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

Abstract

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