Incidence of a Capital Income Tax in a Growing Economy with Variable Savings Rates

Abstract

The theory of economic growth has emphasized that the capital stock, unlike the labour force, is not an original factor of production but represents the accumulation of past incomes.2 Any analysis of the incidence of a tax on capital income should therefore begin by considering how the tax affects the stock of capital. Although a comparative static analysis with a varying capital stock can be instructive, the process of capital accumulation is represented best by a model of economic growth. The purpose of this paper is to examine how savings behaviour affects the long-run incidence of a tax on profits 3 in a growing economy. The analysis is in terms of a general tax on all capital income but the results are obviously relevant to understanding the incidence of the corporate income tax. With a fixed capital stock, owners of capital would bear the entire burden of a general tax on profits 4 and would avoid some of the burden of a partial tax on capital (such as the corporate income tax) to the extent that capital can shift away from the taxed sector to the untaxed sector without significantly reducing the marginal product of capital in the untaxed sector. Harberger's [4] analysis of such a model has shown that, with reasonable parameter values, the US corporate income tax is borne almost entirely by capital and is therefore quite similar in incidence to a general tax on capital income with a fixed capital stock. The current paper shows that replacing the usual static model and fixed capital stock by a model of a growing economy with variable savings rates substantially alters the conclusions about the incidence of a general tax on profits. For a wide range of plausible parameter values, a substantial fraction of the burden of a general profits tax is borne by labour. The assumption of a fixed capital stock may, therefore, also yield quite misleading conclusions in the analysis of the corporate income tax.