Implicit Taxes in Imperfect Markets

Implicit taxes are defined as the pre-tax rate of return disadvantage earned on an investment that is taxed preferentially. Implicit tax theory predicts that implicit taxes will fully offset any benefit from preferential tax treatment leading to no benefit from lower explicit taxes; however, implicit tax theory assumes perfect market competition. This paper relaxes the assumption of perfect market competition and finds that firms in industries with lower competition bear lower implicit taxes, and firms in industries with higher competition bear higher implicit taxes. These findings are consistent with firms in industries with less competition having price setting power. Further, these findings are consistent with competition forcing firms in high competition industries to pass along tax savings to customers while firms in low competition industries can retain more of their tax savings. These findings further answer the call in the literature for more research on determinants of cross-sectional variation in implicit taxes (Shackelford and Shevlin 2001).