Advertising, Profits, and Corporate Taxes

SOME of the highest profit rates appear in industries that advertise heavily. These high earnings have been attributed to barriers to entry associated with product differentiation 2, 6. A possible alternative explanation is that the treatment of long-lived advertising as current expenses leads firms that invest heavily in such intangibles to overstate their rates of return since their equity is understated 1, p. 153; 15, p. 167. The same practice may result in the understatement of their dollar profits so that they pay less tax than other firms whose investments are all tangible. The purpose of this paper is to work out more precisely the overor under-statement of profit and rate of return involved in the expensing of advertising and to evaluate the mis-statement in practice.' Part I develops conceptually the conditions under which overor under-statements can be expected. Part II recomputes dollar profits and rates of return for a variety of industries, estimates the tax avoidance that results, and examines the relationship between recomputed profit rates and advertising. Part III contains a proposal for policy change.