The Incidence of Capital Taxation and the Magnitude of Its Burden

Decreasing the tax on capital may increase after-tax incomes of capital and labor by reducing the deadweight loss associated with inefficiently low levels of capital investment. This paper identifies five key considerations that impact the effect of decreasing the capital tax rate: the elasticity of substitution between capital and labor, capital’s and labor’s shares of total output, the presence and magnitude of capital externalities, the elasticity of capital supply and the extent of the initial tax distortion. An open economy model highlights the impact that these factors have on capital tax incidence and the magnitude of the capital tax burden. 1 The author would like to thank James R. Hines Jr., Joel Slemrod, Dan Silverman, Clemens Sialm and participants at University of Michigan’s Public Finance Seminar for invaluable comments and suggestions. All remaining errors are, of course, my own. ∗ Economist, Regional Affairs Department, Federal Reserve Bank of Kansas City, email: [email protected]