Effects of tax incentives on long-run capital formation and total factor productivity growth in the Canadian sawmilling industry

Abstract

The goal of this study was to analyze effects of tax incentives on long-run dynamics of total factor productivity (TFP) growth and capital formation in the Canadian sawmilling industry over a 40-year period (1961–2000). Simulated tax incentives involved increasing capital cost allowance and investment tax credit and reducing corporate income tax. The production technology was specified as a function of capital, labor, energy, sawlogs, and a time dependent technological progress variable. A translog multilateral index number model was applied to measure and analyze TFP. Two analytical phases were followed. In the first phase, without the tax incentives, we analyzed annual levels and growth rates of TFP1; and parametrically examined effects of output growth and time dependent technology on the growth of TFP1. Over the study period, the average annual growth rate of TFP1 was 2%; and the parametric results revealed that the marginal effects of each of output growth and technological progress on TFP1 growth were highly significant. The second phase involved recalculation of the rental price of capital to estimate effects of the simulated tax incentives on capital formation and growth of TFP (= TFP2). As expected, the average annual share of capital in total cost with the tax incentives rose to 12% from 9% without the tax incentives. The average annual capital intensity also rose to real $15,263.70 with the incentives from real $10,402.91 without the incentives. Most importantly, higher capital formation, motivated by the tax incentives, raised aggregate quantity of the inputs significantly, leading to a slightly lower TFP2 than TFP1, because output was unchanged. In short, the data validated the hypothesis that tax incentives do indeed spur capital formation and TFP growth.