IMPLICATIONS OF BENCHMARK STATE AND LOCAL TAX RATES FOR MEASURES OF ESTIMATED IMPLICIT TAXES

The results of this study indicate that a likely reason why a negative relation between estimated implicit taxes and pretax returns is empirically observed is the researcher’s election to choose a zero tax rate as the benchmark state and local tax rate. Normally, an observed negative relation between estimated implicit taxes and pretax returns supports the hypothesis generated by implicit tax theory. This conclusion regarding the implicit tax hypothesis may be premature whenever the incidence of state and local income taxes contributes to this empirical finding. First, state income taxes, treated as a negative subsidy when the benchmark state and local tax rate is set at zero, will likely cause implicit taxes to be underestimated. Second, the observed relationship between estimated implicit taxes and pretax returns appears to be reversible depending upon the researcher’s election of a statutory tax rate that incorporates the selected benchmark state and local tax rate. The present study uses a sample of 848 firms covering the years from 1989 through 1998 to show how the relation between estimated implicit taxes and pretax returns can be manipulated by the selection of the benchmark state and local tax rate. Since choosing an accurate benchmark state and local tax rate can be problematic, the present study suggests adjusting both estimated implicit taxes and pretax income by the amount of state and local income taxes incurred. The results, using the regression model making this adjustment, appear to nullify the negative bias of a zero tax rate as the benchmark state and local tax rate.