These days, what passes for policymaking in America manages to be simultaneously farcical and sinister, and the evil-clown aspects extend into the oddest places. Hence the tale of the Mnuchin Treasury’s incompetent attempt to suppress an internal analysis – to send it down the mnemory hole? — on the incidence of corporate taxation. This paper reached the inconvenient conclusion that most of the tax stays where it’s applied – with the owners of corporate capital – with only a small share falling indirectly on workers. In general, attempts to suppress stuff like this fail thanks to leaks. But in this case the paper has already been published in a peer-reviewed journal, so that even if the Treasury were locked down tight everyone could read it anyway.
But let’s leave that story on one side; I want to talk a bit about the actual economics of corporate tax incidence. This is not usually my subject, but there’s an intersection with international economics that seems relevant, and which – as far as I can tell, although I’m not as familiar as I should be with the literature – isn’t being appreciated in the current discussion. Specifically: while global capital markets should tend to equalize after-tax rates of return in the long run, the imperfect integration of goods markets implies that the long run is pretty darn long – not enough for us to be all dead, but long enough that return equalization should take decades.
Oh, and a warning: I try to tell readers when something is going to be wonkish and incomprehensible, but this is going to be really, really, really wonkish and incomprehensible, unless you spent years doing perfect-foresight dynamic models. Actually, maybe this is being written for Olivier Blanchard and three or four other people. Whatever.
Anyway, to set the stage: this whole literature goes back to Harberger, who envisaged a closed economy with a fixed stock of capital. He showed that in such an economy a tax on profits would fall on capital, basically because the supply of capital is inelastic.
The modern counterargument is that we now live in a world of internationally mobile capital; this means that for any individual country the supply of capital, far from being fixed, is highly elastic, because capital can move in or out. In fact, for a small economy facing perfect capital markets, the elasticity of capital supply is infinite. This means that the after-tax return on capital is fixed, so any changes in corporate tax rates must fall on other factors, i.e. labor.
Most analysis of tax incidence nonetheless allocates only a small fraction of the corporate tax to labor, for three reasons.
First, a lot of corporate profits aren’t a return to capital: they’re rents on monopoly power, brand value, technological advantages, and so on. Inflows of capital won’t compete those profits away, so the international capital market isn’t relevant to the incidence of taxes on those profits.
Second, America isn’t a small country. We are, instead, big enough to have a strong effect on worldwide rates of return.
Third, imperfect integration of both capital and goods markets is a reality. Rates of return probably aren’t equalized even in the long run; anyway, if a corporate tax cut brings in more capital, this will drive down the relative price of US products, which will limit the return on additional capital and hence keep workers from getting the full benefit of the tax cut.
I’m fine with all that. But I think it’s also important to ask exactly how inflows of capital that equalize rates of return are supposed to happen. Once you ask that question, you see that long run analysis may not be good enough for policy purposes.
Suppose the US were to cut corporate tax rates. This would initially raise the after-tax rate of return on capital, which would provide an incentive for foreign capital (or overseas assets of US firms) to move into the country. This would, in turn, drive the after-tax rate of return back down. How would it do this? By increasing the U.S. capital stock, reducing the marginal product of capital (and raising that of labor).
But how would the capital stock be increased? One does not simply walk into Mordor unbolt machines in other countries from the floor and roll them into America the next
week. What we’re talking about is a process in which U.S. investment exceeds U.S. savings – that is, we run current account deficits – which increases our capital stock over time.
There’s an immediate irony here: the rhetoric calling for corporate tax cuts is all about “competitiveness”, yet the initial impact would be bigger trade deficits. But never mind that: think about what it takes to have a bigger trade deficit.
I’ve spent three decades pointing out the fallacy of the doctrine of immaculate transfer – the notion that international flows of capital translate directly into trade imbalances. Exporters and importers don’t know or care about S-I; they respond to signals from prices and costs. A capital inflow creates a trade deficit by driving up the real exchange rate, making your goods and services less competitive. And because markets for goods and services are still very imperfectly integrated – most of GDP isn’t tradable at all – it takes large signals, big moves in the real exchange rate, to cause significant changes in the current account balance.
So, a U.S. corporate tax cut should lead to a stronger dollar, which affects the current account deficit that is the counterpart of an inflow of capital. But how much stronger does the dollar get? The answer, familiar to international macroeconomists, is that the dollar rises above its long-run expected value, so that people expect it to decline in the future – and the extent of the rise is determined by how high the dollar has to go so that expected depreciation outweighs the rise in after-tax returns compared with other countries.
The point is that the knowledge that we’re looking at a one-time adjustment limits how high the dollar can go, which limits the size of the current account deficit, which limits the rate at which the U.S. capital stock can expand, which slows the process of return equalization. So the long run in which returns are equalized can be quite long indeed.
Suppose we assume rational expectations. (I know, I know – but for a benchmark it may be useful.) Then we can think of the adjustment process I’m describing as a little dynamic system in e, the exchange rate, and K, the capital stock. High K means a low rate of return compared with r*, the foreign rate of return, so e must be rising. High e means large trade deficits. The phase diagram looks like this:
where the saddle path is the unique path along which expectations about the future exchange rate are fulfilled. You can solve for that path by linearizing around a steady state; the solutions to that system have two roots, one negative, one positive, and the negative root tells you the rate of convergence along the saddle path.
At any given time the capital stock K is given; the exchange rate e jumps to put the system on the saddle path, and then it converges over time to the long run equilibrium.
So the story of a corporate tax cut is as follows: initially we’re at a point like A. Then the tax cut raises the long-run equilibrium capital stock. But it takes time to get there: first we get a currency appreciation, as shown by the jump from A to B, and then over time we converge to C.
The question is, how fast is this convergence? And we do have enough information to put in some stylized-fact numbers. I assume Cobb-Douglas production, with a capital share of 0.3. The capital-output ratio is about 3, implying an initial rate of return of 0.1. And the modelers at the Fed tell us that the impact of the exchange rate on net exports is about 0.15 – that is, a 10 percent rise in the dollar widens the trade deficit by about 1.5 percent of GDP.
When I plug these numbers in, assuming I’ve done the algebra right, I get a rate of convergence of .059 – that is, about 6 percent of the deviation from the long run eliminated each year. That’s pretty slow: it will take a dozen years to achieve even half the adjustment to the long run.
What this says to me is that openness to world capital markets makes a lot less difference to tax incidence than people seem to think in the short run, and even in the medium run. If you’re trying to assess the effects of tax policies over the next decade, a closed-economy analysis is probably closer to the truth than one that assumes instant equalization of returns across nations.