Wednesday, October 18, 2017

Furman and Summers revoke Summers' academic work on investment

Former CEA chair Jason Furman writes “The economic debate about the %age of the corporate tax paid by labor ranges from 0% to 100%. The new CEA study puts it at 250%.”

Larry Summers reiterates Furman’s argument, calling the CEA and its estimate “dishonest, incompetent and absurd.”

Furman’s first sentence has the economics of investment completely backwards.

I will point to academic papers in a minute, but they can be understood with capital supply and capital demand, as shown below.

The red area (R) is the revenue from a capital income tax.  The red and green areas (R + G) are the losses from that tax suffered by owners of the factors of production, combined for capital and all other factors.  The revenue is a LOWER BOUND on the factor owners' loss.

In the long run, all of the factor owners' loss from a capital income tax is a loss to labor (the area below the horizontal dashed line is negligible; see A below).  Therefore, in the long run, capital-income tax revenue is a LOWER BOUND on labor’s loss.

Furman and Summers have it backwards.  They don't seem to understand that the wage gains from a cut come not only from the Treasury but also the economic waste created by the corporate tax.

(A) Why would labor bear all of the burden in the long run?  Well, ask Larry Summers back when he used to be an academic studying these matters.  His 1981 Brookings paper, which even today is an article commonly used by me and others to teach this in graduate school, says so on page 81 equation (7).  The left-hand-side of that equation is a perfectly elastic long-run supply of capital: it says that the supply curve in my picture is, in the long run, properly drawn as horizontal.  See also Lucas (1990, p. 303, equation 4.3).

(B) OK, the long-run Furman ratio must be greater than 100%, but how big is it?  If we (i) begin, as is today’s reality, with a high tax rate, and (ii) conservatively assume that the only channel for benefits is a higher capital stock (more on that below), then 250% is about right for cuts to somewhat lower rates.

Using a Cobb-Douglas aggregate production function with labor share 0.7, and a 50% capital-income tax rate (combining corporate, property, and the capital components of the personal income tax), I get a Furman ratio of 350%.  With a 40% tax rate instead, the Furman ratio is 233% (algebra here; these refer to modest tax-rate reductions -- not going all of the way to zero).

If the current CEA said 250%, then it got Furman's ratio much closer than Furman did, who puts it less than 100%.

Note that Summers now calls the 250% "unprecedented in analyses of tax incidence," yet I am getting it from his own paper about how the corporate-income tax works (see esp. p. 95)!

(C) Are there labor benefits not shown in the picture?  Again, let’s go to the academic incarnation of Larry Summers.  He once made contributions to supply-side economics!  In his chapter in “The Supply-Side Effects of Economic Policy,” Summers wrote that labor likely benefits from corporate income tax cuts even WITHOUT ANY increase in the aggregate capital stock because that capital would be “better allocated to the corporate sector.”

Update on (C): Greg Mankiw points out still more labor benefits not shown in the picture.  His source -- you guessed it! -- Larry Summers.

To summarize, anyone using Larry Summers’ academic work for policy analysis, is, according to Larry Summers, “dishonest, incompetent and absurd.”

(update: Summers' reply now revokes academic work more generally.  He also wants you to forget that he said CEA's Furman-ratio result to be "unprecedented in analyses of tax incidence."

Moreover, he digs his hole deeper with his critiques of the simple model.  I.e., President Trump should be thanking Summers for unwittingly strengthening the case for corporate tax reform.

See my comments on Summers 1981 here.)

1 comment:

andy w said...

Can you elaborate more on the claim that, in the long run, the supply of capital is perfectly elastic? Do you mean that the supply of capital to the U.S. is elastic or the global supply of capital?

My understanding is that capital is not perfectly mobile across borders, and that the total stock of global savings/investment does not respond to tax rates. Am I wrong?

If I'm right about the above, this would imply that (i) from a global perspective, the total burden falls almost entirely on capital, (ii) the total burden is approximately 100% of revenue, and (iii) labor bears some burden domestically but this is counterbalanced by higher wages for foreign workers.