Are Capital Taxes Harmful?
About This Event

A substantial economic literature has developed in recent years that suggests that taxation of capital in theory can have very harmful economic consequences over time. Indeed, some authors who have conducted research based on theoretical grounds have even argued that capital taxes should be set to zero. Yet most countries continue to rely on capital taxation, and very little empirical work has been done until now to document that this practice has caused significant economic harm. Professor Casey Mulligan of the University of Chicago has just finished an innovative new study in this area. At this event he will present his findings and will discuss how--by using a novel approach--he has come to the conclusion that capital taxation is the major distortion that exists today in capital markets.

Agenda
9:15 a.m.

Registration

9:30 Presenter: Casey Mulligan, University of Chicago
Discussants: Kevin A. Hassett, AEI
William G. Gale, Brookings Institution
Moderator: Veronique De Rugy, AEI
11:30

Adjournment

Event Summary

October 2004

Are Capital Taxes Harmful?

Substantial economic literature has developed in recent years that suggests that taxation of capital in theory can have very harmful economic consequences over time.  Indeed, some authors who have conducted research based on theoretical grounds have even argued that capital taxes should be set to zero.  Yet most countries continue to rely on capital taxation, and very little empirical work has been done until now to document that this practice has caused significant economic harm.  Professor Casey Mulligan of the University of Chicago has just completed an innovative new study in this area.  At an October 8 AEI event, he presented his findings and discussed how he has arrived at the conclusion that capital taxation is the major distortion that exists today in capital markets.

Casey Mulligan
University of Chicago

Casey Mulligan shed light on the distortion that capital taxes create in the capital market. Despite the harmful effects of capital taxes, many countries still rely heavily on capital taxes in their aggregate economies, and this reliance can have grave ramifications over time in regards to the economic well-being of those countries.

By focusing the analysis more on the real economy than the financial economy, several conclusions are reached:  The first is that capital taxation drives a wedge between consumption growth and the expected pre-tax capital return.  For example, capital taxation creates a significant spread between the rate paid by investors and the rate earned by savers that is not arbitraged away over time. 

Other empirical results show that consumption growth tends to be elastic on after-tax capital returns and inelastic on financial asset returns.  In his discussion on capital markets and the efficiency of intertemporal allocation, he cites capital taxation and regulation of businesses as reasons why investors might benefit more than savers. Asking firms to regulate their businesses incorrectly can lead to a distortion. Investors might also benefit more than savers because of regulations on savings. People may not be allowed to save as much as they would like or as little as they want to. Finally, the burden of the capital income tax seems to be "passed on."  It may be transmitted through higher markups or reduced capital accumulation.

Mulligan concluded that capital taxes are harmful and that they create a gap between borrower and saver rates. Capital taxation leads to a shift in the burden to the customers or labor through higher prices charged by firms or by reduced capital accumulation in the long run.

William Gale
Brookings Institute

The standard Euler equation values need to be adjusted in order to capture what is really occurring.  Typically in the Euler equation, r and t are set such that σ = 0.  However, these typical numbers are incorrect.  When the right values of r and t are used, we find that σ = 1, a difference that has important implications.  The right r represents capital income (NIPA) over capital stock (BEA), and the right t is corporate, property, and a portion of personal income tax revenues over personal income.

Mulligan's work raises many questions.  What does the consumption function tell us when it comes to the incidence, i.e. the transfer of capital taxes?  The incidence of capital taxes is how much r (1-t) changes when t changes.  When the capital tax rate changes, does r (1-t) change at all, and if so by how much?  The answer to this question will provide a better understanding of how the capital tax affects capital markets. 

Kevin A. Hassett
AEI

In his presentation, Kevin Hassett discussed old and new capital, the effects of capital taxes, and whether or not they are bad for the economy by examining the effects of different taxes on selected countries and the discrepancies between the corporate taxes and corporate tax revenue of some selected countries. It is interesting to note that corporate tax revenue, as a percentage of GDP in most of the selected countries, was less than the corporate tax rates. He made use of a number of taxes like the effective marginal, average capital, and statutory tax rate during the course of his presentation. The correlations in most of the charts are high, and a positive correlation exists between the effective marginal tax and investment as a percentage of GDP in the different countries. In addition, average tax rates have a big effect on capital taxes. In conclusion, the aggregate consumer Euler equation does not tell too much about the capital tax incidence.

AEI interns Rebecca Uwaifo and Jim Moore prepared this summary.

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