Should-Read: Paul Krugman: The Transfer Problem and Tax Incidence

Should-Read: To my knowledge, the Tax Foundation has never provided an answer to Paul Krugman’s critique that their “long run” takes not 10 years to arrive but 30:

Paul Krugman: The Transfer Problem and Tax Incidence: “These days, what passes for policymaking in America manages to be simultaneously farcical and sinister, and the evil-clown aspects extend into the oddest places…

…The actual economics of corporate tax incidence… [has] an intersection with international economics that… isn’t being [much] appreciated in the current discussion…. [In the] equaliz[ation of] after-tax rates of return in the long run… the long run is pretty darn long… return equalization should take decades….

Harberger… a closed economy with a fixed stock of capital… a tax on profits would fall on capital, basically because the supply of capital is inelastic. The modern counterargument is that we now live in a world of internationally mobile capital…. For a small economy facing perfect capital markets, the elasticity of capital supply is infinite… so any changes in corporate tax rates must fall on other factors, i.e. labor. Most analysis of tax incidence nonetheless allocates only a small fraction of the corporate tax to labor, for three reasons. First, a lot of corporate profits are… rents on monopoly power, brand value, technological advantages…. Third… rates of return probably aren’t equalized even in the long run…. I’m fine with all that….

I think it’s also important to ask exactly how inflows of capital that equalize rates of return are supposed to happen…. Suppose the US were to cut corporate tax rates…. How would the capital stock be increased? One does not simply walk into Mordor unbolt machines in other countries from the floor and roll them into America the next week. What we’re talking about is a process in which U.S. investment exceeds U.S. savings–that is, we run current account deficits–which increases our capital stock over time…. Exporters and importers don’t know or care about S-I; they respond to signals from prices and costs. A capital inflow creates a trade deficit by driving up the real exchange rate, making your goods and services less competitive. And because markets for goods and services are still very imperfectly integrated–most of GDP isn’t tradable at all–it takes large signals, big moves in the real exchange rate, to cause significant changes in the current account balance….

How much stronger does the dollar get?… The knowledge that we’re looking at a one-time adjustment limits how high the dollar can go, which limits the size of the current account deficit, which limits the rate at which the U.S. capital stock can expand, which slows the process of return equalization. So the long run in which returns are equalized can be quite long indeed…. I assume Cobb-Douglas production, with a capital share of 0.3. The capital-output ratio is about 3, implying an initial rate of return of 0.1. And the modelers at the Fed tell us… a 10 percent rise in the dollar widens the trade deficit by about 1.5 percent of GDP…. Assuming I’ve done the algebra right, I get a rate of convergence of… percent of the deviation from the long run eliminated each year… a dozen years to achieve even half the adjustment…. Openness to world capital markets makes a lot less difference to tax incidence than people seem to think in the short run, and even in the medium run…