Is advertising a negative externality? If so, why does the government allow advertising expenses to be used to reduce taxes? Are there any jurisdictions that do not allow advertising expenses as a business tax deduction?

I suppose you could say so, if you don't like advertisements.  One could also argue that crust on bread is a negative externality on those who like their sandwiches without crust, since they bear the unwanted cost of having to remove the crust.  But like advertising this is a matter of preference.  Some people like advertisements, and learn about new products from them.  With pollution, no 3rd party really benefits.  So it is more clearly a negative externality.

Advertising costs don't increase the cost of goods you buy by very much: The percent of sales that most businesses spend on advertising is between 1 to 30 percent. About 60% are under 5%. So, this "arms race" usually amounts to about 5% of the cost of the item, which is probably less than your state/local sales tax. Most of those businesses spending large percentages on advertising are new businesses and small businesses. I will say, that advertising does favor the larger firms because per sales dollar, they are usually able to spend less on advertising. For example, Wal-Mart spends about .4% of it's sales revenue on advertising. Not everyone has to advertise: I disagree with some of your assumptions. Not all firms have to advertise (heavily) to compete. If I go to the store, I can buy Ms. Baird's or I can buy a brand of bread that doesn't advertise. Usually the brand that doesn't advertise is cheaper. If I'm willing to take a chance on a brand I haven't heard of I will buy the cheaper. People shell out fistfuls of cash for a fragrance sponsored by some celebrity, but you can by the knockoffs and the local drug store that are equal quality but lower price and almost no advertising cost. Advertising Increases Price Competition Also, when you go to the store, like the previous example, price comparisons are easy to make. This isn't always the case. In environments where there is no advertising you can charge higher prices, or worse, practice price discrimination charging more to wealthy or "undesirable" clients. Advertising increases price competition in these industries and drives prices down. Pre-internet this was even more important. Advertising Increases Quality Competition Suppose you have just improved the quality of your product. In theory, your market share should go up, but if no one knows about it, it won't. You will lose money because you investing in quality and weren't rewarded for it. With advertising, you can spend the money on quality improvement, advertise, and then other firms will be forced to match your quality or charge lower prices. Advertising Makes Media Cheaper Enjoying your YouTube video? Network TV? Newspaper? Advertising is actually creating a positive externality in this situation, because I often am not buying the product but I am enjoying the benefits of the free or reduced costs of the media I'm consuming. Even the musicals at the high school I work at are funded largely by the advertisements in the program. On the other hand... Some Advertising Spreads Misinformation Rather Than Information Advertisements usually inform, but this isn't always the case. They aren't allowed to outright lie, and if they do they get sued. There's nothing to keep them from saying that this product might cause the girl of your dreams to fall in love with you, or imply that you need the "real thing" rather than the equal quality knockoff, or any other psychological trickery. (It's worth noting that many firms will also run "attack ads" clarifying misinformation from their competitors.) Advertising Sometimes Promotes Monopolistic Competition Under "perfect" free market conditions, firms make little (or no) profit because they have to charge the same price as their competitors and their competitors can always undercut them to receive 100% of the business. In the real world, firms use product differentiation to decrease competition and charge higher prices. This happens when I think that JIF peanut butter is superior to all other brands of peanut butter, and I will only buy it. Now JIF can charge higher prices than they should be able to. But if another firm say (Peter Pan peanut butter) has done the same thing and come to the conclusion they will only buy Peter Pan peanut butter, JIF AND Peter Pan can both charge higher prices. This has been seen distinctly in U.S. pharmaceuticals, because people don't know medicine and are therefore highly influenced by the ads they see on T.V. After seeing these ads, they become much less likely to look into generic or older equally effective drugs. In short this is where advertising increases prices. On the whole I would say advertising is actually beneficial to a market economy, and if the government allows you to deduct business expenses, there is no reason advertising shouldn't count.

How do you define "a negative externality"?  Advertising is a system that businesses use to increase sales, that's almost the definition of a business expense. Does advertising make the price of bread higher? Possibly. But consider this: in a world without advertising, brand loyalty is generally established by experience, which makes it much more difficult for a new brand to break into the market. In fact, I strongly suspect that the very concept of brands as we know it coincides very closely with the rise of advertising. In that sense, advertising is socially useful: it encourages multiple brands, which encourages competition, which keeps prices down. So it's not at all inconceivable that prices would be higher without advertising. As for why governments allow advertising to be deducted, it's tradition and experience. Most governments allow the deduction of actual business expenses, both for reasons of fairness, and reasons of practicality (not allowing such deductions would drive companies out of business, or into another country). Advertisement has long been accepted as a business expense, and continues to be as such. Allowing the government to dictate which expenses they think a business should and should not pursue, and enforcing that with tax law, would be a level of interference with commerce that the United States has long been reluctant to consider.

Well first the growth in the home computer market was a sector wide result of demand for new technology. Regardless of that the principle that advertising doesn't increase market size on market share was well documented. Since you are a finance analyst you may not have covered the subject matter. While taking my marketing degree it was covered in the third year (est) and confirmed in Sociology and Marketing. I am away and don't have access to my marketing texts. That makes this a good question for quora. I'll post a link

"Advertising does not increase sales for the market sector only for the firm. No benefit for the public interest there. Macro micro thang."   I've never heard this before, can you point me towards some evidence for it? When Apple started advertising home computing, didn't the market for home computing grow?

It might be useful to address this question from the perspective of the customer- Letting customers that would want a product know that it is available is a value add. (Not an externality and not negative) Letting customers that might want the product know is debateable, but is probably worth it. Letting customers that are not interested in the product know is a waste of value from both sides- the customer has wasted time / attention, the advertiser has wasted money and effort trying to reach someone that isn't going to buy.  (Negative, not certain this qualifies as an externality- it wasn't just a byproduct, it was an intentional action) I'm trying to decide if there is another category of people that are convinced by advertising to make a purchase that they would not otherwise make- if the advertiser helps someone make a more informed decision, then they are creating value.  If they convince someone that they should make the purchase on other means, I'm not sure.  If they help the customer realize it will bring them social status, then is that really misleading the customer? So I'm not claiming to have the final answer, but so far as I can see, it doesn't look like an externality.