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Article Excerpt
INTRODUCTION
This review of thinking about corporation income tax incidence will take us through several steps--the traditional trichotomy, the general equilibrium revolt against it, the open economy revolution, and some smoke--and--mirrors issues. Finally, it will take special aim at corporation tax incidence in today's developing nations, and conclude with some reflections on their use of the corporate income tax. For further elaboration of many of the points made here, see Harberger (2008).
THE TRADITIONAL TRICHOTOMY
The typical public finance textbook of, say, the 1940s and 1950s, took what it thought was a quite general (and, hence, quite safe) position. Some of the tax was surely passed on to consumers, some of it was likely passed back to workers, and the rest of it had to be borne by the residual claimants--the shareholders. Little in the way of genuine analysis was offered in support of this view, but it nonetheless succeeded in establishing itself as the standard treatment.
The biggest flaw in this approach was its confusion with respect to the time dimension. Shareholders are indeed the residual claimants, but the negative shock created by a new tax does not stay with them forever. Capital will flee from areas with lowered rates of return and, as it does, so will move the whole capital market to a new equilibrium rate of return. Thus, all segments of the capital market will tend to share in whatever fate ends up being inflicted on the equilibrium net--of--tax rate of return of corporate shareholders. If this real rate of return goes down, so too will all other returns, including real interest rates on bonds, real rental rates on buildings and land, and real yields on bank deposits.
While the traditional trichotomy could claim to be right about shareholders being the residual claimants in the very short run, it is not in the short run that product prices would be driven upward, and real wages, downward, to absorb part of the tax. Indeed, it would be the very process of the capital market seeking its new equilibrium that would set in motion those product and labor market adjustments.
THE GENERAL EQUILIBRIUM REVOLT
It was this revolt, in which I was one of the players (Harberger, 1962), that tried to formalize the above critique of the traditional trichotomy. Perhaps its defining feature was a model with two sectors (corporate and non--corporate) and two factors (labor and capital). Factor supplies were taken as given and a closed economy was assumed. Equilibrium meant equalizing real wages and real after--tax rates of return across the two sectors.
Perhaps the greatest insight that emerged from this analysis was that capital bearing 100 percent of the burden of the corporation income tax was not an unlikely limiting case (the upper limit of the shareholders' fraction of the trichotomy), but was rather a result situated somewhere in the middle of the plausible range of outcomes. My classroom illustration of this result starts with a capital stock earning a nine percent return in both the corporate and non--corporate sectors, in the no--tax situation. When a tax is imposed taking 50 percent of the income from corporate capital, but nothing from capital in the non--corporate sector, we have two extreme cases. One is that the net--of--tax return stays at nine percent. The corporate gross--of--tax return goes to 18 percent, and the burden is pushed forward to consumers of the corporate product. The wage rate is the numeraire for this example. Thus, with both the wage rate and capital's net--of--tax rate of return remaining the same as before, and with the prices of corporate-sector products rising to reflect the tax, we have both capital and labor sharing the burden of the tax--but only in their roles as the consumers of the output of the corporate sector.
At the other extreme we have the case where, when the tax is imposed, the gross--of--tax rate of return stays at nine percent for the corporate sector. That means that the net--of--tax rate of return goes down to 4.5 percent in both sectors. The fall to 4.5 percent in the corporate sector reflects, in the post--tax equilibrium, what the government collects in corporate tax revenue. But capital's burden is a lot greater than this, as its take from the economy has been cut in half (over both sectors). The fall from nine percent to 4.5 percent in the non--corporate sector is reflected (under assumptions of competition) in a gain to consumers of non--corporate products. Capital, thus, ends up bearing a burden equal to [[K.sub.x] + K.sub.y](1 - [[beta].sub.ky])]/K.sub.x] times the burden of the tax, where [[beta].sub.ky] is the fraction of the non--corporate product that ends up being bought by capitalists.
Thus, if capital ends up being equally split between the two sectors, and if capital's gross--of--tax share in the product ends up at 40 percent, then in the first extreme case, the burden of the tax would be ten percent of GDP, and it would be shared between labor and capital in the proportions [[beta].sub.Lx] and [[beta].sub.Kx]. At the other extreme we would have capital bearing between one and two times the burden of the tax (depending on the fraction of the non--corporate product that is bought by capitalists).
In the interesting case where Cobb--Douglas production functions prevail in both sectors, and where product demands are determined by a Cobb--Douglas utility function, capital ends up bearing precisely the full burden of the tax. In the numerical example, this would correspond to the rate of return going down to six percent, and the ending capital...
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