International Tax and Public Finance, 1:227-245 (1994)

9 1994 Kluwer Academic Publishers

Taxes and Production: The Case of Pakistan

JEFFREY I. BERNSTEIN
Carleton University, Ottawa, Canada and the National Bureau of Economic Research, Cambridge, MA, U.S.A.
ANWAR SHAH
The World Bank, Washington, DC, U.S.A.

Abstract

This paper investigatesthe effectivenessof investmentincentives and corporate income taxes in influencing pro-
duction and investmentdecisionsin the Pakistaniwearing apparel and leather products industries. Three tax instru-
ments are considered: the corporate income tax (CIT), the investmenttax credit (ITC), and the capital cost allow-
ance (CCA).
The results show that since there are significant capital adjustment costs, it is important to distinguish between
the short, intermediate,and long-runeffectsassociatedwith the tax instruments. Productiondecisionsare relatively
more responsiveto changes in the ITC rate compared to changesin either CCA or CIT rates in each run. However,
only in the long run for the apparel industry are the ITC and CCA rates cost effectivein stimulating investment.
The CIT is never cost effective. Thus targeted instruments outperform the general CIT instrument. In addition,
although the incentive to invest is enhanced, there is little effect on output. Therefore, tax incentives essentially
make production techniques more capital intensive.

Key words: production,taxes, capitaladjustment, corporateincometax, investmenttax credit, capitalcost allowance

Tax policy is an important government instrument that has been used to influence output
supply, factor requirements, and capital expenditures. The purpose of this paper is to develop
and estimate a model in order to investigate the effectiveness of investment incentives and
corporate income taxes in altering production and investment decisions in the Pakistani
wearing apparel and leather products industries. These industries are selected because of
their importance in the Pakistani economy. The two industries account for 2.4 percent of
total manufacturing output, employ about 1.9 percent of the total labor force, and con-
tribute 1.9 percent of labor compensation.
Few econometric studies focus on the effects of corporate tax policy on the structure
of production (see Bernstein and Nadiri, 1988). Some studies that have looked at this prob-
lem for developed economies are Kesselman, Williamson, and Berndt (1977), Fraumeni
and Jorgenson (1980), Jorgenson (1981) dealing with U.S. production, and Bemstein (1986),
who analyzes Canadian production. The significance of the production approach is that
changes in corporate tax policy can be analyzed simultaneously in terms of both output
and input decisions.
Three tax instruments are considered in this paper: the corporate income tax, the invest-
ment tax credit, and the capital cost allowance. A n important feature of the model is that
it allows for deviation from long-run equilibrium in the analysis of the effects of these three
instruments. The ability of tax policy to influence output supplies and input demands can
228 JEFFREY I. BERNSTEIN AND ANWAR SHAH

be hindered in the short run because of adjustment costs. Capital-adjustment costs relate
to the completion of plant construction and the installation of equipment.
Adjustment costs create rigidities that prevent factors of production and thereby also output
from moving to their long-run magnitudes. These costs can affect the pattern of changes
associated with tax policy. For example, an increase in the investment tax credit rate lowers
the user cost of capital and thereby increases the demand for capital. However, adjustment
costs limit the ability of producers to incur additional capital expenditures. As a result,
production processes shift to inputs with little or no adjustment costs that are complemen-
tary to capital. As the capital-adjustment process is completed, capital is substituted for
these complementary factors.
The paper is organized into four further sections. Section 1 contains the theoretical model.
Section 2 includes the empirical specification, estimation results, and an analysis of the
capital adjustment process for the Pakistani wearing apparel and leather products industries.
Section 3 relates to the analysis of the effects of corporate tax policy on production, and
tax policy effectiveness in terms of investment expenditures induced relative to lost govern-
ment tax revenue. The last section contains the summary and conclusion.

1. The theoretical model

A production process is defined by the following relationship:

y, = f ( K t - 1 , vt, A K t , A t ) , (1)

where y is the output quantity, K is the m dimensional vector of quasi-fixed factors (or
inputs subject to adjustment costs), v is the n dimensional vector of variable factors, and
A is the indicator of the level of technology. The production function is denoted by f It
is defined for normegative input quantities, andfis nonnegative with positive marginal prod-
ucts. The production function also declines with respect to the net investment vector, AKt
= K t - Kt-1. The net investment vector in the production function represents adjustment
costs. Adjustment costs are measured as foregone output. Inputs are diverted from output
production to changing or installing a quasi-fixed factor. The loss in output represents the
internal costs of adjustment (see Treadway, 1971, 1974; Mortensen, 1973; Epstein, 1981).1
The stocks of the quasi-fixed factors or capital inputs accumulate according to

K t = I t -4- ( I m - ~)Kt_l, (2)

where I is the m dimensional investment vector and 6 is an m dimensional diagonal matrix

of fixed depreciation rates such that 0 _< 6i ~ 1, i = 1, . . . , m. In addition, Im is the
m dimensional identity matrix.
Producers sell their products, hire or purchase factors of production, accumulate capital
stocks, and finance their operations, such that the flow of funds is given by

PtYt - wfvt - qrtIt + A B t + P s t A N s t - rbtBt-1 -- T c t - Dt = 0, (3)

T A X E S A N D P R O D U C T I O N : T H E C A S E O F PAKISTAN 229

where the product price is denoted by p, w is the vector of variable input prices, q is the
vector of capital purchase prices, B is the nominal value of outstanding bonds, zkBt = B t -
Bt-1 is the value of net new bond issues (net of retirements), Ps is the price of shares, Ns
is the quantity of outstanding shares, ZXNst = Nst - Nst_ 1 are new share issues, r b is the
interest rate on bonds, Tc are income taxes, and D is the value of dividends.
The flow of funds can be further decomposed by considering income taxes. In Pakistan
the corporate income tax rate at 30 percent and a super tax rate at 20 to 25 percent have
been maintained consistently during the last three decades? With respect to fiscal incen-
tives directed toward investment, Pakistan has relied upon a variety of instruments. These
include accelerated capital consumption allowances, investment tax credits, and tax holidays.
Capital consumption allowances follow accelerated declining balance schedules for ma-
chinery and equipment (25 percent) and structures (10 percent). In addition, in the initial
year of investment the allowance is 25 to 50 percent. Up to 1976-1977 the general invest-
ment tax credit for modernization and replacement of plant and equipment was introduced
at a rate of 15 percent but was restricted to designated areas and industries. Since that
time, the credit was made available regardless of location and industry. Tax holidays of
four years existed over the sample period for firms in the two industries under considera-
tion. The holiday was eliminated in 1972-1973 and then reinstated the following year?
In terms of the theoretical model, first we consider the investment tax credit. At time
t with a rate of 0 < t,it < 1, i = 1, . . . , m , the ith capital stock investment tax credit is

ITCit = Pitqitlit i = 1 .... , m. (4)

Second, there are capital cost allowances associated with the depreciation of the capital
stocks. In general, depreciation deductions equal d/~ on a unit value of the original cost
of the ith capital stock of age r. The capital cost allowance at time t for the ith capital
stock installed at different times is

CCAit =~]j qit-~Iit-~(1 - ~itPit)dir i = 1 ..... m, (5)

T=0

where 0 < (bit ~_. 1 is the proportion of the investment tax credit that reduces the deprecia-
tion base for tax purposes. In Pakistan, because the investment credit does not reduce the
depreciation base, the bit = 0.4
Income taxes are defined at time t by the rate 0 < uct < 1, based on revenue net of
interest payments, net of capital cost allowances, and net of investment tax credits. Thus,
income taxes at time t are

Zct = uct(PtYt - wrtv, - ?'btnt-1 -- irmCCAt) - i~ITCt, (6)

where in is the m dimensional identity vector, C C A and ITC are m dimensional vectors
of capital cost allowances and investment tax credits, respectively.
Substituting equation (6) (the income tax equation) into equation (3) (the flow of funds
equation) yields
230 JEFFREY I. BERNSTEIN AND ANWAR SHAH

(PtYt - w~vt)(l - uct) - qTtlt + i~(u~tCCAt + ITCt) = [Dt/(Pst_lNst_O

+ Apst/pst-llP,t-lN,,-i + rbt(1 -- Uct)nt-1 -- A(pstN~,) -- 2tB,, (7)

where Aps t = P~t - Pst-p The left side of equation (7) shows revenue net of tax, net of
variable input cost, and net of investment expenditures. The right side of the equation shows
the flow of funds to bondholders and shareholders.5
Producers maximize the expected present value of the flow of funds to their owners.
In order to determine this expected value, define financial capital as lit = P s t N s t + n t and
so AVt = A(PstNst) + A~Bt, then equation (7) can be rewritten as

Ft = [r~t/(1 + et-~) + rbt(1 -- u~t)et_j(1 + et_~)]Vt_l - AVt, (8)

where F is the left side of equation (7), which is net after-tax revenue. The rate of return
on shares is rst = Dt/(Pst_lNst_l) + z~Pst/Pst_l, which consists of the payout ratio--that is,
dividends per value of outstanding shares plus the capital gains (or losses) on share prices.
Leverage of a firm is et-1 = Bt-l/pst-lNst-1, which is the ratio of debt to equity capital.
Define o as the expression in the square brackets in equation (8). It is a weighted average
of the rates of return on equity and debt and thus is the rate of return on financial capital.
Assuming that firms cannot affect the rates of return on financial capital that they supply
(for example, these rates can be fixed on the world financial markets), then producers act
to maximize the expected present value of financial capital.6 Solving for Vt and applying
the conditional expectations operator yields the expected value of financial capital to be

Jt = Et ~ c~(t, r)[PrYr -- WTvT -- QVrlr - imM~l, (9)

T=t

where Et is the expectations operator conditional on information known at time t, the dis-
count rate is the rate of return on financial capital or(t, t) = 1, or(t, t + 1) = (1 + Or+l)-1,
P = p(1 - uc) is the after-tax product price, and Wj = wj(1 - uc), j = 1. . . . , n are the
after-tax variable factor prices.7 Q is an m dimensional vector of after-tax capital purchase
prices, QiT = qiT(1 - vi7 - Y"s~oOt( t, 7" + s)ot(t, "r)-lucr+s(1 - dpiTvir)dis). 8 M is an m
dimensional vector of tax reductions at time t, due to capital cost allowances arising from
past investment expenditures MiT = ucTZ~=,qi~_sI,.~_s(1 -- 4)i~-s Pir-s)dis .9 Production deci-
sions pertain to the net after-tax flow of funds so that the right side of (9) is maximized
by selecting output supply, variable factor, and capital demands.
Production decisions can be solved in two stages. The first stage relates to the short-run
decisions and the second stage concerns the intertemporal choices. In the first stage, the
short-run equilibrium is found by maximizing after-tax variable profit at each point in time
by selecting output supply and variable factor demands conditional on the capital inputs
and subject to the production function. Thus,

max PtYt - W.Tvt, (10)

(Yt,Vt)

subject to equation (1), given the capital inputs.

TAXES AND PRODUCTION:THE CASEOF PAKISTAN 231

Substituting the solution to the short-run production problem into (10) leads to the after-
tax variable profit function

7rt = II(Pt, Wt, Kt-1, Agt, At), (11)

where 7r is after-tax variable profit (defined by (10)), II is the after-tax variable profit func-
tion that is defined for nonnegative after-tax prices and capital inputs. It is increasing in
the after-tax product price and capital inputs and decreasing in the after-tax variable factor
prices and net investment levels) ~
The output supply and variable factor demand functions can be obtained from (11) by
using Hotelling's Lemma (see Diewert, 1982):

Y7 = IIp(Pt, Wt, Kt-D AKt, At) (12)

f f = - V n w ( p t , wt, K,_~, zXKt, At). (13)

The short-run equilibrium output supply and variable factor demand functions depend on
after-tax prices, capital inputs, investment levels, and technology indicator.H
The second stage of the program involves the determination of the demands for the capital
inputs. This stage relates to the intertemporal aspects of production decisions. Demands
for the capital inputs can be obtained from substituting (11) into (9),

max Et ~ ] co(t, r)[II(P~, W~, K~_ 1, AK~, A 0 - QfI~], (14)

{x,}~=, t=~

subject to the capital-accumulation equations (denoted by equation set (2)). The first-order
conditions for this problem at any time period, after substituting equation set (2) into (14), are

V(OTrt/OAKt) -- Qt + Eta(t, t + 1)[V(OTrt+l/OKt) - V(OTrt+JOAKt+l)

+ (Ira - r = 0m. (15)

Equation set (15) implies that the marginal cost of a capital input is equated to the ex-
pected marginal benefit of that capital input.~2 The marginal cost consists of the first two
components in (15)--the after-tax marginal adjustment cost and the after-tax purchase price.
The expected marginal benefit consists of the remaining three components--the expected
after-tax marginal profit, the expected after-tax adjustment-cost reduction, and after-tax
purchase-price reduction from installing and purchasing (or renting) the respective capital
input in the previous period. Equation set (15) shows the intertemporal tradeoff between
higher expected after-tax future profit due to increases in the capital inputs and lower after-tax
current profit in order to obtain the increases in the capital inputs.
The complete set of equilibrium conditions are given by equations (12), (13), and (15).
These equations define a temporary equilibrium of producer behavior, in which output
supply, variable factor, and capital-input demands are determined. A significant feature
232 JEFFREY I. BERNSTEIN AND ANWAR SHAH

of the temporary equilibrium arising from the dynamic model is that it encompasses both
short- and long-run effects of tax policy initiatives. In addition, because the dynamic model
relates to the simultaneous determination of output supply and variable and quasi-fixed
factor demands, changes in corporate tax policy can be analyzed for the complete set of
production decisions.

2. The estimation model and results

In order to estimate the dynamic model of production, we need to parameterize the after-
tax variable-profit function (given as equation (11)). This function is assumed to be a nor-
malized quadratic and is written as

7Ft = t30 + t3pe t "}- ~gWet "[- ~ k g t _ l + I~aA t

+ 0.5[[JppP? + t3teW~2 + 13kkg2_l + ~aa A2 ]

+ wet + ;3pketK,_ + A,

+ 13ekWetKt_l + 13eaWetAt + 13kaKt-lAt + 0.5t3iiAK 2. (16)

In the specification of the normalized after-tax variable-profit function, it is assumed

that there are two variable factors (labor and intermediate inputs) and a single capital input.
In addition, since the after-tax varaible profit function is homogeneous of degree one in
after-tax prices, then we normalize after-tax product and labor prices and after-tax variable
profit by the after-tax price of the intermediate input. Thus 7r, P, and W e are now defined
as being normalized by the after-tax price of the intermediate input. 13
The output-supply and variable-factor demand equations that are specific to the normal-
ized quadratic after-tax varaible-profit function are

y, = 3p + 13ppPt + 13peWet + 13pkK~_l + 3paAt (17)

--Vg t = t~g + ~ffWg t -t- ~pePt --}- t~ekgt_ 1 -F ~faAt . (18)

Since -Vm = 7r - Py + Weve, then the intermediate input demand equation is

--Vrn t = t~0 + ~ k g t _ l + t~ah t -- 0.5t3ppe? - 0 . 5 ~ f f W 2 -Jr 0.5t~kkg2_l

-t- 0.5[3kkg?_ 1 + 0.5/~aa A2 -- {JpePtWet q- ~kagt_lZt -t- 0 . 5 ~ i i A K 2. (19)

Thus, equations (17), (18), and (19) define the short-run equilibrium conditions based
on the normalized quadratic after-tax variable-profit function. These equations show that
short-run output-supply and variable-factor demands depend on relative after-tax prices,
the capital input, net investment, and technology indicator.
TAXES AND PRODUCTION: THE CASE OF PAKISTAN 233

The equilibrium condition for the capital input, based on the normalized quadratic after-
tax variable profit function, and under the assumption that the discount rate, after-tax rela-
tive prices, and technology indicator are not expected to change, can be written as

K t -~ (0.5/Skk)(p -}- ~kk/{Jii -- [(p --[- 5kk/fJii) 2

+ 4flkk/flU]05)(13k + ~pkPt + flekWet + flkaAt -- Wkt)

-[- (1 -[- 0 . 5 ( p + ~kk/~ii -- [(p -'[- ~kk/~ii) 2 "[- 4 ~ k k / ~ i i ] O ' 5 ) ) g t _ l , (20)

where the after-tax normalized factor price of capital or the normalized after-tax rental
rate is Wkt = Qt(p + 6), and Q is now the normalized (by the after-tax price of the inter-
mediate input) after-tax purchase price of capital.14 Equation (20) shows that capital ac-
cummulates according to a flexible accelerator process with the speed of adjustment given
by m = -0.5(o + ~kk/~ii -- [Co H- ~kk/~ii) 2 q- 41~kk/~ii] 0"5) and the long-run demand for
capital is K[ = (--1//3kk)(13~ + BpkPt + 13ekWet -b t3kaA t -- Wkt).
Equation (20) shows the demand for the capital input. It is a function of the relative
after-tax output and variable input prices, after-tax rental rate, along with the discount rate,
technology indicator, and lagged quantity of the capital input.
The estimation model consists of the system of equations (17) through (20). Error terms
are appended to each equation. These error terms represent technology and optimization
shocks. They are assumed to have zero expected values and a symmetric positive definite
variance-covariance matrix. There are four endogenous variables--outputs supply Yt, labor
and intermediate input demands vet and Vmt, and capital input demand K t. In addition, the
exogenous variables are the normalized after-tax prices Pt, Wet, Wkt, the discount rate o,
lagged capital Kt_l, and the technology indicator At. The nonlinear seemingly unrelated
regression equations estimator is used.
Corporate tax effects are estimated for the Pakistani wearing apparel (SIC 322) and leather
products (SIC 323) industries. The sample period is 1966-1984 (see the data appendix).
The estimation results are presented in Table 1. The data for wearing apparel and leather
products industries are pooled in estimation.~5 The model fits the data quite well as seen
by the high correlation coefficient for each equation,
The after-tax variable-profit function must be nondecreasing in the product price and
nonincreasing in the variable-factor prices. This monotonicity condition is satisfied at each
point in the sample as the estimated quantities of output supply and variable factor demands
are positive. The function must also be convex in prices. This condition implies that
Bpp > O, ~ee > O, 13pel3ee - B2e > 0. From the estimates presented in Table 1, we see
that this condition is satisfied. The function must also be concave in capital and net invest-
ment, so that/3kk < 0, t3ii < 0. Again from Table 1, this condition is satisfied.~6
The adjustment cost parameters t3ii 1 and t3ii2 are significant (see Table 1) so both Paki-
stani industries are not in long-run equilibrium. The mean value of m, the adjustment speed
is 0.15 with a sample standard deviation of 0.0046 for the wearing apparel industry and
is 0.27 with a sample standard deviation of 0.0043 for the leather products industry (m
differs across industries since the estimates of/3kk and ~ii differ between the industries).
The minimum value for m in the wearing apparel industry is 0.14 while in the leather
234 JEFFREY I. BERNSTEINAND ANWARSHAH

Table 1. Estimation results.

Parameter Estimate Standard error

G0 0.6569 0.3255
/3p1 -0.6380 0.4185
/3p2 1.0351 0.1189
/3ei 0.5265 0.4544
j3e2 - 1.1359 0.2508
/3kl -0.6319 0.2133
/3~2 0.8729 0.1417
Ha -0.0487 0.9661E-02
t3ppI 0.7153 0.3075
t3pp2 1.2166 0.3430
/3ee1 15.8799 3.7637
/3ee2 30.1465 7.1338
/3k~1 -0.7120 0.1194
/3~2 -0.8931 0.1543
~ii 1 - - 49.0066 9.8668
~ii2 - 18.5949 5.2519
13pe -2.1984 0.4298
{3pk 1.3987 0.1556
/3ek - 1.1384 0.2310

Correlation
Equation coefficient Root MSE

Output supply 0.902 0.588

Intermediate demand 0.879 0.700
Labor demand 0.897 0.581
Capital demand 0.987 0.075
Objective function 126.076

products industry it is 0.26. The maximum value is 0.16 and 0.28, respectively. Thus esti-
mates of the speed of adjustment are quite stable over the sample period. The estimated
value of the speed of adjustment implies that 15 percent of the capital-stock adjustment
occurs for the wearing apparel industry within the first year of capital accumulation, whereas
for the leather products industry 27 percent of capital stock adjusts in one year. Indeed,
for the Canadian, U.S., and European manufacturing sectors, Mohnen, Nadiri, and Prucha
(1986) and Morrison and Berudt (1981) for the U.S. manufacturing sector estimated speeds
of adjustment that are very similar to the magnitudes estimated in this paper, t7

3. Corporate tax effects on production

In this section, we examine the effects of change in the corporate income tax (CIT), invest-
ment tax credit (ITC), and capital-cost allowance (CCA) rates on the production structure
or output supply and input demands in the Pakistani wearing apparel and leather products
industries. Since these industries are not in long-run equilibrium, the tax policy effects
are analyzed for the short, intermediate, and long runs.
TAXES AND PRODUCTION: THE CASE OF PAKISTAN 235

In order to investigate the effects of changes in corporate tax policy on the structure of
production, it is necessary to know the normalized rental-rate elasticities with respect to
each of the tax instruments. The reason is that production decisions are made according
to after-tax relative prices, but all after-tax relative prices, except the one associated with
the capital input (that is the normalized after-tax rental rate), are independent of the income
tax, investment tax credit, and capital cost allowance rates. Hence tax policy operates through
the relative after-tax rental rate.
Tax policy affects production decisions in the following way. A change in a tax instru-
ment alters the relative after-tax rental rate. This change then triggers movement in output
supply and factor demands through their respective elasticities with respect to the relative
after-tax rental rate. Thus two sets of elasticities are required for the determination of the
effects of tax policy initiatives, the elasticity of the relative after-tax rental rate with respect
to each of the tax instruments, and the relative after-tax rental-rate elasticities of output
supply and factor demands. These two types of elasticities are multiplied together to com-
pute the effect of a change in any one tax instrument on each of the production decisions.
Consider the relative after-tax rental-rate elasticities with respect to the tax instruments.
Note that the relative after-tax rental rate is Wk = (q(p + 6)(1 - UcZ - p))/(1 - Uc), q
is now the normalized before-tax acquisition price of capital (normalized by the before-tax
intermediate input factor price), and z = d / ( p + d ) is the present value of depreciation
deductions for tax purposes. First, the elasticity with respect to the ITC rate, keeping depre-
ciation deductions and corporate income-tax rate fixed, is

eit c = -q(p + 6)(1 + Uc(OZ/aU))u/Wk(1 -- Uc) < O. (21)

In Pakistan the ITC rate does not affect the present value of depreciation deductions, so
Oz/Ou = 0. Increases in the ITC rate lower the rental rate of the capital input.
Second, the elasticity with respect to the CCA rate, keeping the ITC and CIT rates
fixed, is

ecc~ = - q ( P + 6)Uc(Oz/Od)d/Wk(1 - uc) < O. (22)

In Pakistan, as noted, the present value of depreciation deductions is calculated using the
declining balance method of depreciation for tax purposes. Thus, Oz/ad = p/(O + d) 2 > 0.
Increases in the CCA rate lower the relative price of the capital input.
Lastly, the CIT elasticity on the after-tax relative rental rate, keeping the ITC and CCA
rates fixed, is

eci t = q(p + 6)(1 - u - ucz)uc/Wk(1 -- Uc) > O. (23)

Clearly, increases in the CIT rate cause the relative-factor price of capital input to rise.
The tax elasticities (based on a 1 percent change in each tax instrument) of the after-tax
relative rental rate are presented in Table 2. From Table 2, we observe that the ITC and
CCA elasticities are relatively constant over the sample period and across the two indus-
tries. However, we find that the CIT elasticity for both industries decreases over the sample
period. The CIT elasticity ranges from a high around 0.4 percent to low of 0.04 percent.
236 JEFFREY I. BERNSTEINAND ANWARSHAH

Table 2. Tax elasticities for the rental rate.

eitc ecca ecit

Wearing apparel
1977 -0.338 -0.285 0.359
1978 -0.366 -0.262 0.200
1979 -0.376 -0.251 0.144
1980 -0.361 -0.268 0.225
1981 -0.363 -0.267 0.217
1982 -0.348 -0.271 0.248
1983 -0.361 -0.256 0.179
1984 -0.386 -0.225 0.034

LeCher produc~
1977 -0.326 -0.287 0.425
1978 -0.348 -0.273 0.299
1979 -0.375 -0.252 0.150
1980 -0.349 -0.275 0.298
1981 -0.353 -0.273 0.271
1982 -0.330 -0.278 0.351
1983 -0.366 -0.252 0.146
1984 -0.386 -0.225 0.037

The ITC and CCA elasticities average around 0.35 and 0.25 over the period for both indus-
tries. The ITC rate appears to generate consistently greater effects on the rental rate com-
pared to the CCA rate.

3.1. Short-run tax effects

In this section we determine the effects of changes in the ITC, CCA and CIT rates on out-
put supply, and input demands in the short-run. The short-run equilibrium is defined as
equation set (17) through (20) at each point in time, under the assumption that the existing
capital stock has been determined in the previous period.
In the short run the demand for capital is affected by the after-tax relative rental rate.
However, in this run, output supply and labor demand depend on the existing capital stock,
which is given (see equations (17) and (18)). Hence these two functions are independent
of the rental rate. The short-run elasticity of capital is found by differentiating equation
(20) with respect to the relative after-tax rental rate. as This elasticity is multiplied by the
relative after-tax rental rate elasticities with respect to each of the tax instruments (given
by equations (21) through (23)).
The short-run effects of a 1 percent change in the three tax instruments for 1977 and
1984 are found in Table 3. Since increases in the ITC and CCA rates, and decreases in the
CIT rate cause the after-tax rental rate to decline, we consider these change in Table 3.
In all cases the tax effects are highly inelastic. A 1 percent increase in the ITC rate in
1984 leads to a 0.004 percent rise in the demand for capital in the apparel industry and
a 0.002 percent rise for the leather industry. The CCA elasticities are half the magnitude
TAXES AND PRODUCTION:THE CASE OF PAKISTAN 237

Table 3. Short-run tax elasticities (1 percent change in each rate).

Apparel Leather

1977 1984 1977 1984

ekitc 0.011 0.004 0.003 0.002

ekcca 0.009 0.002 0.003 0.001

ekcit 0.012 O.0004 0.004 0.0002

of the ITC elasticities. The CIT effects are ten times smaller than the ITC elasticities. In
addition, the tax elasticities decline over the period 1977 to 1984.
Equal percentage increases in the credit and allowance rates and decreases in the income-
tax rate imply differential revenue losses for the government. Thus an alternative way to
evaluate the effectiveness of tax policy is to consider the three policy changes in relation
to an equal value of lost government revenue. From Table 4, we observe the effects of changes
in the three tax rates on investment expenditures per Pakistani rupee of lost government
revenue. This ratio is calculated in the following manner. The numerator is the tax elasticity
of capital for a specific tax policy multiplied by the nominal value of capital in short-run
equilibrium. This gives the additional nominal value of capital expenditures and hence the
investment expenditures generated by a tax policy initiative. The numerator is the benefit
associated with government policy. The denominator is the loss in government revenue
attributed to the tax policy change. It is calculated as the percentage change in one of the
ITC, CCA, and CIT rates times the tax base of the specific instrument in short-run equilib-
rium. The denominator is the cost associated with the government policy. We refer to these
ratios as benefit-cost ratios.
The benefit-cost ratio for an increase in ITC rate is

Bi~c = e ~ i t c q K S / q l S v , (24)

where e~itc = e~keit c is the short-run ITC elasticity of capital demand, which equals short-
run rental-rate elasticity of capital times the ITC elasticity of the rental rate. The denominator
is the tax reduction due to the increase in the ITC and is thereby the loss in government
revenue (see equation (4) and the definition of the rental rate in the data appendix). The
superscript s represents short-run equilibrium magnitudes. 19

Table 4. Short-runtax effectsper Pakistani rupee of lost governmentrevenue.

Apparel Leather
1977 1984 1977 1984
ITC 0.722 0.279 0.261 0.109
CCA 0.523 0.230 0.182 0.090

CIT 0.046 0.001 0.014 0.000

238 JEFFREY I. BERNSTEIN AND ANWAR SHAH

Next for a 1 percent increase in the CCA rate, the benefit-cost ratio is

BcSca = e~ccaqKS/(qlSucP/(p + d ) ) , (25)

where ekcca
~ = ekkec~ is the short-run CCA elasticity of capital demand, which equals the
short-run rental-rate elasticity of capital times the CCA elasticity of the rental rate. The
denominator is the loss in government revenue due to an increase in the CCA (see equation
(5), and the definition of the rental rate in the data appendix).2~
Lastly, for a 1 percent decrease in the corporate income-tax rate, the benefit-cost ratio is

BcSt= _e~citqKS/_ (pyS _ w r v ~ _ rb B _ C C A s)uc, (26)

where ekcitS = ekkeci

ts is the short-run CIT elasticity of capital demand, which equals the
short-run rental-rate elasticity of capital times the CIT elasticity of the rental rate. The
denominator is the loss in government revenue due to a 1 percent reduction of the CIT
rate (see equation (6)).
We can observe from Table 4 that in the short run for both industries changes in the
ITC rate generate the highest level of investment expenditures per rupee loss to the Pakistani
government, while the CCA rate ranks second. We estimate that the investment expenditures
per rupee loss to the government associated with increases in the CCA rate varies from
around 70 to 90 percent of the magnitude arising from increases in the ITC rate. In 1984,
a 1 percent increase in the ITC rate generates around 0.28 of investment expenditures per
rupee loss to the government in the wearing apparel. This stimulus is two and a half times
more than that found in the leather products industry.
It is not surprising that changes in the CIT rate do not stimulate investment to the same
degree found for the other two rates. Clearly, governments change the CIT rate for a variety
of reasons, while policies resulting in variations to ITC and CCA rates are directed toward
investment expansion. Nevertheless, it is interesting to see how inelastic capital accumula-
tion is per rupee loss of revenue to the government from a decrease in the CIT rate. For
the wearing apparel and the leather products industries, the short-run magnitudes in 1984
are very close to zero.

3.2. Intermediate-run tax effects

The intermediate run equilibrium is defined by equations (17), (18), (19), and (20) under
the assumption that capital adjustment has occurred for one period (that is, one year). This
means that in the intermediate run lagged capital is replaced by the short-run equilibrium
capital in the four equations.
Intermediate-run tax elasticities for output supply and input demands are derived by using
the tax elasticities of the relative after-tax rental rate and multiplying these elasticities by
the intermediate-run rental-rate elasticities of output supply and input demands. The
intermediate-run tax elasticities are presented in Table 5. In the intermediate run, because
capital has adjusted for one year, output supply and all input demands are influenced by
the CIT, CCA, and ITC rates through the rental rate on capital.
TAXES AND PRODUCTION: THE CASE OF PAKISTAN 239

Table 5. Tax elasticities in the intermediate run (1 percent change in each rate).

Apparel Leather

1977 1984 1977 1984

eki ~ 0.019 0.008 0.006 0.003

eyi~ 0.010 0.003 0.003 0.001
ee~ c 0.007 0.003 0.003 0.002
emitc 0.039 0.005 0.002 0.002

e~c a 0.016 0.005 0.006 0.002

eycc a 0.009 0.002 0.002 0.0007
eecca 0.006 0.002 0.003 0.001
emcca 0.033 0.003 0.001 0.001

ekcit 0.021 0.0007 0.008 0.0003

eyci t 0.011 0.0003 0.003 0.0001
eecit 0.008 0.0002 0.004 0.0002
emcit 0.041 0.0004 0.002 0.0002

F r o m Table 5, we observe that the intermediate-run tax effects on output supply and input
demands are quite inelastic. The demand for capital is relatively more elastic, and inputs
are relatively more responsive than output. This implies that tax policy tends to make pro-
duction more capital intensive rather than stimulate output growth. Production decisions
respond by around 50 percent more to increases in the ITC rate compared to the CCA
rate, while elasticities associated with the CIT rate are ten times smaller than the ones
for the ITC. Comparing industries, we see that the effects in the apparel industry are gener-
ally at least twice the magnitude for leather products. In 1984, a change in the ITC rate
leads to an elasticity for capital demand of 0.008 percent in the apparel industry and 0.003
percent in the leather industry. The tax elasticities are quite stable, but production becomes
somewhat more inelastic with respect to tax policy over the sample period for both industries.
Table 6 shows the effects of changes in the ITC, CCA, and CIT rates on investment ex-
penditures per rupee loss of government revenue in the intermediate run. Table 6 is based
on similar benefit-cost ratio formulas as equations (24), (25), and (26) for the short run,
except that in the construction of Table 6 intermediate equilibrium magnitudes are used.
In addition, we use the intermediate-run tax elasticities of capital.

Table 6. Intermediate-run tax effects per Pakistani rupee of lost

government revenue.

Apparel Leather

1977 1984 1977 1984

ITC 0.885 0.710 0.253 0.250

CCA 0.641 0.585 0.176 0.205

CIT 0.112 0.001 0.013 0.000

240 JEFFREY I. BERNSTEIN AND ANWAR SHAH

Table 7. Tax elasticities in the long run (1 percent change in each rate).

Apparel Leather

1977 1984 1977 1984

ekitc 0.046 0.029 0.016 0.006

eyitc 0.042 0.020 0.011 0.004
eeitc 0.033 0.018 0.014 0.006
emitc 0.056 0.033 0.013 0.005

ekcca 0.038 0.017 0.014 0.004

eycca 0.036 0.012 0.009 0.002
eecca 0.028 0.011 0.012 0.004
emcca 0.047 0.019 0.011 0.003

ekcit 0.048 0.003 0.021 0.0006

eycit 0.045 0.002 0.014 0.0004
eecit 0.036 0.002 0.018 0.0006
emcit 0.059 0.003 0.017 0.0005

We find that, as in the short-run, the ITC rate is relatively more effective in generating
investment expenditures. The CCA rate ranks second. In addition, once the capital-adjust-
ment process begins to affect production decisions in the intermediate run, tax policy effec-
tiveness increases relative to the short run. In 1984, in the apparel industry an increase
in ITC rate leads to investment expenditures of around 0.71 per rupee of lost government
revenue, and an increase in CCA rate leads 0.59. In addition, the CIT rate does not appear
to stimulate investment in the intermediate run. Comparing the two industries, tax-policy
initiatives relating to ITC and CCA rates are two to three times more effective in the ap-
parel industry than in the leather industry.

3.3. Long-run tax effects

The long-run equilibrium is defined when capital adjustment is completed. In the long-
run, net investment is zero, so investment is used only for replacement purposes. The long-
run equilibrium is defined by equations (17), (18), (19), and (20) under the assumption
that AK = 0. The long-run tax elasticities on output supply and input demands are derived
in the same manner as the intermediate run. The long-run rental-rate elasticities are multi-
plied by the tax elasticities on the rental rate.
The results for the long-run tax elasticities are presented in Table 7. As in the other runs,
the elasticities are quite inelastic. These effects are also larger in absolute value relative
to the intermediate run. The pattern of long-run tax elasticities is similar to the intermedi-
ate run.
Table 8 shows the long-run effects of the ITC, CCA, and CIT rates on investment expen-
ditures per rupee of lost government revenue. Table 8 is based on calculations from benefit-
cost ratios similar to the ones used for the short and intermediate runs, except that now
long-run equilibrium values and tax elasticities are used in the formulas.
TAXES AND PRODUCTION: THE CASE OF PAKISTAN 241

Table R Long-runtax effectsper Pakistanirupeeof lost governmentrevenue.

Apparel Leather
1977 1984 1977 1984
ITC 1.112 1.748 0.240 0.522

CCA 0.806 1.441 0.168 0.433

CIT 0.200 0.004 0.026 0.000

In the long run, as in the other runs, increases in the ITC rate, followed by increases
in the CCA rate are more effective in stimulating investment expenditures per rupee of
lost government revenue, compared to decreases in the CIT rate. In addition, the long-run
effects are substantially greater than the intermediate-run effects, especially for the ITC
and CCA rates.
In the long run in the apparel industry, increasing tax incentives through the ITC and
CCA actually generate investment expenditures in excess of the loss in government revenue.
The extent of the differences between the various production runs shows the importance
of accounting for the capital-adjustment process in determining the effectiveness of tax-
policy initiatives. In 1984 for the wearing apparel industry an increase in the ITC generates
investment expenditures of about 1.7 per rupee of lost government revenue, while an in-
crease in the CCA generates 1.44. These effects are three times greater than those obtained
for the leather products industry. Once the capital-adjustment process is completed, the
industries become more flexible and are better able to take advantage of the government
incentives to invest in capital.

4. Summary and conclusion

In this paper a dynamic model of production is developed in order to analyze the short-,
intermediate-, and long-run effects of corporate tax policy on output supply and input de-
mands. The model is applied to the wearing apparel industry and the leather products indus-
try in the Pakistani economy. Three tax instruments are considered--corporate income tax
rate, investment tax-credit rate, and capital-cost-allowance rate. The fact that production
decisions are simultaneously analyzed allows for the determination of the complete set of
effects associated with tax policy initiatives.
We find that production decisions are relatively more responsive to changes in the in-
vestment tax credit (ITC) rate compared to the capital-cost allowance (CCA) or corporate
income tax (CIT) rates. Changes in the ITC rate are around 50 percent greater than the
effects associated with changes in the CCA rate. The CIT rate exerts virtually no effect
on production. The inference here is that targeted instruments are superior to general-purpose
instruments.
When we evaluate the tax instruments in terms of their effectiveness, measured as invest-
ment expenditures per unit of revenue loss to the government, changes in the ITC and CCA
242 JEFFREY I. BERNSTEIN AND ANWAR SHAH

rates are substantially more cost effective compared to changes in the CIT rate. We also
estimate that the ITC is more cost effective than the CCA in stimulating investment. More-
over, only in the long run (that is, on completion of the capital-adjustment process) in the
wearing apparel industry is the government able to generate investment expenditures that
exceed lost revenue through increases in the ITC and CCA rates. Thus it is important to
distinguish between different production runs in evaluating the effectiveness of alternative
policies to stimulate investment.
Finally, in the intermediate and long runs the demand for capital is more elastic with
respect to tax incentives compared to the demands for noncapital inputs and output supply.
This implies that, although there is some increase in the supply of output, the major ef-
fect of increases in the ITC and CCA rates is to make production techniques more capital
intensive.

Acknowledgments

The authors gratefully acknowledge the financial support of the World Bank. Bjorn Larsen
provided excellent computer assistance. In addition, we want to thank two anonymous ref-
erees and Jack Mintz for their comments and suggestions.

Appendix

The data were obtained from the Census of Manufacturing Industries, published by the
Federal Bureau of Statistics, and from the Economic Survey Statistics Supplement: 1987-88
and Public Finance Statistics, both of which are made available by the Finance Division
of the government of Pakistan. For each of the two industries, the variables are defined
in the following manner. Output quantities are in constant Pakistani rupees and calculated
as the gross value of output divided by the industry output deflator (1976 = 1.00). The
output price index is taken to be the output deflator. The wage rate is calculated as total
employment costs for a year divided by the total number of work days in the year. This
figure is then indexed (1976 = 1.00). Labor input quantity is measured in constant rupees
and is calculated as employment costs divided by the wage rate. Quantities of intermediate
inputs are measured in constant rupees and calculated as the ratio of the value of intermediate
inputs (eneregy and raw materials) to the intermediate input deflator (1976 = 1.00).
Investment is measured in constant rupees and is calculated from investment expenditures
divided by the investment acquisition or purchase price index (1976 = 1.00). The capital
stock is formed by accumulating investment according to the perpetual inventory method.
The depreciation rate (6) used in constructing the capital stock is 0.08.21 This rate is the
average for the Pakistani manufacturing sector. The benchmark or initial capital stock was
formed by dividing investment in the initial period by the sum of the depreciation and aver-
age capital-growth rates.
The after-tax rental rate on capital is Wk = q(P + 6)(1 -- UcZ -- u), where q is the
before-tax investment deflator, p is the cost of financial capital, O ranges from 0.03 to 0.06
and is defined as the before-tax interest rate on fixed assets in the Pakistan economy, 6 = 0.08
is the depreciation rate, Uc = 0.56 is the corporate income tax (CIT) rate, and u = 0.15
TAXES AND PRODUCTION: THE CASE OF PAKISTAN 243

is t h e i n v e s t m e n t - t a x c r e d i t ( I T C ) rate. F i n a l l y , z = d / ( p + d ) , w h e r e d is d e f i n e d as t h e
c a p i t a l c o s t a l l o w a n c e ( C C A ) rate, w h i c h a v e r a g e s a r o u n d 0.25. D e p r e c i a t i o n d e d u c t i o n s
are based on the declining balance method in Pakistan.
Table 9 s h o w s t h e q u a n t i t y a n d p r i c e d a t a f o r t h e initial a n d t e r m i n a l p e r i o d s in t h e s a m -
ple (1966-1984) for both industries.

Table 9. Industry data: prices--1976 = 1.00; quantities--millions of 1976 rupees.

Output Labor Inter. Input Capital

Price Quantity Price Quantity Price Quantity Price Quantity Rent.

Apparel
1966 0.36 20.33 0.28 5.07 0.45 10.25 0.36 53.00 0.05
1984 2.13 415.26 2.32 41.12 2.00 310.03 1.61 149.50 0.16

Leather
1966 0.23 443.39 0.41 15.32 0.45 148.90 0.36 46.30 0.05
1984 2.09 1212.77 3.91 20.28 2.00 924.40 1.61 109.70 0.16

No~s

1. The model can be readily generalized to include multiple outputs. The production function is also assumed
to be twice continuously differentiable and quasi-concave in the inputs and net investments. The subscript
t represents the time period.
2. Losses are permitted to be carried forward six years, but there are no carryback provisions. These provisions
are not relevant for this paper because we are dealing with production at the three-digit SIC. In this case
there are no losses.
3. These holidays turn out not to be important for this paper because it deals with producers at the three-digit SIC
level. At this level of aggregation, any new entrants have a small market share relative to existing production.
4. Since capital must be fully depreciated, then it must be the case that E~=0 di7 = 1, i = 1, . . . , m. Notice
that d is the per-dollar depreciation for tax purposes. At this point in the model, the framework is consistent
with any form of tax-based depreciation. Moreover, capital-cost-allowance rates can vary over time so that the
model is consistent with initial allowance rates that differ from rates pertaining to capital that has aged more
than one year. However, in order to empirically specify the present value of depreciation deductions (that is,
used for example in the after-tax rental rate), then tax-based depreciation must be formulated. (See the discussion
of the rental rate in the data appendix.) In Pakistan depreciation for tax purposes is declining balance.
5. Adjustment costs are generally considered to be internal to the production process and measured as foregone
output. Thus these costs are expensed for tax purposes. This seems to be a reasonable treatment because
we only observe net (of adjustment cost) output, there is no explicit consideration of adjustment costs in
tax law, and there are no data specifically on adjustment costs.
6. See Abel (1982) and Auerbach (1983) for a discussion on the role of shareholders and bondholders within the
context of corporate taxation. In this model financial decisions (that is, the payout and leverage ratios) are
determined separately from production decisions. Thus when considering production decisions, financial con-
cerns are predetermined. This is a reasonable assumption in light of the position of Pakistan in world financial
markets, and also since we are focusing on the effects of corporate tax policy on the structure of production.
7. Expectations are formed over the future values of the exogenous variables--namely, the discount rate, after-
tax prices (that is, all prices, tax, credit, and allowance rates), and the indicator of technology. Production
is considered to occur under risk neutrality.
244 JEFFREY I. BERNSTEIN AND ANWAR SHAH

8. If the discount rote is not expected to change, then Qir = qir( 1 -- Vir -- (ES=0Ucr+s(1 - r Pit)dis)/( 1 + p)s).
If, in addition, the tax rates and credits are not expected to change, then Qir = qi~(1 - vi - Uc(1 -
4~ivi)~=odis/( 1 + p)s). The latter is the more standard formula and is a special case of the after-tax purchase-
price formula developed in the model (see Hall and Jorgenson, 1967, 1969; Abel, 1982; Auerbach, 1983;
Boadway, Bruce, and Mintz, 1984; and Bernstein and Nadiri, 1988).
9. At any time t, M does not affect output supply and input demand decisions because from the vantage point
of the present the vector is predetermined.
10. The function is also twice continuously differentiable, homogeneous of degree one and convex in after-tax
prices, and concave in capital inputs and net investment.
11. It is assumed that the second-order conditions are satisfied.
12. It is assumed that the second-order and transversality conditions are satisfied. The symbol 0 m signifies an
m dimensional vector of zeros.
13. This functional form is not symmetric with respect to the variable-factor demand functions. The demand
function for the normalized factor has a different form from the other variable factors. Empirically, however,
the elasticities are so inelastic that the asymmetry turns out to be unimportant.
14. We can assume that the exogenous variables evolve according to autoregressive processes (see Epstein and
Yatchew, 1985).
15. There are thirty-eight (or 19 years x 2 industries) observations. In addition, because we are estimating four
equations, then the degrees of freedom are (38 • 4) - 19 = 133, where 19 represents the number of param-
eters. We also allow for differences among industries in the first- and second-order parameters in the after-
tax variable-profit function. We find that there are significant differences between the industries with respect
to the first-order parameters, /3p,/3e, /3k. In addition, we find that the second-order parameters, [3pp, t3~e,
~kk, ~ii, differ between industries. The estimation and other empirical results are derived using TSP version
4.2 software.
16. There are three other integrability conditions that the after-tax variable profit function must satisfy. They
consist of homogeneity of degree one in prices, summability of profit components to unity, and symmetry
of second order price derivatives (see Diewert, 1982). The profit function has been defined so as to satisfy
these three conditions.
17. Although the speeds of adjustment are similar to those obtained for North American and European economies,
this finding does not imply that the production technologies are the same across countries.
18. The calculation of the elasticities in the short, intermediate, and long runs use the appropriate equilibrium
magnitudes of output supply and input demands in each of the production runs. In the short-run, intermediate-
input demand is affected by the rental rate through adjustment costs, but this effect turns out to be small.
An appendix showing the equilibrium conditions in each of the runs is available from the first author on request.
19. The calculation of the benefit-cost ratios in the short, intermediate, and long runs use the equilibrium magni-
tudes of the appropriate production runs.
20. Recall that the capital cost allowance is based on a declining balance formula, such that z = d/(p + d).
Thus (Oz/Od)d/z = p/(p + d).
21. The estimation model was also carried out with depreciation rates of 0.07 and 0.09. The estimation results
were very similar to the ones presented in Table 1.

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