Category: Equitablog

Should-Read: Jared Bernstein also wishes that we had (1) Greg back. It is indeed the case that the old (1) Greg-teaching-students-about-public-finance-issues was much better than the current (2) Greg-going-as-far-as-he-believes-he-can-to-be-helpful-to-the-Republican-Party:

Jared Bernstein: When econ models potentially mislead, econ profs should say so: “Greg Mankiw points out the direction [but not the magnitude] of Hassett’s result is consistent with a particular economic model…

…teaching his students how to get a result like Hassett’s by imposing standard assumptions common to such models. Greg… answers the question: is there an economic model that might defend Kevin’s findings, at least directionally if not their magnitudes? Answer: yes…. [But the] question… is: what’s the real-world likelihood that corporate tax cuts will raise workers’ wages anywhere near the amount Hassett claims?… The answer… is “very low”… based on both theory and evidence….

The interesting economics question is to why the [Mankiw] model predicts such an unrealistic result…. Which of the assumptions most fail to comport with reality? To the extent that we want to train students to be useful practitioners as opposed to proficient, yet unrealistic, modelers, answering those questions would also provide some real educational value-added…. The model assumes that the US is a small, open economy… assumes away imperfect competition…. Summers made a great point about this: The modelling of Mankiw and others “illustrate why well-resourced, team-based institutions with a strong culture of attention to detail like the Congressional Budget Office, the GAO, the Joint Tax Committee Staff or the Tax Policy Center are so important.” By “detail,” I take him to mean an unbiased use of literature (unlike Hassett, who totally cherry-picked), and more important, an historical perspective…. Corporate tax cuts never come close to the wage impacts Hassett claims, and Mankiw’s modelling supports. Real modelers analyzing real policy proposals must reference real empirical results, and not just the ones that go their way.

This all points to a bigger problem…. A well-placed, highly-pedigreed economist (Hassett) makes an implausible claim…. His claims can be and are, if not defended, then apparently corroborated, by an economic model, in this case by other highly pedigreed economists. This is lovely development from the perspective of the politicians and their donors who crave these high-end tax cuts. All they need is some “analysis,” regardless of how cherry-picked, and a little backup from other erudite economists saying “under certain conditions, yeah… this could happen.” They—those other erudite economists—shouldn’t do that….

They should be explicit about how applicable the model is to the real world, and whether the assumptions it violates are germane to policy makers (Krugman does so here; Furman here)…. In the hurly-burly of political economy, it’s an egregious omission, one with the potential to mislead policy makers and, once the tax cuts fail to generate the result predicted by the model, reduce the trustworthiness of economic analysis.

Should-Read: Dani Rodrik: Growth Without Industrialization?: “FLow-income African countries can sustain moderate rates of productivity growth into the future, on the back of steady improvements in human capital and governance…

…But the evidence suggests that, without manufacturing gains, the growth rates brought about recently by rapid structural change are exceptional and may not last…. Sub-Saharan Africa’s economic growth has slowed precipitously since 2015, but this reflects specific problems in three of its largest economies (Nigeria, Angola, and South Africa). Ethiopia, Côte d’Ivoire, Tanzania, Senegal, Burkina Faso, and Rwanda are all projected to achieve growth of 6% or higher this year. In Asia, the same is true of India, Myanmar, Bangladesh, Lao PDR, Cambodia, and Vietnam.

This is all good news, but it is also puzzling. Developing economies that manage to grow rapidly on a sustained basis without relying on natural-resource booms – as most of these countries have for a decade or more – typically do so through export-oriented industrialization. But few of these countries are experiencing much industrialization. The share of manufacturing in low-income Sub-Saharan countries is broadly stagnant – and in some cases declining. And despite much talk about “Make in India,” one of Prime Minister Narendra Modi’s catchphrases, the country shows little indication of rapid industrialization.

Manufacturing became a powerful escalator of economic development for low-income countries for three reasons…. It was relatively easy to absorb technology from abroad and generate high-productivity jobs…. Farmers could be turned into production workers in factories with little investment…. Manufacturing demand was not constrained by low domestic incomes: production could expand virtually without limit, through exports….

What, then, are we to make of the recent boom in some of the world’s poorest countries? Have these countries a discovered a new growth model?… Growth-promoting structural change has been significant in the recent experience of low-income countries such as Ethiopia, Malawi, Senegal, and Tanzania, despite the absence of industrialization…. Rapid structural change in these countries has come at the expense of mostly negative labor productivity growth within non-agricultural sectors…. The African model appears to be underpinned by positive aggregate demand shocks generated either by transfers from abroad or by productivity growth in agriculture….

Because of low income elasticity of demand for agricultural products, outflows of labor from agriculture are an inevitable outcome during the process of development. The labor that is released must be absorbed in modern activities. And if productivity is not growing in these modern sectors, economy-wide growth ultimately will stall…. Continued convergence with rich-country income levels seems achievable. But the evidence suggests that the growth rates brought about recently by rapid structural change are exceptional and may not last.

Should-Read: Chye-Ching Huang: GOP Tax Framework Looks Much Like Kansas’ Failed Tax Cut Package: “In 2012, Kansas adopted an array of tax cuts that were large, costly, and heavily titled to those high on the income scale…

…Although proponents claimed these tax cuts would supercharge the state’s economy, Kansas’ job and economic growth lagged behind those of most neighboring states and the nation after the tax cuts took effect, and the deep revenue losses led to round after round of budget cuts in key programs. This year, state lawmakers considered the damage, and they reversed course and repealed most of the tax cuts. Yet many policymakers in Washington are now proposing costly, regressive federal tax cuts that have a great deal in common with the tax cuts that performed so poorly in Kansas….

Rep. Lynn Jenkins (R-Kansas) has argued that Republicans have “learned from Kansas’ missteps.” Sharon Wagle, president of the Kansas State Senate, has claimed that “[c]omparing the 2012 Kansas tax plan to the ongoing tax reform discussions on the federal level is disingenuous.” Those who make this argument protest too much…. The GOP leaders’ federal tax-cut plan closely follows Kansas’ failed experiment.  And many of the same salesmen who touted the Kansas plan in 2012 now are making the same type of outsized claims that the proposed federal tax cuts will ignite remarkable economic growth….

In 2012… Kansas Governor Sam Brownback promised the state tax cut would act “like a shot of adrenaline into the heart of the Kansas economy.”… Stephen Moore and Arthur Laffer, who helped design the Kansas plan, declared it would have a “near immediate” positive economic impact…. That’s far from what actually occurred, [but] this hasn’t stopped supply-side tax-cutters in the White House and on Capitol Hill…. Stephen Moore — who, as noted, helped design the Kansas plan — now says the GOP tax plan is “not that much different from the one that Trump campaigned on — and that economist Larry Kudlow and I helped draft.”  Moore claims the GOP tax plan will produce the same type of results that he and his allies earlier insisted would occur in Kansas…. Council of Economic Advisers Chair Kevin Hassett contends that the GOP tax plan’s corporate rate cuts will cause large increases in typical workers’ wages — a claim that leading economists have shown rests on assumptions they describe as “ludicrous.”  Similarly, Treasury Secretary Steven Mnuchin says that the GOP tax plan will boost growth so much that it will reduce budget deficits by $1 trillion, a claim no mainsatream economist considers plausible….

The Kansas experience is especially relevant today because the GOP tax plan largely replicates key provisions of the Kansas tax cuts. Cutting the top rate on “pass-through” income and providing powerful incentives for tax avoidance…. Boosters of the GOP tax plan claim they will come up with rules to prevent tax avoidance under their pass-through proposal. But no one should give that assertion much credence…. They’ve yet to present any proposals to do that. And tax experts are deeply skeptical that Congress and the Administration could write and enforce rules…. Individual income tax rate cuts…. Swelling the budget deficit….

Kansas’ tax cuts are an important cautionary tale that federal policymakers ignore at their constituents’ peril…

Should-Read; Andrew Gelman: Using black-box machine learning predictions as inputs to a Bayesian analysis: “We started by using the output from the so-called machine learning as a predictor… http://andrewgelman.com/2017/09/20/using-black-box-machine-learning-predictions-inputs-bayesian-analysis/

…then we fit a parametric model to the machine-learning fit, and now we’re transitioning toward modeling the raw data. Some interesting general lessons here, I think. In particular, machine-learning-type methods tend to be crap at extrapolation and can have weird flat behavior near the edge of the data. So in this case when we went to the parametric model, we excluded some of the machine-learning predictions in the bad zone as they were messing us up…

Must-Read: Above a Shiller CAPE of 25, we have essentially three observations as to what happens next. Hence “we have little idea what is likely, and past performance is not a reliable guide to future results” is the only sound thing to say. As Jim Powell says: with two data points you have an estimate of the mean and an estimate of the standard error, for you think your two data points are at μ ± σ/2. And then he laughs:

Chandrasekhar Ramakrishnan: The DeLong-Shiller Redux: “2014, Robert Shiller and Brad DeLong…. [Shiller] claims if the value of this [CAPE] ratio is above 25, a major market drop is probably brewing…

…[DeLong] writes “we find that we cannot calculate a ten-year return for the 2007 CAPE peak of 27.54 — we still have three years to go.” Those three years have in the meantime transpired, and we now have the data necessary to calculate the ten-year return for May 2007, when the aforementioned peak occurred. This seems like a good time to revisit the DeLong-Shiller argument….Earnings/price can… be estimated as 1/CAPE. He calls the EMH-expected-returns for a given value of CAPE “warranted returns”, and to visualize his framework, DeLong constructs the following plot, which I’ve updated to include the latest data. This plot shows CAPE vs. 10-year returns and includes a curve to indicate the warranted returns. Reflecting on the fit of the curve, DeLong remarks, “Given the naiveté of the framework, that turns out to be… a remarkably good guide to the central tendency of the distribution of future ten-year returns conditional on the CAPE.” And I would have to agree….

Past performance is not an indicator of future performance. Nonetheless, we can see what past performance at today’s CAPE levels would yield. We have earnings data up to the end of Q2 2017 and using that, we can compute CAPE and try the following impossibly naïve model: for a current CAPE value (for which we do not yet have returns data), take the 19 closest values in the past and average these to get a prediction. This is of course not how machine learning should be done…

I should point out that my “warranted” returns are for somebody reinvesting their portfolio and holding to ∞, thus eliminating valuation-ratio risk and valuation-ratio mean reversion from the problem. They also assume that reinvested earnings are neither dissipated in corporate empire building nor able to earn supermarket returns via superior information.

When CAPE is high and when your horizon is less than ∞, you should incorporate some estimate of valuation-ratio mean reversion—and that is what Ramakrishnan does…

Must-Read: I confess that I, at least, never heard Larry Summers say: “A-list people do not directly criticize A-list people: doing so is a way to become a B-list person”. I doubt he has ever said it that way.

I have, however, heard Larry say—many times—that it is in general not wise to presume bad faith or incompetence on the part of, say, present or former fellows at places like, say, the American Enterprise Institute.

First of all, people think differently and disagree. Economics ain’t rocket science. As John Stuart Mill said, in economics:

What was affirmed by Cicero of… philosophy… may be asserted without scruple… that there is no opinion so absurd as not to have been maintained by some person of reputation. There even appears to be on this subject a peculiar tenacity of error—a perpetual principle of resuscitation in slain absurdity…

You might be the one maintaining the absurd position. You should keep an open mind, and mark your beliefs to market.

Second, strident criticism of error according to a hermeneutics of bad faith or a hermeneutics of incompetence may be effective at rallying one’s own troops to the cause, but it is not effective in winning converts from the other side, or even at persuading the rational middle of good-hearted and public-spirited people fresh to the issue.

Thus, the view was, we should invite Kevin Hassett to present his view of the “Tax Reform” framework to the Tax Policy Center, and name him a Distinguished Speaker. We should presume that Charles Murray’s rantings are not at base motivated by whatever made him burn a cross in imitation of the KKK. We should presume that there is competence at some level behind Casey Mulligan’s claim that 4% of the American labor force quit their jobs and began happily playing video games in the basement as a result of the passage of ObamaCare and similar policies. We should take it for granted that John Cochrane has done his math correctly when he claims that a 20% VAT could provide a progressive replacement to America’s tax system. We should keep a open mind to Nick Eberstadt’s argument that Americans have been unmanned by their receipt of unemployment insurance, Medicaid, Medicare, and Social Security—never mind the fact that such programs neither greatly alter incentives nor are perceived as “welfare” by beneficiaries—and turned into a nation of “takers”, in the phrase coined by right-wing goldbug loon Edmund Contoski. And we should spend our time and energy going the extra mile to presume that their positions are advanced in competence and good faith, and arguing earnestly against the positions they advance with evidence and logic, in one gigantic interminable game of whack-a-mole.

I have long thought that Larry was wrong here.

I have long thought that the best working rule is: everybody gets three strikes—three mistakes that are highly unlikely to have been made by someone working competently and in good faith, with plenty of opportunities to recant, correct error, and mark beliefs to market.

After three strikes, they are out. After they have struck out, then it is not irresponsible to work according to a hermeneutics of bad faith or incompetence. Rather, it is irresponsible not to.

Not to do so—to assume good faith and competence where it is absent—is, IMHO, very destructive of the public sphere in the long run. It sets in motion a downward Gresham’s Law spiral. Those who are willing to argue in bad faith are not constrained in the degree to which their doctrines can please their political masters and their think-tank donors. Those who are not competent are, similarly, unconstrained by reality—and pure fantasy can, also, often be very pleasing to political masters and think-tank donors. And so bad economists will drive out good ones: in the esteem of their political masters, in their positions in think tanks, in the financial support that they can elicit.

Larry might have thought—he has never argued this way to me, but it is a plausible argument—that it is the business of economists on each political “side” to police their own, and require quality analysis. And in the center and on the center-left there is indeed such a tendency. Charlie Schultze in the 1980s had no tolerance for the arguments of Bob Reich, who he thought dangerously overestimated the administrative and planning competence on the one hand and the relative autonomy from industry-specific rent-seeking on the other of the American government. When the smart and well-intentioned Gerry Friedman put forth a series of arguments that my faction thought greatly overstated the good that could be done by a not too massive public investment and spending program, the smackdown was intense. The view is that analyses that are not in the range of those made by politically-disinterested analysts and forecasters who do not have a career-making or -breaking dog in the fight are not analyses that should be used for policy planning or policy advocacy.

But there is no much less policing of intellectual quality on the right than on the center and the center-left. And so the downward Gresham’s Law quality-of-economic-analysis spiral continues.

It gives me no pleasure to watch the evenhanded, hermaneutics-of-good-faith-and-competence Larry vanish. But he has. And now we have a different Summers: one who is downright shrill:

Larry Summers: One last time on who benefits from corporate tax cuts: “I recently asserted that Kevin Hassett deserved a failing grade for his ‘analysis’ projecting that the Trump administration proposal to reduce the corporate tax rate from 35 to 20 percent would raise the wages of an average American family between $4,000 to $9,000…

Larry states that in his view it is Kevin Hassett who crossed the ultimate line in terms of tone and respect, and that that line-crossing deserves universal condemnation:

Hassett had, for what seemed like political reasons, impugned the integrity of people like Len Burman and Gene Steuerle who have devoted their lives to honest rigorous evaluation of tax measures by calling their work “scientifically indefensible” and “fiction”…

And this line-crossing imposes on analysts a duty to call Hassett’s garbage analysis what it is, rather than to presume it is both competently done and made in good faith:

The analysis from Hassett, chief of the White House Council of Economic Advisers (CEA), relies heavily on correlations between corporate tax rates and wages in other countries to argue that a cut in the corporate tax rate would boost returns to labor very substantially…. The CEA ignores our own historical experience…. The corporate tax cuts of the late 1980s did not result in increased real wages…. The same is true in the United Kingdom…. These examples feel far more relevant to the corporate tax issue analysis than comparisons to small economies and tax havens like Ireland and Switzerland upon which the CEA relies…. No one has defended the 4,000 dollar[/year wage boost] claim [of Hassett’s] as a “very conservatively estimated lower bound,” let alone endorsed the plausibility of the $9,000 claim…. The Wall Street Journal… published two very optimistic versions of what the wage increase could be… below CEA’s lower bound…

Then Larry turns to those who have… not defended Hassett, but not criticized Hassett either: who have, while not endorsing his numbers, tip-toed up to the line of what they think they can do in terms of providing half-hearted support for Hassett:

Casey Mulligan and Greg Mankiw… make use of simple academic abstract models that do not capture the complexities of a policy situation to argue that wage increases could be larger than the tax cut…

Let me skip over Mankiw for the moment, and go to Summers on Mulligan and company:

Mulligan accuses me of rejecting the results of my 1981 paper on Q Theory which he claims to like and teach. I’m flattered that he appreciates my paper, but am fairly confident he draws the wrong conclusions…. One central aspect… was the recognition that the corporate tax rate is… not a sufficient statistic for assessing the impact of the corporate tax system…. It is necessary to build in assumptions about depreciation allowances, debt finance and so forth…. The main point… which Mulligan entirely ignores, was that because of slow adjustment costs, the impact of tax changes was felt primarily on asset prices for a long time…. The primary impact of a corporate tax cut would be to raise after-tax profits and the stock market. This in turn, as I noted, primarily benefits wealthy individuals….

It is worth noting that Larry Kotlikoff and Jack Mintz’s response to criticisms of the Trump tax plan suffers from the same deficiencies as Mulligan’s. The authors include no corporate tax detail, no recognition of the impact of the tax proposal on asset prices, and no treatment of the budget consequences of tax cuts. The newest, boldest bit of claim inflation regarding the tax bill comes from the Business Roundtable: “a competitive 20 percent corporate tax rate could increase wages sufficient to support two million new jobs.” This would, coupled with job growth projected even in the absence of a corporate rate cut, take the unemployment rate well below 3 percent! I would be very interested to see the underlying analysis.  I would be surprised if it is convincing…

Mulligan has long seemed to me to be far past his three strikes:

And Summers on Mankiw:

Mankiw’s blog is a fine bit of economic pedagogy. It asks students to gauge the impact of a corporate rate reduction on wages in a so called “Ramsey” model or equivalently in a small fully open economy, with perfect capital mobility. Even with these assumptions, he does not get answers in the range of the CEA’s estimates. As a device for motivating students to learn how to manipulate oversimplified academic models, Mankiw’s blog is terrific as one would expect from an outstanding economist and one of the leading textbook authors of his generation…

I would not have used the word “terrific” (or “gorgeous”). I think that the Greg we have here is not primarily (1) Greg-teaching-students-about-public-finance-issues but rather (2) Greg-going-as-far-as-he-believes-he-can-to-be-helpful to the Republican Party. And I wish we had (1) Greg instead.

Why do I think this? First of all, as John Maynard Keynes wrote in his obituary for Alfred Marshall:

The study of economics does not seem to require any specialised gifts of an unusually high order…. Yet good, or even competent, economists are the rarest of birds. An easy subject, at which very few excel! The paradox finds its explanation, perhaps, in that the master-economist must… reach a high standard in several different directions… be mathematician, historian, statesman, philosopher… understand symbols and speak in words… contemplate the particular in terms of the general, and touch abstract and concrete in the same flight of thought…

And the most important element of this combination needed to be a good economist is to choose the right model for one’s analysis.

Greg begins his analysis of the effects of a corporate tax cut on the U.S. with “an open economy…”. In so beginning he has already served his readers ill. The U.S. is not a small open economy. You choose a model that applies, not a model that does not apply.

The second most important element of this combination is that one chooses a complete model and does a complete analysis. Corporate tax cuts are cut, yes. But then what? There is a government budget constraint there somewhere—or if there isn’t, that is a very important element of the situation. Is government spending cut? Is it cut now or in the future? Are other taxes raised? Which taxes? And when? Kevin Hassett called the Tax Policy Center’s analysis “scientifically indefensible” and “fiction” in large part because they had done a complete analysis, filling in the parts of the tax cut framework that were missing with what seemed to them to be reasonable assumptions. But Mankiw doesn’t do a complete analysis. The corporate tax rate is cut. Full stop.

Third, there is a math error in Greg’s presentation. When in a small open economy you cut the corporate tax rate t by an infinitesimal amount dt, that tax rate cut has three first-order effects on tax revenue. It (a) reduces how much revenue is collected from each dollar of tax base, (b) reduces production and the tax base by reducing the pre-tax rate of profit, and (c) raises the tax base by encouraging more investment. The “static” revenue-loss calculation ignores term (c). The first-order “static” revenue loss is then:

But Greg misses term (b), and so he calculates the revenue loss as:

This error inflates Mankiw’s calculations by a factor of 1/(1-t).

He thinks that he is demonstrating that the gain in wages is greater than the “static” revenue loss because the cut in taxes calls forth extra investment and higher productivity. But you can recognize that this interpretation is wrong by considering the case in which more capital is useless and unproductive. In that case, note that Mankiw’s math still claims that wages grow by a factor 1/(1-t) bigger than the corporate revenue loss even when the tax cut does not induce any extra investment at all.

This is the kind of math error that can happen to anyone—and does happen to me, especially in a blog post. We are all bears of very little brain, and none of us as smart individually as we are smart collectively, especially in that for of thinking that is manipulating systems of symbols.

More serious are the other two flaws. One models the behavior one wants to see students adopt. (1) Choosing an appropriate model, and (2) performing an analysis with a complete model are both very important things to, well, model.
Larry reaches more or less the same assessment about Mankiw’s choosing the wrong and an incomplete model—and then piles on still more complications:

…As a guide to the effects of the Trump administration’s tax cut, I do not think it is very helpful…. A cut in the corporate tax rate… in the presence of expensing… has very little impact on the incentive to invest…. The United States is not a small open economy…. A big cut in the corporate rate does not happen in isolation as a break for new investment… monopoly profits… other ways… benefit[ing] shareholders without encouraging investment… increases in other taxes or enlarged deficits… capital moves out of the noncorporate sector…

And I should also note Larry wishing for the public sphere debate on tax policy he wants to see. One in which due attention is paid to the true authorities:

the highest quality assessment… has been provided by Jane Gravelle,… of the Congressional Research Service. It looks at all the literature… recognizes that the issues are complex… does not start with a point of view… provides little support for claims that corporate rate cuts will raise revenue, help the middle class or spur rapid wage growth…

One in which all recognize the win-win importance of building up technocratic gatekeepers like CBO, GAO, CRS, and TPC, not tearing them down:

The inadequacy of their analyses illustrate why well-resourced, team-based institutions with a strong culture of attention to detail like the Congressional Budget Office, the GAO, the Joint Tax Committee Staff or the Tax Policy Center are so important…

One in which CEA Chairs regard themselves primarily as custodians of the intellectual quality of the public discourse rather than regarding themselves primarily as servants of their political masters:

I served with 7 CEA chairs — Martin Feldstein, Laura Tyson, Joe Stiglitz, Janet L. Yellen, Martin Baily, Christy Romer and Austan Goolsbee… all of them fighting with political figures… insist[ing] that CEA analysis had to be… respected and validated by outside economists… refus[ing] to cheerlead for Administration policies at the expense of their professional credibility. I cannot imagine any of them releasing an estimate as far from the professional mainstream as $4000 to $9000 wage increase from a corporate rate cut claim. Chairman Hassett should for the sake of his own credibility, that of the Administration he serves and the institution he leads, back off.

I started with Mill citing Cicero on philosophy. Let me end by citing Cicero on politics: how the problem with his ally Marcus Porcius Cato was that Cato acted as though he was living in the Republic of Plato rather than the Sewer of Romulus. At this stage I would be happy with the Sewer of Romulus. I would like to see some pushback from the right: people saying that, just as Kevin Hassett two decades went way too far with his claims that (a) the equity premium return was disappearing and that (b) that disappearance would carry the Dow to 36000 by 2004, Kevin Hassett has gone way too far with his claims of a 4000-9000 dollar/year average wage gain.

I am not holding my breath.

Must-Read:

• Rule 1: Paul Krugman is right.
• Rule 2: If you think Paul Krugman is wrong, consult Rule 1:

Paul Krugman: Some Misleading Geometry on Corporate Taxes (Wonkish): “There’s a fairly simple geometric way to see where the optimistic view that cutting corporate taxes is great for wages comes from…

…[Then] it becomes a lot easier to ask “What’s wrong with this picture?” (Answer: a lot)…. Envision a small open economy with a fixed labor force (because labor supply isn’t of the essence here) that can import from or export capital to the rest of the world…. Saving… also isn’t of the essence: the stock of capital, we’ll assume, changes only through capital inflows or outflows…. Let’s… assume… factors of production are paid their marginal products. Then we can represent the economy with Figure 1, which has the stock of capital [per worker] on the horizontal axis and the rate of return on capital on the vertical axis. The curve MPK is the marginal product of capital, diminishing in the quantity of capital because of the fixed labor force. The area under MPK – the integral of the marginal products of successive units of capital – is the economy’s real GDP, its total output….

The economy faces a given world rate of return r. However, the government imposes a profits tax at a rate t, so that to achieve a post-tax return r domestic capital must earn r*/(1-t)…. That… determines the size of the domestic capital stock…. In the initial equilibrium real output is a+b+d. Of this, d is the after-tax return to capital, b is profit taxes, and a – the rest – is wages.

Now imagine eliminating the profits tax (we can also do a small cut, but that’s harder and this is already sufficiently wonky). In equilibrium, the capital stock rises by ∆K, and… [GNP] to a+b+c+d… (e is returns to foreign capital)…. Profit taxes disappear: that’s a revenue loss of b. But wages rise to a+b+c, a gain of b+c….

What’s wrong with this picture?…. Four reasons…. First, a lot of what we tax with the corporate profits tax is… monopoly profits and other kinds of rents. There is no reason to believe that these rents would be bid down by capital inflows…. Second, capital mobility is far from perfect. Third, the US isn’t a small open economy…. Finally… what we’re showing here is long-run equilibrium… [after] capital inflows take place as the counterpart of trade deficits, which in turn have to be created by a temporarily overvalued real exchange rate. And the kind of adjustment we’re talking about here would require moving a lot of capital, meaning very big trade deficits, meaning a strongly overvalued dollar, which would itself be a deterrent to capital inflows. So we’re talking about a slow process…. Long-run analysis is a very poor guide to the incidence of corporate taxes in any politically or policy-relevant time horizon…

Paul is, of course, 100% correct.

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There is a footnote with respect to Mankiw to be written here…

Suppose that you cut the corporate tax rate in this model from its initial level t by an amount Δt. The reduction in revenue collected is then:

By contrast, Mankiw miscalculates the “static” reduction in revenue as simply:

That is where the factor 1/(1-t) that puzzles him—”dw/dx = 1/(1 – t). I must confess that I am amazed at how simply this turns out. In particular, I do not have much intuition for why, for example, the answer does not depend on the production function”—comes from.

And do note that Alan Auerbach is right when he writes:

this result… is a combination of (1) the standard result that in a small open economy labor bears 100% of a small capital income tax…

and wrong when he writes:

the burden of a tax increase exceeds revenue collection due to the first-order deadweight loss…

The burden of a tax increase exceeds revenue collection due to the first-order deadweight loss, but Mankiw is claiming that even for an infinitesimal change in the tax rate—for which the deadweight loss term is infinitesimal relative to the distribution term—the ratio of revenue lost to wages gained is 1/(1-t). And that is simply a miscalculation of what the revenue loss is.