Measures of gross domestic product and employment tell us how the economy is doing in producing goods and services and creating jobs. Measures of productivity link what the economy produces to the inputs – technology, labor and capital – used to produce it. When productive capital becomes scarce, then output per worker – labor productivity declines, hiring slows and so do wages for new hires. Historically, productivity growth has led to gains in compensation for workers and greater profits for firms. This has big implications for tax policy – especially the degree to which capital is taxed since capital – an essential ingredient to improvements in workers’ living standards – is highly responsive to changes in the tax climate.
Countries that reduced taxes saw large increases in productivity; countries with a higher tax burden saw lower productivity gains.
See figure 1
Ireland, with the largest tax climate improvements, has seen the largest increase in labor productivity. Ireland, with a corporate income tax rate of 12.5 percent, tops the list of recipient countries for U.S. companies that shift their place of incorporation to another country. The large decline in capital taxation that took place in Ireland in the 1990s coincides with large worker productivity gains.
See figure 2
Lessons from Chamley and Judd
According to Chamley (1986)2 and Judd (1985)3: 1), capital should not be taxed in the long run, and, 2) it is impossible to tax capital income, hand all of the tax revenue to workers and not wind up with a smaller economy in the long run. However, since these famous results, many economists have questioned the model’s assumptions in an attempt to disprove Chamley and Judd’s conclusions.
First, capital is an intermediate input used for future production. That means the taxation of capital is inefficient, since it will put the economy inside its production frontier. Second, a tax on capital today is an ever-increasing tax on future consumption but not current consumption, thus making future generations worse off. Third, a tax on capital reduces the size of the capital stock and aggregate output in the long run, because it takes time to build new capital goods and only finished capital goods are part of the productive capital stock that can then be transformed into consumption goods. Half-finished factories are not part of the productive capital stock. For example, the average time between the decision to undertake an investment project and the completion of it is 21months. In addition, the average lag between the design of a project and when it becomes productive is about two years.4
Finally, increasingly interconnected markets have contributed to more elastic responses of capital flows to tax changes. The importance of capital goods for the production process cannot be overstated and any tax on capital discourages capital accumulation.
Should capital be taxed in the short term? What about the long term?
The standard theory of optimal taxation argues that a tax system should maximize social welfare subject to a set of constraints. The goal should be to enact a tax system that maximizes households’ welfare, given the knowledge that household members respond to whatever incentives the tax system provides.
Pioneering work on optimal taxation is the work of Frank Ramsey (1927), who suggested that if a social planner must raise a given amount of tax revenue, he must do so such that only commodities with inelastic demand are taxed. Another important contribution on this topic is the work of James Mirlees (1971), who posits that when a tax system aims to redistribute income from high ability to low ability individuals, the tax system should provide sufficient incentive for high-ability/high-income taxpayers to keep producing at the high levels that correspond to their ability, even though the social planner would like to target this group with higher taxes. This is because a higher tax on high-income individuals would discourage them from exerting as much effort to earn that income.
The Mirlees result implies that consumption and labor elasticities – the responsiveness of consumption and labor supply to their respective prices – are crucial for determining the optimal tax rates. If high-income workers were more responsive to an increase in their tax bill, this would imply lower optimal marginal tax rates on high incomes, all else equal. In other words, optimal tax policy should not cause the tax base to shrink.
Optimal taxation implies no taxation of human and physical capital because both are intermediate inputs used for both current and future production (see, Diamond and Mirrlees, 1971). Optimal taxation also rules out taxes with differential effects across time periods.
Since individuals ability and earnings change over time and since individuals are forward looking, tax policy that aims to redistribute efficiently should be both backward- and forward-looking, thus making redistribution a very challenging proposition.
Most recently, Chari, Nicolini and Teles (2017)5 employ a standard open economy macroeconomic model to show that capital should never be taxed both in the long run and in the short run. It is never optimal to introduce inter-temporal tax wedges, meaning that it is never optimal to tax capital. If consumption and labor elasticities are constant over time, then optimal taxation implies that consumption and labor should be taxed at constant rates over time. However, when current capital is being taxed or confiscated, it imposes higher taxes on future goods. Lastly, any taxation that aims to redistribute income across individuals should be such that individuals’ consumption and labor decisions aren’t distorted.
What does the empirical evidence suggest?
Theoretical wonder aside, it turns out that the empirical evidence on the effects of taxation largely supports a move away from capital taxation.
Economists agree unanimously that higher tax rates have a negative effect on economic growth.
Romer and Romer (2010)6 find that exogenous tax increases have a negative effect on real GDP. The maximum effect of a tax increase equivalent to 1 percent of GDP is a fall in output by almost 3 percent after 10 quarters. Tax increases have a very large and sustained negative effect on output.
To understand why output declines, Romer and Romer (2010) find that a tax increase (tax on labor and capital) of 1 percent of GDP leads to a 2.55 percent fall in personal consumption expenditures, a 11.19 percent fall in gross private investment. Exports rise substantially and imports fall. The rise in net exports is consistent with the tax increase lowering interest rates and hence reducing capital inflows.
These results are also consistent with the findings of Blanchard and Perotti (2002)7 and Mountford and Uhlig (2009).8 Investment falls in response to both tax increases and government spending increases. Consumption does not rise significantly in response to a fiscal policy change. Government spending increases have a negative effect on the real wage of workers.
Can workers be made better off by taxing the owners of capital?
The economic effect of tax and spending policy is nontrivial. On one hand, higher taxes on capital income discourage investments in productive capital. This reduction in productive capital causes workers to become less productive, thus causing the real wage to decrease.
Declining real wages make workers worse off and reduce the incentive for market work relative to leisure or home production. On the other hand, a lower after-tax income raises the need to work, save, and invest in order to maintain the same living standard. The first effect lowers economic activity – economists refer to it as the substitution effect – while the second effect normally raises activity through the so-called income effect. The impact of the tax hike depends on which one of these effects dominates the other in magnitude.
Now, consider a tax that lowers the real wage of workers and yet at the same time eliminates a negative income effect by providing workers with a windfall – lump sum transfer. Under such a tax scheme, the fall in the real wage generates a substitution effect that discourages work and the transfer mitigates some of the decline in income resulting in a substitution effect that exceeds the income effect in magnitude. For that reason, workers become less attached to paid market work and economic growth slows.
Tax hikes lower productivity, harming both capital owners and workers. This is because of a large negative response of capital investments to tax hikes. The decrease in investment results in declining living standards.
What Ramsey and Mirlees taught us is that good tax policy should not diminish productive capacity and cause the tax base to shrink. The large negative response of capital investments to taxation qualifies capital as a commodity that should never be taxed.
- Chamley, Christophe, “Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives,” Econometrica, 1986, 54 (3), pp. 607–622.
- Judd, Kenneth L., “Redistributive taxation in a simple perfect foresight model,” Journal of Public Economics, 1985, 28 (1), 59 – 83.
- Kydland and Prescott, 1982. “Time to Build and Aggregate Fluctuations,” Econometrica, vol 50, 6, pages 1345-1370.
- Chari, Nicolini and Teles, 2017. “Ramsey Taxation in the Global Economy” Federal Reserve Bank of Minneapolis Working Paper 745 https://minneapolisfed.org/research/wp/wp745.pdf
- Christina D. Romer & David H. Romer, June 2010. “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,” American Economic Review, American Economic Association, vol. 100(3), pages 763-801. https://eml.berkeley.edu/~dromer/papers/RomerandRomerAERJune2010.pdf
- Blanchard O and Perotti R. 2002. “An empirical characteriz ation of the dynamic effects of changes in government spending and taxes on output.” Quarterly Journal of Economics. 117(4): 1329–1368
- Mountford A. and Uhlig H. 2009. “What are the effects of fiscal policy shocks?” Journal of Applied Econometrics 24: 960-992