Passing the burden: corporate tax incidence in open economies

empirical analysis are described in Section 3. Empirical results are analyzed in Section 4;
conclusion and policy analysis follow in Section 5.

2. Theory

2.1 The Effect of Corporate Taxes on Wage

In a closed economy, Harberger (1962) finds that corporate taxes do not affect wages. In
Harberger’s model, the economy is closed, the quantities of capital and labor are fixed, and
capital and labor are freely mobile between industries. In this setting, if a source-based corporate
tax is imposed, the after-tax return to capital in the corporate sector will decrease. Capital will
move to the non-corporate sector in pursuit of higher returns until the after-tax returns have
equalized across the corporate and non-corporate sectors. This increase in capital in the non-
corporate sector will decrease the marginal productivity of capital in that sector resulting in a
lower return. Similarly, as capital leaves the corporate sector the marginal productivity of capital
in that sector will rise. Labor can move between sectors to ensure that their wages will not
change due to changes in the amount of capital. Thus, the burden of the corporate tax falls
entirely on capital in both the corporate and non-corporate sectors.

There are several lessons to take away from Harberger’s model. First, the mobility of
factors within a country ensures that the return to a factor must be equal across sectors. Also,
with a fixed supply of capital and a closed economy, labor bears none of the burden of a source-
based corporate tax. In this model, deadweight loss is created by the inefficient allocation of
capital between corporate and non-corporate industries. Harberger estimates a deadweight loss of
only eight percent of corporate revenue. Gravelle and Kotlikoff (1993) add product
differentiation to the closed economy model and find that capital still bears the complete burden

<<   3   4   5   6   7   8   9   >>

More intriguing information