Passing the burden: corporate tax incidence in open economies

2.3 The Effect of Openness on the Incidence of Corporate Taxes

In today’s global economy, not only are goods and services traded among countries, but
capital is also mobile. Capital mobility assures that the return to capital will be equal across
countries. Therefore, if a tax on capital is levied in a single small country, it can not affect the
worldwide return to capital. This can be seen in equation (1) where r* is defined as the world
rate of return on capital.

(1 - τ_κ ) MPK = r *                               (1)

If the tax on capital (τk) is increased, the marginal productivity of capital (MPK) must increase in
order to keep the return to capital set at the world price. This occurs as capital flees the home
country in pursuit of a higher return; the decrease in capital will increase the marginal
productivity of capital in the home country and investors will continue to pursue outside
opportunities until the marginal productivity of capital has increased to the point where equation
(1) holds. As producers in the home country use less capital, the marginal productivity of labor
will decline resulting in lower wages at home. Thus, a tax on capital is borne entirely by labor in
a small open economy, and we would expect the corporate tax rate to have a negative effect on

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wages.

Harberger (1995) reevaluates the incidence of the corporate tax by assessing the burden
of the tax in an open economy. Not only does Harberger find a negative effect of corporate taxes
on wages, but he also finds that labor’s burden from corporate taxation is 2 to 2.5 times as large
as corporate tax revenue. In an open economy, there are more opportunities for inefficiencies to
occur as a result of source-based corporate taxes. As in the closed economy, capital may be
inefficiently allocated between the corporate and non-corporate sector within a country; in
addition, capital may now be inefficiently allocated across countries. In an open economy,

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