How Taxes Affect Economic Behavior

By Henry J. Aaron; Joseph A. Pechman | Go to book overview

The illusion effect identified by this paper lends support to the Modigliani-Cohn thesis that illusion has a prominent influence. As economists, Modigliani and Cohn are apprehensive about their results because they feel that persistent irrational behavior is indicated. In this paper we argue that, while the market may in fact be undervalued in a fundamental sense based on "true" economic data, the market price may still be appropriately termed rational: share prices accurately reflect available, though faulty, information.

A bull market is possible for the 1980s. If widely used measures of corporate worth should be restated to capture assets on the same current value basis as liabilities, a 20 percent jump in share prices could be achieved. The accounting profession is contemplating changes in this direction with its efforts in the field of replacement cost analysis. Most discussions of this area have focused on the impact on annual profits,29. but the effects on balance sheets will be proportionately greater. If a complete and correct accounting overhaul is achieved, there is good reason to believe the market will respond vigorously.


Appendix: Calculating the Expected Present Value

The EPV is:

,

where the variables are as defined in the text. Alternative expectation regimes were tested for each of the three expectation variables: de, the growth in per-share dividends; ge, the growth in per-share adjusted aftertax economic earnings; and PIe, the growth in the price deflator for business fixed investment. A total of five expectation regimes were tested.

____________________
29.
As we argued earlier in the text, earnings adjustments of two types are necessary. First, depreciation should be calculated on a replacement cost basis, and second, the reduced real value of debt must be recognized. These two adjustments would produce an earning series consistent with balance sheets updated to reflect assets measured in replacement value terms, except that the earnings measure would correctly not include pure inflation gains in equity-financed nominal asset values.

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