Advertising, Profits, and Corporate Taxes Revisited

Advertising, Profits, and Corporate Taxes RevisitedAuthor(s): John J. Siegfried and Leonard W. WeissSource: The Review of Economics and Statistics, Vol. 56, No. 2 (May, 1974), pp. 195-200Published by: The MIT PressStable URL: http://www.jstor.org/stable/1924439 .

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ADVERTISING, PROFITS, AND CORPORATE TAXES REVISITED

John J. Siegfried and Leonard W. Weiss*

IN a recent issue of this REVIEW one of the authors' estimated the over- or understate-

ment of profit and rate of return which result from the corporation income tax rule permitting firms to write off long-lived advertising expenditures in the year in which they are incurred. Analyses of this type are a prerequisite for useful tests concerning the equalization of profit rates across industries and a complete accounting of the distribution of government tax bur- dens. We believe that the basic approach in that paper was useful, but several improvements in technique are desirable. The purpose of this note is to introduce those improvements and revise the estimates of reported and "true" profits and rates of return for the 38 Internal Revenue Service (IRS) "minor industries" and 10 large advertisers used in the previous study.

First, following Comanor and Wilson,2 the article excluded firms with less than $500,000 of assets because of the likelihood that a large part of profits are taken in the form of execu- tive compensation in smaller firms. Unfortu- nately this improvement in the data is not costless. As the article demonstrates, the magnitude of the over- or understatement of profit and rate of return depends on (1) the level of advertising, (2) the annual rate of depreciation, and (3) the rate of growth of advertising expenditures. By excluding firms of less than $500,000 assets, the article biased the growth in advertising over the 1958-1963 period upward. This bias occurs because some firms will grow across the $500,000 cutoff and few will decline across it during the period of the analysis. The advertising expenditures of these firms were treated entirely as new advertising for the year in which they entered the sample when, in fact, their advertising expendi-

tures may have grown at a rate similar to other firms during that year. Consequently the advertising expenditures measured for an industry in the original article are likely to exhibit a growth rate greater than the true rate of growth of advertising expenditures for that industry. Therefore, the original article tended to exaggerate the understatement of profits and of the rate of return on equity.

A second modification arises because of the alternative tax accounting procedure assumed in the article. A major purpose was to estimate the underreported profits due to expensing of advertising relative to a treatment of the expenditures as investments under current tax laws. The article used a perpetual exponential depreciation scheme to estimate "true" profits, but this is slightly less generous than the double declining balance option now available for depreciating producer durables. Under present IRS rules, a firm may switch to straight line depreciation for the remaining undepreciated balance of an asset at any time during the asset's service life. For an asset with a six year service life and with a discount rate more than zero it becomes advantageous to switch to straight line depreciation in the fourth year of the asset's life. The failure to allow for the option to switch to straight line depreciation tends to mildly reinforce the upward bias in the estimates of underreported profits and rates of return.

Third and most important, Harry Bloch3 has shown that the procedure used in the article overstates the "subsidy" involved in expensing advertising since it does not allow for tax liabilities that would be incurred on additions to the undepreciated balance of advertising investments. We will use the following notation (slightly different from that in Weiss and Bloch).

Received for publication January 22, 1973. Revision accepted for publication October 1, 1973.

1 L. W. Weiss, "Advertising, Profits and Corporate Taxes," this REVIEW, LI (Nov. 1969).

2 W. S. Comanor and T. A. Wilson, "Advertising, Market' Structure, and Performance," in this REVIBW, XLIX (Nov. 1967).

3 H. Bloch, "Advertising, Competition and Market Per- formance," unpublished Ph.D. dissertation, University of Chicago, September 1971, pp. 18-22.

[ 195 ]



196 THE REVIEW OF ECONOMICS AND STATISTICS

,iTt = accounting profits before tax in year t T*t "true" profits before tax in year t

r - annual rate of growth in advertising It = net investment in advertising in year t

(i.e., current advertising expense less depreciation charged to current and past advertising)

Tt tax payments in year t mt marginal tax rate in year t

T*t = taxes that would be paid in year t if advertising were capitalized and depre- ciated.

In the article, "true" profits were defined as 7T*t = ITt + It.

This is a correct statement if applied to before tax profits, but the article used the same approach in computing after tax "true" profits. In fact, however, if required to capitalize and depreciate advertising, firms would pay taxes on It. As a result, after tax "true" profits would be

-*t T*t t - Tt + (1 - mt)It.

Consequently, the "subsidy" to advertising was exaggerated. With a marginal tax rate of 52 % (appropriate for most firms over $500,000 assets in 1963), the "subsidies" estimated in the original article would be little more than twice what they should have been. The statement that profit rates are understated where IT/E < r/l+r and vice versa still seems to be valid.

In addition to estimating the tax advantage from expensing advertising, the original article went on to recompute rates of return for 38 IRS minor industries used by Comanor and Wilson and to regress these "true" profit rates on variables that had been used by Comanor and Wilson. The error pointed out by Bloch does not appear to affect those computations, because the "true" after tax profits actually earned depend on taxes actually paid (Tt) rather than those they would have paid under another set of tax rules. In other terms:

7T*t - -Tt - Tt + It

because It was not subject to tax in 1963. We conclude that the reestimates of the Comanor- Wilson regressions are not affected by Bloch's criticism.4

Fourth, the original article did not mention the possibility that a portion of the subsidy to advertisers arising from the expensing provision might be captured by the owners of scarce advertising resources. Since the expensing provision in effect lowers the price per unit of advertising services to the firm purchasing ads, an increase in the demand for advertising services can be expected.

The extent to which the subsidy is passed along to the owners of scarce advertising resources depends on the elasticity of supply for these resources and the increase in demand for them generated by the tax break. In a situation where the advertisers are bidding for advertising resources in relatively fixed supply (e.g., the limited television spectrum), we expect the per unit price to advertising to rise with relatively little expansion in the real out- put of advertising services. The subsidy to advertisers through the tax write-off provision would then accrue to the owners of advertising resources in the form of rents. The proportion of the subsidy that is transferred to the owners of advertising resources should vary according to the composition of their advertising (e.g., television, newspaper, billboards, direct mail) and the elasticities of supply of the relevant media. In any case, the inducement to increased use of economic resources in advertising is exaggerated.

Finally, the original article applied the same depreciation rate to advertising in every industry. This is obviously a crude approximation. Surely the true depreciation rates will differ with the type of product advertised and perhaps with the type of advertising (e.g., advertising that emphasizes price vs. that which attempts to associate a brand name with glamour). In general we do not have the data on which to base distinctions of this sort, but one recent study does suggest a source of systematic bias in the approach of the original article.

Peles5 estimated depreciation rates of 35-

4 They would not be affected by the failure to convert to straight line depreciation after the fourth year either, since that is purely a tax rule. The estimation of "true" profit rates that would be equalized in competitive markets

in the long run would depend on the actual depreciation pattern, not the procedures permitted by the IRS. The exaggeration in advertising growth rates may have introduced an error into the Comanor-Wilson reestimates however.

5 Y. Peles, "Rates of Amortization of Advertising Ex- penditures," Journal of Political Economy, 79, no. 5 (Sept./ Oct. 1971), pp. 1032-1052.



ADVERTISING, PROFITS, AND CORPORATE TAXES 197

45% for cigarettes and 40-50% for beer, but he concluded that automobile advertising was fully amortized in the year it was undertaken. This was because advertising in year t increased the stock of cars in year t + 1 and this reduced demand in year t + 1. The effect of advertising on stocks of cars offset any positive effect of advertising on sales in subsequent years. In other words, automobile advertising is a current expense and is properly expensed on the com- panies' books.

T. R. Stauffer has developed a very sophis- ticated analysis of biases in accounting profits.6 He concluded that the bias introduced by the expensing of advertising depends not only on growth and depreciation rates but on the time profile of cash flow associated with fixed capital outlays and on the ratio of nondepreciable working capital to fixed capital as well. It appears from his examples that capitalization of advertising will correct accounting profit rates in the right direction though seldom com- pletely if rectangular cash flow profiles (for fixed capital outlays) are assumed. With a rapidly declining cash flow profile, however, capitalization of advertising may introduce an opposite bias from that due to the expensing of advertising. In most examples presented by Stauffer, the error in profit rates was much less when advertising was capitalized and de- preciated than when it was expensed.7

In his model, the correct treatment of advertising cost can only be accomplished if the treatments of depreciable fixed assets and working capital are revised at the same time. The revisions he proposes are quite complex and essentially require a general reworking of the entire accounts of each firm. They mix the

effects of accounting changes for advertising and tangible assets. Moreover, they are only "correct" on a conceptual basis quite different from that used in current accounting practice. The simple capitalization and depreciation of advertising does seem to reduce the bias in corporate profit rates in his model in all but extreme conditions, it is entirely attributable to advertising, and it extends the currently conventional accounting practice to advertising. We conclude that capitalization of advertising is a useful though perhaps incomplete adjustment.

The large firm sample, the switch to straight line depreciation option, and the after tax profits vs. before tax profits problems are corrected here and revised estimates of under- or overreported profits and rate of return are calculated for the sample of 38 consumer goods industries and 10 large advertisers used in the original article. No attempt is made to measure the transfer of the gains to owners of scarce media in the form of rents.

The total advertising expenditures, net income after taxes, and after tax rate of return for the sample of 38 industries including all corporations in each industry are reported in table 1. The revised estimates of underreported profits and underreported rates of return for the 38 industries and 10 firms are reported in tables 2 and 3V8 In general, the first two revi-

6 T. R. Stauffer, The Measurement of Corporate Rates of Return and the Marginal Efficiency of Capital, Ph.D. thesis, Harvard University 1971 (unpublished), pp. III- 46-65.

7The only exceptions occurred where working capital was three times fixed capital, growth was 2% per year, and the cash flow profile declined rapidly. The major source of bias in this case was an 8.6% understatement of profits with no advertising at all due to biases in depreciation of fixed inputs. Since capitalizing advertising expense tended to reduce reported profits in his examples, it increased this understatement of profits to 12.5% when advertising was four times fixed capital outlays. Except for the 2% growth rate, all the parameter values assumed are at or beyond the extreme outer limit of observation in manufacturing industries.

8 To adjust for the option of firms to switch to straight line depreciation we revise the original formulation used to compute r*t and E*t. These were:

-* tt + Att- (1 -X) 4

J,==o (A3Ai A5t_ and

4 E*t Et + X i= A+I At-i

where

Et= accounting equity at the end of year t E*t - "true" equity at the end of year t At investment in advertising in year t X the ratio between year-end net value of an

advertising investment and its value at the start of the year. The annual depreciation rate is therefore (1 - X).

Adjusting the algorithms to permit firms to write off the remaining undepreciated balance of the investment in advertising commencing in the fourth year produces the revised formulae:




TABLE 1. - ADVERTISING EXPENDITURES, REPORTED PROFITS AND RATE OF RETURN FOR 38 IRS "MINOR INDUSTRIES"

(millions of dollars and percentage points)

A A 7r 7r 7r/E 7r/E Industry over $500,000 all firms over $500,000 all firms over $500,000 all firms

Soft Drinks $165.3 $190.1 $130.6 $145.6 13.4% 12.5%o Malt Liquors 243.1 244.7 98.0 98.8 7.8 7.8 Wines and Brandy 16.7 17.5 7.4 7.6 9.2 8.8 Distilled Liquors 72.9 72.9 70.8 69.8 6.1 6.0 Meat Packing 89.8 95.4 76.4 92.2 5.1 5.6

Dairy Products 134.8 144.8 139.2 152.2 7.2 7.0 Canning 136.3 141.4 123.3 124.5 7.5 7.3 Grain Mill Products 231.4 235.3 177.9 190.4 8.6 8.7 Bakery Products 106.9 112.3 80.1 80.9 7.4 7.0 Sugar 4.8 5.0 96.6 96.6 10.4 10.3

Confectionarya 73.0 75.9 78.9 79.7 12.1 12.0 CigaretteSb 287.8 287.8 290.6 290.6 13.0 13.0 Other Tobacco Productse 28.9 29.0 23.7 25.5 6.5 6.8 Knit Goods 29.5 30.7 57.2 69.6 8.0 8.2 Carpets 9.7 9.8 9.3 6.0 3.1 2.0

Men's Clothing 45.9 47.9 78.4 86.1 7.6 7.8 Women's Clothing 41.5 53.5 56.3 68.0 8.0 7.2 Household Furniture 34.8 44.8 71.5 83.4 8.0 7.9 Periodicals 42.4 48.2 41.7 35.5 7.5 5.8 Books 55.3 61.1 82.9 83.8 10.1 9.7

Drugs 385.9 405.0 364.3 362.5 13.9 13.5 Soap and Detergents 343.7 348.8 154.1 155.2 12.1 11.7 Paints 39.4 44.9 93.2 94.9 9.0 8.6 Toiletries and Perfumes 176.1 185.5 79.3 80.2 15.7 15.3 Petroleum Refiningd 221.7 222.5 1704.0 1730.4 4.7 4.7

Tires 102.5 102.5 182.6 182.5 8.1 8.1 Footwear 40.6 41.5 51.5 50.6 6.1 5.6 Hand Tools and Cutlery 59.7 64.6 96.7 104.5 15.5 15.0 Electric Appliances 86.8 87.8 114.4 115.3 8.4 8.4 Radio and TV Sets 51.9 53.4 83.7 78.2 8.0 7.3

Motor Vehicles 161.5 162.2 2229.6 2230.8 17.2 17.1 Motorcycles, Bicycles

and Trailer Coachese 7.1 9.7 24.0 24.6 15.0 13.7 Optical, Medical Instruments 49.4 53.7 60.4 67.4 8.9 8.9 Photographic Equipment 54.2 55.5 169.0 165.4 14.0 13.7 Clocks and Watches 23.2 23.2 14.2 14.4 8.5 8.5

Jewelry 11.6 14.5 15.9 21.1 7.5 7.6 Toys, Games, Sporting Goods 47.8 53.0 29.2 21.1 5.4 3.5 Costume Jewelry 2.3 3.1 2.1 -1.5 5.4 -3.1

Total or Mean $3716.2 $3879.5 $7259.0 $7384.4 9.2 % 8.4% a 1961-1962 ads and reported profits and 1957-1958 to 1961-1962 time period for Confectionary. b The largest six firms in Tobacco Products. e Tobacco Products minus the largest six firms. d Major industry Petroleum Refining and Related Industries. e Transportation Equipment other than motor vehicles and parts, aircraft and parts, ships and boats, and locomotives and cars.

sions have little effect on the size of the subsidy, but Bloch's correction for the marginal tax rate reduces the estimates substantially.9 Using all firms in each IRS industry reduces the size of aggregate understated profits for the 38 IRS

At =Tt t At - (1 - X)X3Zo

(AtAt_) - (1 )A3 it==OAt-i and

2

E*t=Et + iZ- X'+1 At-i 4

+ J,=o (5 -i) (1 -X) (X3)At-i where the symbols are defined as earlier.

The adjustment to compute before tax underreported

profits rather than after tax underreported profits requires simply multiplying the estimates of *t- rt by (1 - .52).

9 The aggregate underreported profits of the 38 minor industries ($187.6 million) account for 74% of the aggregate underreported profits in the entire mining and manufacturing sector of the economy in 1963.



ADVERTISING, PROFITS, AND CORPORATE TAXES 199

TABLE 2. - UNDER- AND OVERREPORTED PROFITS AND RATE OF RETURN FOR 38 IRS "MINOR INDUSTRIES"

All Firms Using Straight All Firms Using Line Option and

Weiss All Firmsa Straight Line Optionb Marginal Tax Ratec Industry 7r -7r 7r*/E7r - 7r/E 7,- 7, 7*/E* - 7r/E 7,* -7 7r*/E* - 7r/E * -r 7,*/E* - 7r/E

Soft Drinks $37.0 0.5% 37.8 0.2% 37.6 0.3% 18.1 -1.1% Malt Liquors 9.9 -0.7 15.7 -0.9 15.5 -0.9 7.4 -1.4 Wines and Brandy 2.5 0.1 2.5 0.2 2.5 0.2 1.2 -1.0 Distilled Liquors 7.1 -0.01 6.7 -0.03 6.6 -0.03 3.2 -0.3 Meat Packing 6.9 -0.03 5.1 -0.2 4.9 -0.2 2.3 -0.4

Dairy Products 2.2 -0.7 1.1 -0.7 0.8 -0.7 0.4 -0.7 Canning 4.0 -0.7 2.4 -0.8 1.9 -0.8 0.9 -0.8 Grain Mill Products 24.7 0.3 23.5 -0.4 22.4 -0.4 10.7 -0.9 Bakery Products -5.1 -1.6 -7.3 -1.6 -7.6 -1.6 -3.6 -1.3 Sugar -0.1 -0.1 -0.3 -0.1 -0.3 -0.1 -0.1 -0.1

Confectionary 13.5 -0.6 6.5 -1.0 5.7 -1.0 2.7 -1.4 Cigarettes 29.8 -1.1 29.7 -1.1 29.3 -1.1 14.0 -1.7 Other Tobacco Products 4.0 0.3 3.6 0.2 3.4 0.1 1.6 -0.3 Knit Goods 2.2 -0.2 1.9 -0.3 1.6 -0.3 0.8 -0.4 Carpets 0.6 0.04 0.3 -0.01 0.3 -0.01 0.1 -0.06

Men's Clothing 7.5 0.2 6.5 0.1 6.5 0.1 3.1 -0.2 Women's Clothing -3.0 -1.2 -5.1 -1.2 -5.3 -1.2 -2.5 -0.9 Household Furniture 2.2 -0.3 -0.04 -0.6 -0.1 -0.6 -0.05 -0.5 Periodicals 13.9 1.5 14.7 1.6 14.7 1.6 7.1 0.5 Books 11.1 0.3 12.1 0.3 11.9 0.3 5.7 -0.3

Drugs 55.6 -0.8 60.9 -0.7 59.6 -0.7 28.6 -1.6 Soap and Detergents 90.1 2.0 88.5 1.9 87.7 1.9 42.1 -0.7 Paints 0.9 -0.5 1.0 -0.5 0.8 -0.5 0.4 -0.5 Toiletries and Perfumes 20.6 -3.0 19.9 -3.2 19.2 -3.2 9.2 -4.4 Petroleum Refining 31.3 0.04 20.8 0.01 21.2 0.01 10.1 -0.01

Tires 7.3 -0.3 6.8 -0.3 6.4 -0.3 3.1 -0.4 Footwear 6.4 0.3 5.6 0.2 5.5 0.2 2.6 -0.1 Hand Tools and Cutlery 8.3 -1.2 9.9 -0.6 9.9 -0.6 4.7 -1.2 Electric Appliances 14.0 2.1 11.2 -0.2 10.7 -0.4 5.1 -0.4 Radio and TV Sets -8.3 d -1.2 -8.3 -1.3 -8.1 -1.3 -3.9 -0.9

Motor Vehicles -10.2 -0.4 -0.3 -0.5 -0.2 -0.5 -0.1 -0.4 Motorcycles, Bicycles, and

Trailer Coaches 1.8 0.2 2.6 0.5 2.6 0.5 1.3 -0.2 Optical, Medical Inst. 7.0 0.1 7.0 -0.1 6.8 -0.1 3.3 -0.5 Photographic Equipment 4.8 -0.6 5.1 -0.6 4.9 -0.6 2.4 -0.8 Clocks and Watches 2.5 -0.3 2.0 -0.6 1.9 -0.6 0.9 -1.1

Jewelry 0.1 -0.6 0.7 -0.4 0.7 -0.4 0.3 -0.5 Toys, Games, Sporting

Goods 8.4 0.6 8.5 0.8 8.5 0.8 4.1 0.2 Costume Jewelry 0.4 0.5 0.6 1.4 0.6 1.4 0.3 0.8

Total or Mean (unweighted) $411.9 -0.3% $399.9 -0.3% $391.0 -0.3% $187.6 -0.7%

a Under- and overreported profits and rate of return for samDle including all firms in each IRS "minor industry." b Including all firms in each IRS "minor industry" and assuming switch to straight line depreciation option on the balance of undepreciated asset

cost in the fourth year. e Including all firms in each IRS "minor industry," switch to straight line depreciation in fourth year, and adjusting for impact of marginal tax

rate on before tax profits. d Underreported profits were reported incorrectly as $5.7 million for Radio and TV Sets in the original article.

"minor industries" by about 3 %. Providing for the option to switch to straight line depreciation at any time reduces the aggregate estimates by an additional 2% o.10 An additional 49% reduc-

tion in aggregate understated profits arises from the adjustment for tax liabilities.

No attempt has been made in tables 2 and 3 to allow for the possibility that durable goods advertising depreciates more rapidly than non- durable advertising. The effect of this point is easy to incorporate, however. If the effect of durables falls entirely in the year it occurs then

10 However, the percentage change in estimates for par- ticular industries or firms resulting from allowance for the straight line depreciation write-off option and the addition of firms under $500,000 in assets to the industry sample is often greater than 2 or 31%, respectively.




TABLE 3. -ADVERTISING EXPENDITURES, REPORTED AND "TRUE" PROFITS AND RATES OF RETURN

FOR TEN LARGE ADVERTISERS, 1963

Allowing for Straight Line Option and

Weiss Marginal Tax Rate

A 7r 7r/E 7r*7r r*/E*-7r/E 7r* - 7ra 7r*/E*-7r/Ea

Procter and Gamble $200.0 $115.8 14.8% $46.3 0.5% $22.4 -1.7% Bristol Myers 76.0 19.1 20.0 19.1 -1.1 9.0 -5.9 Colgate-Palmolive 74.0 23.8 9.5 5.9 -1.7 2.8 -2.0

R.J. Reynolds 58.0 129.1 18.1 5.1 -1.5 2.4 -1.8

American Tobacco 55.2 68.8 11.2 9.5 0.1 4.6 -0.6

Coca Cola 46.0 52.4 17.3 9.9 -0.4 4.7 -1.8

Kellogg 39.0 28.2 20.7 5.8 -3.5 2.6 -4.9

Gillette 38.0 41.5 34.1 4.0 -9.0 1.9 -10.1

Anheuser-Busch 32.0 15.6 9.1 6.5 1.1 3.0 -0.5

Schlitz 31.0 12.9 8.9 7.9 2.2 3.7 -0.1

Total or Mean

(unweighted) $649.2 $507.2 16.4% $119.9 -1.3% $57.1 -2.9%

Source: Advertising is estimated total advertising expenditures (measured and unmeasured) from "the 100 Largest Advertisers," Advertising Age, 1957-1964 (usually an August issue). Earnings after tax and equity are from Moody's Industrial Manual 1966. Procter and Gamble earnings are for fiscal year ending March 31, 1964, but ads are for calendar years.

a Assumes a switch to straight line depreciation methods in fourth year of ads' life and adjusts for the impact of marginal tax rate on before tax profits.

the expensing of advertising would be correct for durables, and there would be no under- or overreporting in those industries. The durable goods industries on our list are carpets, furniture, tires, appliances, radio and television sets, motor vehicles, motorcycles, bicycles and trailer coaches, clocks and watches, jewelry, toys, games and sporting goods, and costume jewelry. Hand tools and cutlery should not be treated as durables because the largest part of advertising these is for razor blades. Similarly photographic equipment is primarily a non-durable, film.

Letting II* =I for the durables listed reduces the total underreporting in the next to last column of table 2 from $187.6 million to $180.2 million. At the same time, with HI*/E*

=l/E for these industries, the mean error in profit rate in the last column changes from -0.7% to -0.8%.

The conclusion that "the error (in reported profits and rates of return) due to the expensing of advertising investments is not earth-shaking" is reinforced by the improved estimates reported in this note.



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Advertising, Profits, and Corporate Taxes Revisited