul[, + Z]. Thus the user

cost of capital for the taxpayingfirm takes into account the low tax on the

firm's net revenues. This impliesthe followingcost of capital:

F' - (6+r)(l-ul[#+Z])

(10)

Since p < ul, capital investmentundertakenby the taxpayingfirm is encouraged

by shiftingnet revenues into the associatedtax holiday firm.

If a tax holiday firm is associated with a taxpaying firm, its

investment decision is only affected to the extent that the firm can shift

depreciationdeductionsto the taxpayingcompany. The discussionbelow applies

j2/ As surveyed in Section II, several of the countries may give other tax

incentivesto non-tax holiday firms

thus making post-holiday tax regimes

differentthan the tax regime faced by associatedtaxpayingcompanies.

-24-

to both cases which involve either mandatory or permissive tax depreciation deductions. This can be achieved throughleasing arrangementswhich allow the taxpaying company to own the capital (and deduct depreciation)and receive a taxable lease payment for use of the capitalby the tax holiday firm. The tax

holiday firm, however, can only deduct the lease payment at its effective statutorytax rate which could, in fact, be zero. Thus, since the asset held

by the taxpayingcompany is fully taxed, the only tax minimizingstrategy that

can work is for the lease payment to be less than amount of depreciation deducted so that the taxpaying company incurs a taxable loss on the

transaction.

This "tax-avoidance" technique can be easily prohibited by

requiring lease payments to be no less than the deductiblecosts incurredby the taxpayingcompany that holds the asset. If such a restriction applies,

the capital stock decisionmade by the tax holiday firm is not affected at the margin.

The above discussionassumes that both types of associated firms do

not incur taxable losses. In some countries,associated firms may have to

consolidate accounts when losses are incurred so this may impact on the

investmentdecisions of the two types of firms. If the taxable loss of the

holiday firm is fully written off the Income earned by an associatedtaxpaying firm, the holiday firm is able to transferdepreciationdeductionsto the non-

holiday company. However, income is also transferred,and thus taxable,since

the taxpaying firm adds the income to its own to determine the overall tax

liability. If this happens every year during the tax holiday, the holiday firm's investmentis taxed as if it were not in the holiday (again,assuming

that post-holidaytax provisionsare the same as those that apply to taxpaying

firms in general). Thus the cost of capital for the tax holiday firm, for this

particularcase, is the same as that shown in equation (7.3).

-25-

If the tax loss is incurred by the taxpayingcompany and is written

off against the income of the associated tax holiday firm, investment decisions made by the taxpaying company could be significantly affected.

Without consolidation,a tax loss company may carry forward its tax losses for a maximum number of years, in some countriesindefinitely. In present

value terms, the tax benefit of marginal losses incurred in period t is the discountedvalue of tax writeoffstaken in th. period t' wlsen the firm becomes taxable. This implies that the tax on net revenues earned in period t

by the tax loss firm is u- ul[l+il-(t'-t). As for depreciation,initial and

annual allowancesdeductionsare carried forwardto t' and fully written off

and remaining allowances are written off income after t'. Thus, the present value of depreciationdeductionsduring the tax loss years is equal to

At-up + u(l-sp)l.(l-a)(t'.t))+uZ(l-a)t'-t. Without consolidation,the cost of capital for the tax loss company is the following(correspondingto equation

(7.1)):

F' - (6+r) [1-Atl+ (l+r) (At-At-1)

-C t-

tj)

(l-V)

(11)

If, however, the tax accounts of the associated companies must

be consolidated,the non-holidayfirm must deduct its loss against the income

of the holiday firm whi:h could be fully exempt from taxation. Since fewer

losses are carried forward by the non-tax holiday firm, it becomes taxpaying earlier than t'. Thus, both current and future investmentdecisions of the non-tax holiday firm are affected by consolidationsince future income is

less shelteredfrom taxation. When losses are transferred to the tax holiday firm that is

fully exempt, the tax on income earned by the non-taxholiday firm is zero.

As for depreciationdeductions,there is some value still left to the non-tax

holiday firm since non-transferred future annual depreciation allowances

-26-

remain deductible against future income. All this implies that, in

expression(11), the discountedtax rate is u-O, and the present value of

tax depreciationallowancesis At - u 1 Z[(l-a)/(l+i)]t"-t(t" is the first year

after t in which annual depreciationallowancesare deductibleby the taxpaying

company). If assets, such as structures,are written off slowly over time,

capital investmentof the non-tax holiday firm could be encouragedif losses

must be transferredto the tax holiday firm.

However, future investmentof

the non-taxholiday firm is no longer shelterod from tax writeoffs so that

it becomes more highly taxed as a result of consolidation.

(iii) Personal Taxationand Debt Policy

The analysis so far ignores both personal taxation and debt policy.

To take both of these factors into account the model must be revised

accordingly. This is done by first reformulating the firm's maximization

problem to be one in which shareholders'equity is maximized rather than

cash flows. The equity maximizationproblem is then converted into a value

maximizationproblem which involvesthe firm discounting its cash flowsby a

discount rate that is a weighted average of the costs of debt and equity

finance. As shown later, the discount rate actually varies over time because

of the expected changes in tax rates after the holiday is terminated.

When a firm undertakes investment, it finances capital from

three sources: retained earnings, debt and new equity issues. (The latter

source of finance is ignored to simplifythe presentation.) 14 Investorsface

14/ Since dividends may be exempt during the holiday, new equity may be a favoredsource of finance during a holiday. It is quite easy to adjust the cost of capitalof a holiday firm for now equity financeby letting the cost of finance faced by the firm to depend on the dividend tax rate faced by the shareholders. See Boadway [19881.

-27-

three types of personal taxation. The first is the tax on nominal interest

income which is assumed to be levied at the rate m. The second is tax on

dividendswhich is assumed to be levied at the rate Oo during the holiday and

9j after the holiday (note that the dividend tax rate is assumed to be

net of dividend tax credits that may paid for integrationof corporate and

personal taxes). The third is the nominal capitalgains tax that is assumedto

levied at the rate c on an accrual basis. 15 At the individual level,

interest, dividends and capital gains may be taxed at different rates

according the individual'sincome and nationality. Below, it is assumed that

investorsin the tax holiday firm are identicaland residentof the country.

In a capital market facing no imperfections such as credit

rationing,shareholdersare willing to hold equity at the margin if the net-

of-tax dividendsand capital gains earned by investing in equity equals

the net-of-tax return on investing the same funds in a bond. This

capitalmarket constraintholds each period during and after the holiday period

and is written as follows:

i(l-m)Et- (1-0t+l)Dt+l+ (l-c)[Et+l- Et]

(12)

with

9 t-0O for t<t* and Ot - °1 for t2t*. The dividend in each period is equal

to the nominal net-of-corporatetax cash flow of the firm, Xt, plus new bond

issues (used to financecapital acquiredin period t) less net-of-corporatetax

interestpayments:

Dt - Xt + Bt+l - Bt -i(l-ut)Bt

(13)

jj/ Unless capital gains are exempt from .axation,most countries tax capital gains on a realization basis. The accrual tax rate is derived by calculatingthe present value equivalentof capital gains taxes paid when the asset is disposed. See Auerbach (19831for a discussionof this.

-28-

where ut-uO for t<t* and ut-ul for tMt*. Cash flow (arisingfrom transactions

in real goods) is equal to nominal revenues net of nominal gross

investmentand corporatetax payments (the latter is the tax on revenues

net of capital cost allowances):

Xt - (l+w)tF[Ktj(l-ut)- (l+r)t(Kt+l-Kt+6Kt)(l-utp)+ utaK't (14)

Note that K't is the UCC base for annual depreciationallowances. 16

With differentialtaxation of capital income both at the company

and personal level, there is an incentive for firms to issue securities

which bear the least tax paid by investors. If equity income bears little

tax relative to bonds, equity finance would be preferred and vice versa. In

the model below, only retentions and bond finance are considered.

Since dividend taxes are capitalizedin share values, they have no impact on

the marginal finance decisions. 17 On the other hand, capital gains taxes

are relevant since the retention of profits increase the value of shares

that are assumed to be taxed at the individual level at the rate c. Thus,

§J/The UCC base following:

at

time

t, assuming

t

no

deferral

of

allowance,

is

equal

to

the

K't - K' 0 (l-a)t + E (l-fp)(l+r)s(Kt+l-Kt+6Kt)(l-a)t-.

s-0

This equation, describing the nominal value of the UCC base, is used to compute the present value of tax depreciationallowances.

1Z/ The relevant personal tax rate on equity income depends on the view taken regarding the role of dividends in a financial model. One view, due to Auerbach [1979] is that the dividend tax is full capitalized in share values. If the firm uses retentionsas a source of finance, the relevant tax rate is c. If dividendsconvey informationto the market, the effective personal tax rate on equity income may be a weighted average of personal

dividend and capital gains taxes (Poterba and Summers

assume "tax capitalization"of dividend taxes so that only the capitalgains

tax rate is relevant at the margin. If new equity is issued, the personal dividend tax would directly financialdecisions.

(19851). Below, we

the effective tax on a unit of

-29-

retained profit is ut+(l-ut)c and on

bond interest m. Since equity income is taxed less during the holiday, a

firm would favour equity financecomparedto the period after the holiday.

If there were no cost to issuing differenttypes of securities, only

one least-taxedsource of finance would be used-retentionsor debt. However,

securities are issued at cost so that the firms must minimize the cost of

financial funds trading off tax benefits with other attendant costs. For

example, debt may increase the cost of bankruptcyso it is unlikely that

capital would be fully debt financed. This suggests that an optimal debt

policy may exist although differing in the

Without deriving an optimal debt policy, we assume that the firm finances

itself keeping the its optimal debt-valueratio (denoted yt) constant in each

pre- and post-holidayperiods.

regime:pre- and post-taxholiday. Note that the firm's value at each point of

time, denoted Vt, is the sum of the 'market" value of debt and equity.1 8

There are thus two optimal financialpolicies in each period such that (-yo<

'.)

-

These assumptionsregardingfinancialpolicy may be used to derive

a

value maximizationproblem for the firm.

If equation (13) is substituted

into equation (12),it can be rearrangedto obtain:

Et[l+i(l-m)]+Bt[l+i(l-ut+l)](

1 - 9 t+l)

_

(1-c)

(l-ft+l)Xt+l+ Et+l + Bt+l ( 1 -ft+l)

(1-C)

(1-c)

(15)

]f/The financial policy of the firm is thus determined independentlyof the capital stock decision. This procedure is only valid for particular financialmodels. See Bartholdy,Fisher and Hintz [19871.

Let Vt -

-30-

Et + Bt (1-ft+l)/(l-c) and yt - Bt(l-ft+l)/(l-c)Vt.

The

formulationof this problem requires one to interpretthe "market"value of

the firm carefully. The nominal value of bonds issued by the firm from the

point of view of the equity investor must be corrected by the tax

capitalizationfactor (1-Gt+l)/(l-c). The tax capitalizationfactor reflects

the following. If the firm buys back its bonds in period t+l that were issued

period t (Bt), the value of equity falls by (l-c)Bt but dividend payments

increase by (l1-t+l)Bt. Thus the firm's value rises by (l-Ot+l)/(l-c)when

the firm buys back one dollar of its bonds Bt.

The definitionof Vt is substitutedinto equation (15) yielding:

Vt[l+Rtl - (l-Ot+l)Xt+l + Vt+l

(1-c)

(16)

where Rt - 7ti(l-ut)+ (l-7t)i(l-m)/(l-c),the weighted average nominal net-

of-corporatetax cost of equity and debt finance. Since tax rates and the

weights only have values that differ according to when the

firm is

operating (pre- or post-tax holiday), Rt is only of two values, Ro and R 1 .

Equation (16) holds at each point of time so it is straightforwardto obtain

the value maximizationproblem for the holiday firm that starts up at time

t-O:

t*-l

-o~ z

xt(l-eo)+c

xt(1-01) 1

t-0 (1+Ro)t(l-c) t* (1+Rl)t(l-c)

with 1 _ (l+Rl)t*

.(l+Ro)

(17)

Equation (17) can be further manipulatedby using the definitionof

the Xt and dividing termsby the price index (l+ir)tto yield:

co

( 1 - 9 t)(FlKt](1-ut)-(Kt+l-Kt-6Kt)(1-At)

t-O

(1-c) (l+rt)

f

with rt -

-31-

1 for t<t* and S for t2to; (l+rt)t - ((l+Rt)/(l+w))t and

At- uop + [uoZo(l-Yt)+ ulZl (1i)Ytl

At- u 1 l(p + Z 1 ] - A

(1-90)

for t < t*

for t 2 t*

(18)

with Zt- (l-fP)(l+Rt)a/(a+Rt)and Yt- [(l-*)/(l+Ro)lt*-t.

The analysis of the previous section is repeated by finding the

optimal choices for capital taking into account both personal taxes and

financialpolicy. The user costs of capital for a firm during and at the

end of its holiday are:

Holidav Period-:

F' _ (6+ro)(1-At)+ (l+ro) (At-At-l)

(19.1)

t

(l-uo)

(l-uO)

End of Holidas:

 

Ft

-

(6+ro)(l-A)+ (1+ro)

(A-At*.l(l-#l)/(l-.o))

(19.2)

t*

(l-ul)

(l-ul)

The post-holidayperiod user cost of capital is the same as that derived

earlier for equation (7.3) except that r is replacedby r 1 (the cost of finance

is the weighted average cost of funds in

the post-holidayperiod).

Expressions 19.1 and 19.2 are similar to 7.1 and 7.2 respectively

except for three adjustments. First, the cost of financeis no longer the cost

of equity finance; instead, it is now the weighted average cost of equity and

debt finance during the holiday period. Second, the present value of tax

depreciationallowanceare discountedby the weighted average cost of finance

rather than the cost of equity finance (with the discountrate varying from the

holiday to post-taxholiday period). And third, the value of tax depreciation

allowancesare adjusted for the change in dividend tax rates from the holiday

to post-taxholiday periods.

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Although personal taxationand debt financecomplicate the analysis,

the results easily generalize. There are a few points that are worth noting. First, when the personal tax on dividendschanges at the end of the holiday period, the div Send tax is not "lump sum" as found in the conventional analysis. A jump in the dividend tax directly affects the user cost of

capital through depreciationdeductionssince they are less valuable after the holiday is terminated. Even though we began with the tax capitalizationtheory