Blog Post

The capital tax cut debate

How much do workers gain from a capital gains tax cut? CEA chairman Hasset claims the tax cut will cause average household labour income to increase by between $4000 and $9000. Several commentators note this implies that more than 100% of the incidence of the tax is on labour. This question has triggered a heated discussion in the economic blogosphere, which we review here.

By: Date: October 30, 2017 Topic: Global Economics & Governance

Former chair of the Council of Economic Advisers (CEA) Jason Furman writes on Twitter that “the economic debate about the %age of the corporate tax paid by labour ranges from 0% to 100%. The new CEA study puts it at 250%.” Larry Summers writes in the Washington Post that White House Chief Economist Hasset’s claim that cutting the corporate tax rate from 35 percent to 20 percent would raise wages by $4000 per worker is absurd, as it implies that workers would benefit by $600 billion — or 300 percent of the tax cut. Summers argues that in the presence of full expensing, a corporate rate reduction has no effect on the cost of capital for equity-financed investments and raises the cost of capital for debt-financed investments. Changes in transfer pricing practices induced by tax policy changes do not represent changes in economic welfare or real incomes of Americans. Theory suggests that there are relationships between changes in corporate taxes and changes in wages rather than between the level of corporate taxes and wage growth.

Greg Mankiw answers with an exercise to understand by how much a tax cut will affect wages. In an open economy with a production function y = f(k), capital stock adjusts so that the after-tax marginal product of capital equals the exogenously given world interest rate r = (1-t)f ‘(k) and wages are set by the marginal product of labour, which equals w = f(k) -f ‘(k)*k. If we cut the tax rate t, the static cost of the tax cut (per worker) is dx = -f ‘(k)*k*dt. The effect of a tax cut on wages (dw/dx) will be dw/dx = 1/(1 – t). So if the tax rate is one third, then every dollar of tax cut to capital (on a static basis) raises wages by $1.50. John Cochrane agrees with Mankiw and supplements the post with a dynamic result.

Steve Landsburg weighs in, pointing out that Mankiw’s result is only incidentally about wages. It’s fundamentally about the ratio of the long-run to the short-run government revenue shortfall (not counting the correction to the long-run shortfall that is due to new investment). That’s relevant to wages only because the long-run shortfall happens to end up entirely in the hands of workers.

Casey Mulligan writes along the same lines that Furman and Summers have it backwards.  The red area (R) in Figure 1 is the revenue from a capital income tax. The red and green areas (R + G) are the losses from that tax suffered by owners of the factors of production, combined for capital and all other factors. The revenue is a lower bound on the factor owners’ loss. In the long run, all of the factor owners’ loss from a capital income tax is a loss to labour (the area below the horizontal dashed line is negligible; see A below). Therefore, in the long run, capital-income tax revenue is a lower bound on labour’s loss. Furman and Summers don’t seem to understand that the wage gains from a cut come not only from the Treasury but also the economic waste created by the corporate tax, so the long-run Furman ration must be greater than 100%.

Mulligan argues that If we begin with a high tax rate, and conservatively assume that the only channel for benefits is a higher capital stock, then 250% is about right for cuts to somewhat lower rates. Using a Cobb-Douglas aggregate production function with labour share 0.7, and a 50% capital-income tax rate, it is possible to get a Furman ratio of 350%.  With a 40% tax rate instead, the Furman ratio is 233%.

Lawrence Summers replies on the Washington Post that Mulligan and Mankiw’s analysis is inadequate because they make use of simple academic abstract models that do not capture the complexities of a policy situation to argue that wage increases could be larger than the tax cut. Summers argues that Mankiw’s post is unhelpful for three reasons. First, a cut in the corporate tax rate from 35 to 20 percent in the presence of expensing of substantial or total investment has very little impact on the incentive to invest. Second, neither the Ramsey model nor the small open economy model is a reasonable approximation for the world we live in. Third, a big cut in the corporate rate does not happen in isolation as a break for new investment. Mankiw’s model does not recognise the possibility of monopoly profits or returns to intellectual capital or other ways in which a corporate tax cut benefits shareholders without encouraging investment.

As for Mulligan, Summers argues that he draws wrong conclusions from Summers’ own 1981 paper on Q-theory. One central aspect of the paper was the recognition that the corporate tax rate is, contrary to Mulligan and Mankiw’s assumption, not a sufficient statistic for assessing the impact of the corporate tax system. Summers argues Mulligan entirely ignores the main point of his paper, which was that because of slow adjustment costs the impact of tax changes was felt primarily on asset prices for a long time. He also argues that Mulligan fails to recognise that a corporate rate cut benefits capital and hurts labour outside the corporate sector because it draws capital out of the noncorporate sector, raising its marginal productivity and reducing that of labour.

Brad DeLong argues that Mankiw’s post shows Mankiw is going as far as he believes he can to be helpful to the Republican Party. Mankiw begins his analysis of the effects of a corporate tax cut on the U.S. with “an open economy…”, except the U.S. is not a small open economy, so the model does not apply. DeLong also argues that Mankiw’s model is incomplete, as it disregards the government budget constraint somewhere, the timing of the cut, whether other taxes are raised and if so, what taxes and when. Third, DeLong argues that there is a mathematical error in Mankiw’s presentation, which disregards the fact that a tax cut reduces the tax base by reducing the pre-tax rate of profit. This error inflates Mankiw’s calculations by a factor of 1/(1-t).

Paul Krugman agrees with DeLong (which is music to DeLong’s ears), arguing that the discussion is confused by putting it in the context of Ramsey models, whereas it’s all about international capital mobility. Krugman geometrically represents the distribution of income in a small open economy with a fixed labour force, under the assumption that the stock of capital changes only through capital inflows or outflow and that factors of production are paid their marginal products. He starts from a situation where the economy faces a given world rate of return r* but the government imposes a profits tax at a rate t, so that to achieve a post-tax return r* domestic capital must earn r*/(1-t). He then does a comparative statics exercise, eliminating the profits tax, showing that in equilibrium, the capital stock rises and so does GDP, profit taxes disappear inducing a revenue loss, but wages rise more than the loss of revenue.

Except that – according to Krugman – several things are wrong with this exercise. First, a lot of what we tax with the corporate profits tax isn’t a return to capital; it’s monopoly profits and other kinds of rents. There is no reason to believe that these rents would be bid down by capital inflows, so the revenue loss on those taxes is just a revenue loss, not something shifted to wages. Second, capital mobility is far from perfect. Third, the US isn’t a small open economy – it can affect world rates of return, meaning that it faces an upward-sloping supply curve of capital, which means that the wage gains from profit tax cuts are smaller. Finally, this is a long-run equilibrium, and long-run analysis is a very poor guide to the incidence of corporate taxes in any politically or policy-relevant time horizon. Over shorter horizons, you’d expect very little of the tax cut to be passed on to workers.

Casey Mulligan argues that Delong and Krugman make a “math error”, while falsely accusing Greg Mankiw of making a math error (sic), by equating the wage gain from a small tax cut to the Furman’s static revenue loss. They incorporate an equilibrium price change in the calculation of the corporate-income tax base, whereas the static revenue loss from the corporate-income tax must, by Furman’s definition of “static,” hold corporate income constant.

Robert Waldmann at Angry bear has a very long post on the debate. He agrees with DeLong and Krugman that Mankiw is writing as a partisan Republican, and that with DeLong, Krugman and Summers that Mankiw errs by not considering a complete model and that there is no point in looking at the ratio of one long term effect to a short term effect. But he thinks that the claim that there is a math error is based on an uncharitable guess about which model Mankiw didn’t spell out. Depending on the model which Mankiw didn’t write out, either Mankiw or DeLong could be right. One key issue is that DeLong assumes wages and prices adjust quickly while the capital stock adjusts slowly. The other is that the Ramsey model is not equivalent to a small open economy model.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read about event More on this topic

Upcoming Event

Feb
5
12:00

The quality and quantity of work in the age of AI

At this event, the panelists will discuss the implications of Artificial Intelligence on the labour market and the future of work in general.

Speakers: Robert Atkinson, Anna Byhovskaya, Maria Demertzis, Carl Frey and Daniel Samaan Topic: Innovation & Competition Policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article Download PDF More on this topic

External Publication

Manufacturing employment, international trade, and China

The decline in manufacturing employment is often seen as a major reason for rising inequality, social tensions, and the slump of entire communities. With the rise of national populists and protectionists in recent years, the issue has become even more prominent.

By: Uri Dadush and Abdelaziz Ait Ali Topic: Global Economics & Governance Date: November 28, 2019
Read about event More on this topic

Past Event

Past Event

Improving regulatory policy formulation and institutional resilience in Europe

Are large differences in the resilience of individual economies related to differences in the quality of country-level institutions that shape the absorption and response to these shocks? At this event we'll discuss the evolution of labour markets, and the role of institutional design and good process.

Speakers: Arup Banerji, Maria Demertzis, J. Scott Marcus, Céline Kauffmann and Rogier van den Brink Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: November 13, 2019
Read article More by this author

Blog Post

It’s hard to live in the city: Berlin’s rent freeze and the economics of rent control

A proposal in Berlin to ban increases in rent for the next five years sparked intense debate in Germany. Similar policies to the Mietendeckel are currently being discussed in London and NYC. All three proposals reflect and raise similar concerns – the increase in per-capita incomes is not keeping pace with increases in rents, but will a cap do more harm than good? We review recent views on the matter.

By: Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: July 8, 2019
Read article More on this topic More by this author

Blog Post

The breakdown of the covered interest rate parity condition

A textbook condition of international finance breaks down. Economic research identifies the interplay between divergent monetary policies and new financial regulation as the source of the puzzle, and generates concerns about unintended consequences for financing conditions and financial stability.

By: Konstantinos Efstathiou Topic: Finance & Financial Regulation Date: July 1, 2019
Read article More on this topic More by this author

Blog Post

The June Eurogroup meeting: Reflections on BICC

The Eurogroup met on June 13th to discuss the deepening of the economic and monetary union (EMU) and prepare the discussions for the Euro Summit. From the meeting came two main deliverables: an agreement over a budgetary instrument for competitiveness and convergence and the reform of the European Stability Mechanism (ESM) treaty texts. We review economists’ first impressions.

By: Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: June 24, 2019
Read article More on this topic More by this author

Blog Post

The campaign against ‘nonsense’ output gaps

A campaign against “nonsense” consensus output gaps has been launched on social media. It has triggered responses focusing on the implications of output gaps for fiscal policy under EU rules, especially for Italy. But the debate about the reliability of output-gap estimates is more wide-ranging.

By: Konstantinos Efstathiou Topic: European Macroeconomics & Governance Date: June 17, 2019
Read article More on this topic More by this author

Blog Post

The inverted yield curve

Longer-term yields falling below shorter-term yields have historically preceded recessions. Last week, the US 10-year yield was 21 basis points below the 3-month yield, a feat last seen during the summer of 2007. Is the current yield curve a trustworthy barometer for future growth?

By: Inês Goncalves Raposo Topic: Global Economics & Governance Date: June 11, 2019
Read article More on this topic More by this author

Blog Post

The 'seven' ceiling: China's yuan in trade talks

Investors and the public have been looking at the renminbi with caution after the Trump administration threatened to increase duties on countries that intervene in the markets to devalue/undervalue their currency relative to the dollar. The fear is that China could weaponise its currency following the further increase in tariffs imposed by the United States in early May. What is the likelihood of this happening and what would be the consequences for the existing tensions with the United States, as well as for the global economy?

By: Inês Goncalves Raposo Topic: Global Economics & Governance Date: June 3, 2019
Read article More on this topic More by this author

Blog Post

The next ECB president

On May 28th, EU heads of state and government will start the nomination process for the next ECB president. Leaving names of possible candidates aside, this review tries to isolate the arguments about what qualifications the new president should have and what challenges he or she is likely to face.

By: Konstantinos Efstathiou Topic: European Macroeconomics & Governance Date: May 27, 2019
Read article More on this topic More by this author

Blog Post

The latest European growth-rate estimates

The quarterly growth rate of the euro area in Q1 2019 was 0.4% (1.5% annualized), considerably higher than the low growth rates of the previous two quarters. This blog reviews the reaction to the release of these numbers and the discussion they have triggered about the euro area’s economic challenges.

By: Konstantinos Efstathiou Topic: European Macroeconomics & Governance Date: May 20, 2019
Read about event More on this topic

Past Event

Past Event

CANCELLED: Future of taxation in the EU

Due to a previously unannounced air traffic controllers strike in Belgium, the Prime Minister Morawiecki is unable to land in time for the event. We apologise for any inconvenience.

Speakers: Marie Lamensch, Mateusz Morawiecki and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 16, 2019
Load more posts