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TH E JOU RNALOF
POLIT
ECON OMY
Volume LXX
JUNE 1962
Number 3
215
241
263
N. J. Sinter
299
302
Books Received
319
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THE JOURNAL
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POLITICALECONOMY
Volume LXX
JUNE 1962
Number3
and the other non-corporate, each employing two factors of production, labor
T
HIS paper aims to provide a theoretical framework for the analysis and capital. The corporation income tax
of the effects of the corporation in- is viewed as a tax which strikes the earncome tax and, also, to draw some infer- ings of capital in the corporate sector,
ences about the probable incidence of but not in the non-corporate sector.
this tax in the United States. It is clear Both industries are assumed to be comthat a tax as important as the corpora- petitive, with production in each govtion income tax, and one with ramifica- erned by a production function which is
tions into so many sectors of the econo- homogeneous of the first degree (emmy, should be analyzed in general-equi- bodying constant returns to scale). We
librium terms rather than partial-equi- do not inquire into the short-run effects
librium terms. The main characteristic of the imposition of the corporation tax,
of the theoretical framework that I pre- on the supposition that it is the long-run
sent is its general-equilibrium nature. It effects which are of greatest theoretical
was inspired by a long tradition of writ- and practical interest. In the very short
be borne out
ings in the field of international trade, in run, the tax will necessarily
of the earnings of fixed capital equipment
which the names of Heckscher, Ohlin,
in the affected industry, so long as our
Stolper, Samuelson, Metzler, and Meade
assumption of competition applies. But
are among the most prominent. These
this will entail a disequilibrium in the
writers inquired into the effects of inter- capital market, with the net rate of renational trade, or of particular trade poli- turn to owners of capital in the taxed incies, on relative factor prices and the dis- dustry being less than the net rate of
tribution of income. Here we shall ex- return received by owners of capital in
amine the effects of the corporation in- the untaxed sector, A redistribution of
come tax on these same variables.
the resources of the economy will result,
Our model divides the economy into moving toward a long-run equilibrium
two industries or sectors, one corporate in which the net rates of return to capital
I. INTRODUCTION
215
216
ARNOLD C. HARBERGER
sources, that variations in the rate of interest within the ranges observed in the
United States exert a substantial influence on the level of savings out of any
given level of income. We shall therefore
proceed on the assumption that the level
of the capital stock at any time is the
same in the presence of the tax as it
would be in its absence; but in the conclusion of this paper we shall briefly consider how the results based on this assumption might be altered if in fact the
corporation income tax has influenced
the total stock of capital.
The relevance of this approach for the
analysis of real-world taxes might also
be questioned on the ground that the
economy cannot reasonably be divided
into a set of industries which are overwhelmingly "corporate," and another
set which is overwhelmingly non-corporate. This objection has little validity, at
least in the case of the United States. In
the period 1953-55, for example, the
total return to capital in the private sector of the United States economy averaged some $60 billion per year, $34 billion being corporate profits and $26 billion being other return to capital. Of the
$26 billion which was not corporate
profits, more than 8Qper cent accrued to
two industries-agriculture and real estate, in which corporate profits were negligible. In all but seven industries in a
forty-eight-industry classification, corporation taxes averaged more than 25
per cent of the total return to capital,
and one can, for all practical purposes,
say that no industries except agriculture,
real estate, and miscellaneous repair
services paid less than 20 per cent of their
total return to capital in corporation
taxes, while the three named industries
all paid less than 4 per cent of their income from capital as corporation taxes.
Within the "corporate" sector, different
217
218
ARNOLD C. HARBERGER
LyPL=
2Ypy;
KyPk
=Yp.
If
219
220
ARNOLD C. HARBERGER
relative prices will, to a first approximation, be offset by the losses of those consumers who lose; thus, if we accept this
offsetting as a canceling of effects as far
as people in their role as consumers are
concerned, we can say that capital bears
the full burden of the tax.
III. THE CASE OF FIXED PROPORTIONS
IN THE TAXED INDUSTRY
221
to the production of X, with the production function for X requiring that labor
and capital be used in these fixed proportions, that is, X = Min [(Lx12), Kx]. Assume as before that the initial prices of
labor and capital were $1.00, and that
national income remains unchanged at
$1,200 after the imposition of the tax.
Likewise retain the assumption that expenditure is divided equally between
goods X and Y.
The post-tax equilibrium in this case
will be one in which the price of labor is
$0.83916, the price of capital $0.91255.
Industry X will use 171.25 units of capital and 342.5 units of labor; capital in
industry X will receive a net income of
$156.274, and the government, with a 50
per cent tax on the gross earnings of capital in industry X, will get an equal
amount; labor in industry X will receive
$287.412. These three shares in the product of industry X add up (but for a small
rounding error) to $600, the amount assumed to be spent on X. Industry Y will
employ 328.75 (= 500 - 171.25) units
of capital and 357.5 (= 700 - 342.5)
units of labor, and the total receipts of
each factor in industry Y will be, as
before, $300.3
3 Let W be the net earnings of capital in industry X. Our other assumptions require that capital
in industry Y must receive $300. Therefore, in the
post-tax equilibrium [W/($300 + W)] (500) units
of capital must be employed in industry X. Since
$600 is the total amount spent on X, and since the
government's take is equal to the net amount (W)
received by capital in industry X, labor in X must
receive, in the post-tax equilibrium, an amount
equal to $600 - 2W. Since labor in industry Y must
receive, under our assumptions, $300, total labor
earnings will be $900 - 2W, and the number of
units of labor in industry X must be [($600 - 2W)l
($900 - 2W)](700). (Recall that in this example
there are 500 units of capital and 700 units of labor
in the economy.) The production function for X requires that the industry employ twice as many units
of labor as of capital. Hence we have that (2)[WI
($300 + W)j(500) = [($600 - 2W)/($900 - 2W)]
(700) in the post-tax equilibrium. Solution of this
222
ARNOLD C. HARBERGER
When production in the taxed industry is governed by a Cobb-Douglas function, and fixed proportions prevail in the
untaxed industry, the results of the tax
are very different from those in the case
just discussed. Now the normal result is
for capital to bear more than the full burden of the tax, while labor enjoys an absolute increase in its real income. The
degree of increase in labor's real income
depends on the relative factor proportions in the two industries, but the fact
223
224
ARNOLD C. HARBERGER
Z)](800)
= [($600 - Z)/($900
Z)](700).
Though
tity so chosen that their prices are initially equal to unity. Demand for each product will depend on its relative price and
on the level of income of demanders. The
incomes of consumers will naturally fall
as a result of the imposition of the tax,
and through the consequent restriction
of their demand for goods, command
over resources will be released to the
government. The ultimate demand position will depend on how consumers react
to the change in their income and to
whatever price change takes place, and
on how the government chooses to spend
the proceeds of the tax. Assume for the
sake of simplicity that the way in which
the government would spend the tax proceeds, if the initial prices continued to
prevail, would just counterbalance the
reductions in private expenditures on the
two goods. This assumption, plus the
additional assumption that redistributions of income among consumers do not
change the pattern of demand, enable us
to treat changes in demand as a function
of changes in relative prices alone. Since
full employment is also assumed, the demand functions for X and Y are not independent; once the level of demand for
X is known, for given prices and full employment income, the level of demand
for Y can be derived from the available
information. We may therefore summarize conditions of demand in our
model by an equation in which the quantity of X demanded depends on (p2/p,).
Differentiating this function we obtain
dX =E d( P./ PY) E(dp-dpyp)
(Demand for X),
where E is the price elasticity of demand
for X, and where the assumption that
initial prices were unity is used to obtain
the final expression.
Assume next that the production function for X is homogeneous of the first
degree. This enables us to write
dX
X
dL
dK2
(2)
K:
LL+fK
(Supply of X),
where fL and fK are the initial shares of
labor and capital, respectively, in the
total costs of producing X.
In an industry characterized by competition and by a homogeneous production function, the percentage change in
the ratio in which two factors of production are used will equal the elasticity of
substitution (S) between those factors
times the percentage change in the ratio
of their prices. Thus we have, for industry Y,
d(Ky/Lv)
(Ky/Lv)
-s
-
d(Pk/PL)
(Pk/PL)
k-y
dL _=SV(dPk - dPL)
dkdL
Ly
(Factor responsein Y).
L.,X
S.(dPk+T-dPL)
Lx
(Factor responsein X),
(5)
dLv=-dLx
(6)
( 7)
dpy = gLdPL+
(8)
gKdpk
(3)
R.
Kx
225
(3')
dPL=0.
(9)
226
ARNOLD C. HARBERGER
X =E
[fk(
dPk+T)
ghdPkI
dx
dK.,(2
dLi,
dX= L dl+ A
k
Kx)
K.(-d
(2 )
K:
L,
L.(-dLx)sd
T
(1')
Sud k
(3")
(4')
dK2_dLx =Sx(dpA+T)
Kx
L--
gk-fk)
dPk+ f L L:
(10)
+ fk
_
0 = S.dkp_ L: dL+
+
0=
dk
Kx
dKz
K
Kx dKx
1Kx
(3")
ST =
- x~
SdPkr
dL.
dKx
+ K * (4')
f L
?
dp
_ _
_ _
E(g9k-
~~Lx
1k
fk)
f L
-sx
- 1
( 1
fA
E(
-L21 Ky
_ _
227
Z-Ly)
.;L
-*T=
dPk.
(12)
.fK~+L
228
ARNOLD C. HARBERGER
229
and gk is
4,
dpk
is
gkdpk,
it is clear
solution dpk
fkT/(gk
fk).
ample, capital initially accounts for onetenth of the value of output in X and
one-half in Y, a rise in the price of capital
by 0.25T will permit relative product
prices to remain unchanged. Recalling
that the price of labor is the numeraire,
and therefore is assumed to remain unchanged, one can see that the rise in the
price of X would be (0.1) (0.25T + T) =
0.125T, while the rise in the price of Y
would be (0.5) (0.25T), also equal to
0.125T. Suppose, however, that capital
initially accounts for four-tenths of the
value of product in X, and one-half in Y.
- fk),
which will be positive Then the price of capital will have to
fkTj(gk
when gkis greater thanfk (taxed industry rise by 4T in order to yield the equilibrirelatively labor-intensive) and negative um ratio of product prices. The rise in the
whenfk is greater than gk (taxed industry price of X would then be (0.4) (4T +
relatively capital-intensive). A some- T) = 2T, and the rise in the price of Y
what anomalous aspect of this solution
would be (0.5) (4T), which is also equal
is that the absolute value of dpk varies
to 2T. In the limit, where the factor pro10 Since
fL = L2/(L. + K.) and 1k = Kz/(Lz +
portions are the same in both industries,
K.), it is clear that fLKX = fkLx. The coefficient of
and where the production functions are
S. in the numerator of (12) can therefore be written
such that these proportions cannot be
fLKX[(l/Ky) + (l1Ly)] = fLKXF(Ly + Ky)/(LyKy)]
=fLKX/gLKy. Setting E = 0 in (12), and multiply- altered, the model does not give sufficient
ing numerator and denominator by gLK0, one obinformation to determine the prices of
tains the expression given above for dPk.
230
ARNOLD C. HARBERGER
-fkYT=_
X+Y
(X+Y)(Kx+Ky)
YKxfkT
(X+Y)(Kx+Ky)
fkKYT
Kx+Ky
KX, +
KY
Kx+Ky
Kx+Ky
(X+
Y)(Kx+KK)
=
YKxgkT
(X +Y) (K!+
Kv
(X+
Y)(Kx+Ky)
,
KxKyT
(X + Y) (Ke+ KY)
Equation (10) is therefore satisfied, and
the solution has been verified to be the
correct one.
10. In any case in which the three elasticities of substitution are equal (and nonzero), capital will bear precisely the full
burden of the tax. We have shown that
when So = Sy=
-1,
the solution
_ -fkYKyT
(X+
fxKYT
K + Ky'
If we divide the United States economy into two broad sectors, one corporate
231
232
ARNOLD C. HARBERGER
(Kx/Ky)
(Lx/Ly)
1
2
10
10
dPk_
dub = dl
T [-8E
+ 2OS]
_
16E-6Sy-20os
(13)
(14)
We have evidence which I believe permits us to estimate the order of magnitude of E reasonably well, albeit by an
indirect route. The untaxed sector, Y
consists overwhelmingly of two industries-agriculture and real estate-and
the activity of the latter is principally the
provision of residential housing services.
We know that the elasticity of demand
for agricultural products lies well below
unity, and recent evidence suggests
strongly that the price elasticity of demand for residential housing in the
United States is somewhere in the neighborhood of unity, perhaps a bit above
It is thus highly unlikely that the
it.13
price elasticity of demand for the products of our non-corporate sector (which
would be a weighted average of the price
elasticities of the component commodities, adjusted downward to eliminate the
contribution of substitutability among
the products in the group) would exceed
unity in absolute value; in all likelihood
it is somewhat below this figure. This evidence permits us to use unity as a reasonable upper bound for the elasticity of
substitution between X and Y. A value
of unity for this elasticity of substitution
fL
fk
gk
a value of - - for the elasticity
implies
1/11 10/11 0.5
5/6 0.5 of demand for the products of the non1/6
Substituting these figures into equation (12), we obtain expressions for dpk
in which the incidence of the corporation
13 See Richard F. Muth, "The Demand for Nonfarm Housing," in A. C. Harberger (ed.), The Demrandfor Durable Goods (Chicago: University of
Chicago Press, 1960), pp. 29-96.
233
We can be still less sure about the elasticity of substitution, S,, between labor
and capital in the untaxed sector. We
may recognize the relative success that
agriculture economists have had in fitting Cobb-Douglas production functions
to data for different components of agriculture and perhaps tentatively accept
an elasticity of substitution of unity as
applying there. However, close to half
the contribution of the non-corporate
sector to national income comes from
real estate and not from agriculture. It is
difficult to see how the elasticity of substitution between labor and capital in the
provision of housing services could be
very great. Very little labor is in fact
used in this industry (compensation of
employees is only one-tenth of the value
added in the industry), and it is hard to
imagine that even fairly substantial
changes in relative prices would bring
about a much greater relative use of
labor. Taking the non-corporate sector
as a whole, I think it is fair to assume
that the elasticity of substitution between labor and capital in this sector is
below, and probably quite substantially
below, that in the corporate sector.
We may now attempt to assess the
burden of the corporation income tax in
the United States. Let us take as a first
approximation the Cobb-Douglas case,
in which all three elasticities of substitution are unity. We have seen that this case
Demand Curves for Labor," Journal of Political
Economy, LXIX, June, 1961), 261-70. Both of these
studies were based on cross-section data, Solow's
data being classified by regions and Minasian's by
states. Though the over-all statistical significance of
the conclusion that the substitution elasticity between labor and capital in most manufacturing
industries is not far from unity is good, there is the
possibility of bias toward unity in the results due to
errors of measurement or to differences in the quality of labor among states or regions. It is on this
ground that I regard these results as less firm than
those on elasticities of demand.
234
ARNOLD C. HARBERGER
_2T1
235
236
ARNOLD C. HARBERGER
the tax. Thus, if one thinks that in the in this period would have been 20 per
absence of the corporation tax the net cent greater in the absence of the tax, the
savings rate in the United States might current capital stock would be only 10
be 20 per cent higher than it is now, he per cent less than it would have been in
may set the maximum value for R at the absence of the tax. And if the effect
0.2. This would mean that a maximum of the tax was to reduce savings by 10 per
of half the burden of the corporation tax cent, the current value of R would be
would be "shifted" to labor. If one thinks only 5 per cent.
that the savings rate in the absence of the
I conclude from this exercise that even
tax would be no more than 10 per cent allowing for a rather substantial effect of
higher than at present, a maximum of the corporation income tax on the rate of
one-quarter of the burden of the tax saving leads to only a minor modification
would be "shifted" to labor. The ob- of my over-all conclusion that capital
served constancy of the savings rate in probably bears close to the full burden of
the United States in the face of rather the tax. The savings effect here considwide variations in the rate of return on ered might well outweigh the presumpcapital suggests that the effect of the tax tion that capital bears more than the full
on the rate of saving is probably small. burden of the tax, but it surely is not sufMoreover, no more than half of the pres- ficiently large to give support to the freent capital stock of the United States is quently heard allegations that large fracthe result of accumulations made after tions of the corporation income tax
corporation tax rates became substantial burden fall on laborers or consumers or
in the mid-thirties. Thus even if savings both.
APPENDED NOTES
At the presentation of this paper at the
1961 meetings of the International Association for Research in Income and
Wealth, and in other discussions of its
content, some questions have been raised
that clearly merit treatment, yet that do
not quite fit as integral parts of, or as footnotes to, particular statements in the main
text. These notes discuss two of these
points.
1. OTHER SPECIAL TAX PROVISIONS
RELATING TO CAPITAL
237
238
ARNOLD C. HARBERGER
[gb-fk(+
+M)(
[fLdPd
VL
(7')
A dKx
Finally, the solution for dpk, given in equation (12), now becomes:
L)
KzL)S+S(fLKx+f4
+
)] (y Ks
+M)I (Kx-L)
239
VT.
SySx
KL A N
(JLKX?
(1 2')
240
ARNOLD C. HARBERGER