David R. Henderson  

Hassett's Numbers are Plausible

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In the long run, all of the factor owners' loss from a capital income tax is a loss to labor (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 labor's loss. Furman and Summers have it backwards.
This is from Casey Mulligan, "Furman and Summers revoke Summers' academic work on investment," October 18, 2017.

This is Casey's comment and analysis on the current controversy over whether Kevin Hassett's claim of large increases in wages due to corporate tax cuts make sense.

It's a technical argument and you might not follow all of it. Here's one paragraph that might help:

Why would labor bear all of the burden in the long run? Well, ask Larry Summers back when he used to be an academic studying these matters. His 1981 Brookings paper, which even today is an article commonly used by me and others to teach this in graduate school, says so on page 81 equation (7). The left-hand-side of that equation is a perfectly elastic long-run supply of capital: it says that the supply curve in my picture is, in the long run, properly drawn as horizontal. See also Lucas (1990, p. 303, equation 4.3).

But if you don't know this literature somewhat, the above paragraph might not help you much. So let me explain in simpler words by noting that the key assumption in the above is the assumption of a perfectly elastic long-run supply of capital. Why would it be perfectly elastic? Because capital is quite mobile across countries, so when one country's government cuts it tax rate on capital, that draws in capital from around the world.

Why does this matter? The greater the stock of capital, the higher is the ratio of capital to labor, and, therefore, the higher is the marginal product of labor, and, finally, the higher is the real wage.

Here's Mulligan again, with some of the important parts of the technical argument:

Using a Cobb-Douglas aggregate production function with labor share 0.7, and a 50% capital-income tax rate (combining corporate, property, and the capital components of the personal income tax), I get a Furman ratio of 350%. With a 40% tax rate instead, the Furman ratio is 233% (algebra here; these refer to modest tax-rate reductions -- not going all of the way to zero).

If the current CEA said 250%, then it got Furman's ratio much closer than Furman did, who puts it less than 100%.


HT2 Greg Mankiw.


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COMMENTS (12 to date)
Effem writes:

This seems at odds with reality, which is that the effective corporate tax rate has steadily declined for decades (and is near a record low I believe), while real wages have stagnated. No?

Matthew Moore writes:

@Effem there were a few other changes happening over that period too...

David R Henderson writes:

@Effem,
This seems at odds with reality, which is that the effective corporate tax rate has steadily declined for decades (and is near a record low I believe), while real wages have stagnated. No?
No. On the wage side, real wages, when you adjust for a more-accurate measure of inflation and include non-cash benefits (which are a bigger part of the wage), wages have not stagnated.
On the tax side, I think you mean by “effective” what we economists call average tax rates. But what matters for sucking capital in from other countries, and, indeed, for using our own capital, is the margin: so marginal tax rates matter, and those have stayed constant and high while the rest of the world’s have declined.

Casey Mulligan writes:

The elastic long-run supply of capital also holds in a closed-economy model. If preferences are stationary (roughly not changing), then any amount can be added to the capital stock with no extra utility cost just by saving a little bit extra for a long enough time frame.

The Summers and Lucas models I cited were closed-economy models with this property. Essentially they are the neoclassical growth model.

The empirical evidence to look for is whether the after-tax marginal product of capital varies substantially less than the pre-tax MPK does, because then taxes are pushing up the pre-tax far more than pushing down the after-tax. I have a number of empirical papers confirming this, most recently those with Luke Threinen.

RPLong writes:

According to the Tax Foundation, the United States has the third-highest marginal corporate tax rate in the world, after UAE and Puerto Rico.

This US Treasury report has the US average effective corporate tax rate at 20% for its most recent year, 2011. The Tax Foundation reports that the global average is was 22.5% in 2016.

The US has below-average corporate tax rates, but those of us accustomed to seeing the USA as more of a free trade country by global standards probably expected our number to be lower still. I know I did.

One interesting quote from that Tax Foundation report:

After weighting by GDP, the average top marginal corporate tax rate has declined less. This is mainly due to the fact that the United States, which makes up approximately 25 percent of world GDP, continues to have a high 38.92 percent corporate income tax rate that has not changed in more than 10 years.

Charlie writes:

Tyler Cowen asked Larry about his views on capital taxation and why they've changed over time on his show, "Conversations with Tyler."

COWEN: Here’s a real softball question. What’s the optimal rate of tax on capital income?
[laughter]
SUMMERS: Closer to the tax rate on other income than to zero would be my answer to that. A fair amount of capital income reflects rents of one kind or another. Capital income is substantially held by those at the high end. There’s a fair amount of what’s really capital income in the form of unrealized capital gains that never gets taxed.
So I think the right aggregate capital income tax rate is closer to what would go with a comprehensive income tax than it is to the alternative idea that capital income taxation is just a way of taxing future consumption, and therefore you should tax future consumption and present consumption at the same rate and the tax rate should be zero.
COWEN: If we think about the 1980s, there are a lot of models from that time — some coming from your research — where you have an infinite horizon model with a zero tax rate on capital income. At some point, enough capital accumulates so that even wages are higher. And there’s a steady-state long-run argument that still the number should be zero. What has changed that makes those models less applicable? Is it that we think the elasticity is different, or is it some other variable? What’s changed in our knowledge or your understanding?
SUMMERS: At the technical level, there’s been some mathematical work showing that some of the results that you’re referring to from the 1980s were mathematically wrong. That’s one part.
The second and more consequential part is that the premise of those models was essentially that the supply of capital was infinitely elastic. Whatever the tax rate, you would drive capital to the point where the after-tax rate of return was some fixed number.
That now looks like a very poor description of reality. We’ve seem real interest rates fluctuate substantially, and we don’t see that when real interest rates are higher, savings is lots higher, and when real interest rates are lower, savings is lots lower in the way that many people, including me in the early 1980s, would have expected. So in the absence of that kind of evidence, the argument is very much attenuated.

Casey Mulligan writes:

Summers is fast and loose on interest rates. The theory says that the after-tax MPK is constant. MPK is NOT the same as interest rate on Treasury bills and other liquid financial assets. They are not even positively correlated.

See my papers with Threinen and http://www.nber.org/papers/w9373

I agree with him that the after-tax real rate on TBills fluctuates a lot. I don't see it's relevance.

Ironically, Summers has papers that appreciate the dramatic difference between MPK and TBill return. He somehow forgets that when assessing capital taxation.

Vivian Darkbloom writes:

@effem@Henderson

“Effective tax rate” is typically taxes paid divided by accounting income before tax (as opposed to “taxable income” for tax purposes). Thus, changes in financial accounting can have an effect.

Almost all measures of “effective corporate tax rate” for US corporations refer to the *global income* and *global tax* of US resident corporations rather than merely US domestic income and US tax on that domestic income. Thus, when foreign countries lower their taxes, or when US multinationals become adept at lowering their non-US tax, the measured “effective corporate tax” goes down. It need havie nothing per se to do with US tax policy. This is actually what has been happening and one must look at US real wages versus “effective tax rates” in this global context.

The recent history of lower *non-US* tax as a component of the overall corporate effective tax rate actually explains some of the flow of capital and labor away from the US.

Vivian Darkbloom writes:

@effem@Henderson

“Effective tax rate” is typically taxes paid divided by accounting income before tax (as opposed to “taxable income” for tax purposes). Thus, changes in financial accounting can have an effect.

Almost all measures of “effective corporate tax rate” for US corporations refer to the *global income* and *global tax* of US resident corporations rather than merely US domestic income and US tax on that domestic income. Thus, when foreign countries lower their taxes, or when US multinationals become adept at lowering their non-US tax, the measured “effective corporate tax” goes down. It need havie nothing per se to do with US tax policy. This is actually what has been happening and one must look at US real wages versus “effective tax rates” in this global context.

The recent history of lower *non-US* tax as a component of the overall corporate effective tax rate actually explains some of the flow of capital and labor away from the US.

Alan Goldhammer writes:

I like the title of this blog post! Of course anything is plausible. We have concrete proof of this when Leicester City won the English Premier League championship two seasons ago after just avoiding relegation the year before. Plausible does not mean probable.

I remember when the foreign earnings repatriation legislation passed during the first term of GW Bush and everyone was getting excited about how many new jobs would be created and how this would spark new investment. It didn't do either of those, rather companies used the money for acquisitions and share repurchases which drove up equity prices which increased CEO pay and so on.

I am one who happens to believe that the tax code is bloated and in need of reform. That being said, I don't believe in the kind of black magic tax cuts that promise something that is forever out of reach. Hassett's prediction of increased growth has as much resonance with me as his almost two decade old book promising great riches when the Dow reached 36,000 (I'm still waiting for that one to come true).

Alan Goldhammer writes:

I forgot to point interested readers to the wonderful Justin Fox post, 'Applying the 'Dow 36,000' Discount to Trump's Tax Cuts'

Effem writes:

@David & Matthew

Agree there were other factors at play but that's always the case. I will often side with reality (along with complicating factors) over a model. Just my bias.

Agree wage growth looks a bit better with various adjustments...but still far, far behind growth in returns on capital. There is a big gap to explain away.

As for which tax rate matters, I don't think it's the statutory rate. If I am a multi-national deciding where to locate investment, I will plan according to the actual tax rate I will pay (which is not usually the statutory rate unless you have terrible accountants).

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