, Corporate and Personal Taxation of :. Capital Income in an Open Economy , 

by 

John Mutti 

University of Wyoming 

Harry Grubert 

U.S. Treasury Department 

OTA Paper 55 March 1984 

OTA Papers are circulated so that the preliminary findings of 

tax research conducted by staff members and others associated 

with the Office of Tax Analysis may reach a wider audience. 

The views expressed are those of the authors, and do not 

reflect Treasur'y policy. Comments are invited, but OTA Papers

should not be quoted without permission from the authors. 

Office of Tax Analysis 

U.S. Treasury Department, Room 4040 

Washington, D.C. 20220 

Issued: April 1984 
Table of Contents 

I. 

. 11. 

111. 

IV. 

V. 

Introduction 

An Analytical Model of an Open Economy 

Parameterization of the Model 

Empirical Estimates of the Incidence of 

Capital Taxes 

A. Effects of a Reduction in the Corporate 

Income Tax 

B. Effects of a Reduction in Personal Taxes 

on Capital Income 

Conclusions 

Table 1. Projected Effects of a Reduction in the 

Corporate Income Tax 

Table 2. Projected Effects of a Red-uction in 

Personal Taxes on Capital Income 

References 

Appendix A. The Model in Differential Form 

Appendix B. Derivation of Elasticities and Cross 

Elasticities for Commodity and Asset 

Demand Functions 

Appendix C. Investment in Human Capital 

P 

Page 

1 

4 

16 

20 

20 

27 

32 

34 

35 

36 

38 

41 

42 
Corporate and Personal Taxation of Capital Income 

in an Open Economy 

I. Introduction 

Increased public concern in the 1970s over stagnating U.S. 

economic growth and declining international competitiveness of 

basic U.S. industries has resulted in greater attention being 

focussed on the recent low rates of U.S. capital formation. Proposals to promote more rapid capital accumulation have centered 

on changes in the taxation of capital income, at both the personal and corporate levels. This paper simulates the likely 

effects of such policy changes on the returns to capital and on 

the size of the capital stock, within a model which allows for 

international trade and capital flows. 

The results suggest that only a modest degree of capital 

mobility is necessary to substantially alter the conclusions 

drawn from analyses based on a closed economy. When corporate 

taxes are reduced, after-tax returns to capital rise only 

slightly because of the reallocation of capital to the United 

States. When personal taxes are reduced, the after-tax return to 

capital owned by U.S. investors rises by more than the tax 

reduction. In part, this is because,sectoral differences in 

taxes on capital income interact with the way international 

investment income is taxed to cause an outflow of U.S. capital. 
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Because there already is an extensive literature on the 

incidence of capital taxation, plus many empirical projections 

based on the theory developed, a few comments are warranted at 

the outset to indicate how this paper relates to past work and 

what new insights it provides. Harberger's (1962) seminal 

analysis of the incidence of the corporate income tax in a 

static, closed economy, two-sector model of the United States 

suggested that capital bore almost the entire burden of the tax. 

However, if private savings are responsive to after-tax rates of 

return, and corporate taxation is considered in a framework where 

capital formation is possible (Ballentine 1978), then, even in a 

closed economy, owners of capital can avoid a significant portion 

of the burden of the tax. 

The international implications of tax policy changes at the 

personal or corporate level have not gone unnoticed. It has been 

recognized that additional savings generated by cuts in personal 

income taxes on capital income may flow abroad rather than being 

invested at home. This result becomes more likely when capital 

is highly mobile internationally and the country considered is 

small relative to the rest of the world. Harberger (1978) calculates that real rates of return are fairly similar across countries,and attributes this result to a high degree of capital 

mobility internationally. In that case corporate tax reductions 
-3-

will be more successful in expanding the domestic capital stock 

than personal tax cuts. In countering this view, Feldstein and 

Horioka (1980) present evidence that capital essentially is immobile internationally, and conclude "it is appropriate, at least 

as an approximation, to study income distribution in general, and 

tax incidence in particular, with models that ignore international capital mobility" (p. 328). 

Goulder, Shoven and Whalley (1982) extended the earlier 

Shoven-Whalley domestic tax model to assess the extent of welfare 

changes from corporate and personal tax reductions, allowing for 

varying degrees of capital mobility internationally. The present 

paper pursues a closely related issue, projecting the incidence 

of taxes on capital income. A two country, three factor, three 

good, general equilibrium framework is developed. In contrast to 

the Goulder analysis, the present formulation explicitly considers production in the rest of the world and allows international 

capital flows to affect foreign production capabilities. Also, 

an attempt is made to model accurately the way in which investment income produced in one country is taxed when received by 

residents of another. This is necessary in order to correctly 

project how the relative attractiveness of foreign and domestic 
-4-

investments changes when personal or corporate taxes are reduced 

in the United States. Additionally, the model is presented in 

terms of own and cross price elasticities of demand for foreign 

and domestic assets, which may make the results easier to 

interpret. 

This framework is used to assess empirically how changes in 

capital taxation affect after tax returns to capital, steady 

state saving patterns, and the size of the capital stock available in the United States. As suggested above, the results 

caution against the sweeping judgment of Feldstein and Horioka 

that tax incidence can safely be carried out in a closed economy 

setting . 

11. AR Analytical Model of an Open Economy 

The model presented here builds on earlier work by the 

authors (Mutti and Grubert 1982) which assessed the effects of 

export promotion policies through favorable tax treatment of export income. The industry aggregations represent a compromise 

between the best groupings for trade analysis and the best for 

tax analysis, within a model small enough to allow an intuitive 

understanding of the main factors which operate. The corporate 

tax in this model is therefore a combination of a general tax on 

capital in all sectors and a sectoral tax on capital in the 

traded good sectors. 
-5-

To briefly summarize this approach, two countries are 

modelled, the United States and the rest of the world. Both 

countries produce three goods, and the production of all-goods is 

assumed to require three factors of production, unskilled labor, 

skilled labor, and capital. The three goods represent a net 

export good, a net import good, and a nontrhded good. However, 

domestic output in an industry is not assumed to be perfectly 

su,bstitutablewith output from the same industry in the other 

country. Therefore, consumers in each country allocate income 

among the four tradable goods and their domestic nontradable 

good. The model is not simply a comparative static one in which 

all factor supplies are held constant. While not fully dynamic, 

it looks at the way in which factor supplies, output, and factor 

rewards change from one steady state solution to another after a 

change in tax policy is adopted. Thus, the model explicitly 

considers the way capital formation is affected by tax policy. 

For the sake of brevity, only typical elements from each of 

the blocs of the model are presented. To begin with more familiar features, production or supply conditions are described 

first. The notation of Jones (1965) is used, which also has been 

applied in addressing several issues in public finance (see, for 

example, Vandendorpe and Friedlaender 1976). In each country 

perfectly competitive output and factor markets are assumed. 

Production functions are assumed to be strictly quasi concave and 

linear homogeneous. 
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One basic portion of the model is based on the condition that 

zero economic profits be earned in all industries. For industry 

‘1A the appropriate equation is 

k where Cij is the amount of input i necessary to produce one unit 

of output j in country k. Factor rewards of unskilled labor, L, 

skilled labor, H, and capital, K, are represented by w, q, 

and r, respectively, and PIA is the price of good one produced by 

A

country j. The term tci is the rate of taxation of capital income at the corporate level in sector i in Country A, and tA the Pi 

rate of taxation of capital income at the personal level. 

The gross return to capital is the relevant cost to the 

producer, and it is assumed to equal the value of the marginal 

product of capital, me The marginal product of capital after 

taxation at both the corporate and personal levels is represented 

by r, and thus, m(l-tc)(l-t P )= r. The after-tax return faced in 

each domestic sector is assumed to be the same, but due to differences in taxation at the corporate and personal levels, before 

tax costs of capital differ across sectors. Equation (1) shows 

that a cut in capital taxation at either level will allow U.S. 

producers to reduce the price charged for their output. 
-7-

A second element of the model is based on the condition that 

factors of production be fully employed. For the case of 

unskilled labor in Country A, quantity demanded is shown as: 

A A 

($1 '1A + 'L2 '2A + 'LN 'NA = L~ 

where XiA represents output of the ith good in Country A, and LA 

is the quantity of unskilled labor supplied. The input-output 

coefficients depend upon relative before-tax factor prices. A 

reduction in either tax variable reduces the desired ratio of 

labor to capital per unit of output, with the size of this 

adjustment depending importantly upon the relevant partial 

.elasticity of substitution in production. These factor demand 

equations are set equal to the factor supply equations developed 

below. 

A third important element of the model expresses product 

demand conditions. Based on national income account categories, 

demand for U.S. produced goods will depend upon purchases by consumers, private investors, the government and the foreign sector. 

In this model, no distinction is made between consumers and the 

government, as if the government redistributed any revenues to 

consumers or bought exactly the same mix of goods as consumers. 

This component of demand is considered first. For each good, 

quantity demanded will depend upon relative prices, inclusive of 
-atariffs, and on current income, Y, less savings, s. In other 

words, consumers are assumed to treat current and future consumption as separable, so that choices among current consumptions 

goods simply depend on current relative prices and total consumption expenditure in the present period. As shown for Country A, 

a nation's current income is determined by the value of its output, plus net foreign investment income, plus tariff revenue: 

+ rB Kt - 'A 

'A = 'lAXIA + '2AX2A + XNA (l-tp) (l-tp) 

+ TARi~ 'la I '~BA + TAR2A '2B '2BA 

where Ki 

j is country i's ownership of assets in country j, 'ijk 

.issales in country k of good i produced by country j, and TAR 

is the ad valorem tariff rate imposed by Country A. 

The two capital terms included indicate that foreign investment is a two way flow, attributed here to the desire of investors to diversify their asset holdings. The appropriate return 

from this investment abroad to be included in the determination 

of national income is approximated as what is received after 

foreign taxation at the corporate level. For instance, foreign 

investors are assumed to pay taxes at the corporate level in the 

United States, but they do not face U.S. personal income tax on 

those earnings.' With respect to U.S. foreign investment, the 

majority occurs through corporations, who are not subject to U.S. 
-9-

corporate taxes on income reinvested abroad. Any distribution 

to the United States receive a tax credit for payments of income 

taxes to foreign governments, up to the value of their U.S. 

corporate income tax liability on that income. U.S. firms have 

tended to repatriate income to the United States such that foreign income taxes paid plus foreign withholding taxes approximately equal their corresponding U.S. tax liability. Therefore, 

separate treatment of withholding taxes is not included in the 

U.S. current income measure. 

To determine product demands attributable to private investment requires a more general explanation of how capital formation 

is treated in this model. There is,no specific capital goods 

’ sector. Rather, capital is a composite fabricated from the five 

The United States imposes a statutory withholding rate of 30 

percent on interest and dividends paid to nonresidents, but in 

practice the average withholding rate is less than two percent. Many U.S. tax treaties establish lower rates for residents of treaty countries, while some types of income, such as 

interest on bank accounts, are entirely exempt from withholding taxes by statute. 
-10-

goods available in each country, and we assume that the mix of 

goods required in creating new capital is the same as when 

demanded by consumers. The composite capital good itself is 

assumed not to move in international trade and because demand in 

each country contains a large component of nontraded goods, this 

means that the price of capital goods can be different in the two 

countries. 2 

Also, because there are no explicit financial markets in this 

model, demands for capital goods are derived directly from 

savings. Consequently, in a purely closed economy with no capital flows, the amount of savings in A, SAl would have no impact 

on the pattern of commodity demands. Howeverl if residents of A 

allocate part of their savings to acquire capital goods in B, 

A shown as SB, this amount must be subtracted from national income, 

yA , 

to derive the appropriate scale variable, or budget constraint, in each commodity demand function. When B residents 

choose to invest in A, then an addition to total expenditure in 

B A, equal to SA, must be made. Therefore, the scale or aggregate 

2 Even if there were an explicit capital equipment sector, the 

composite price of capital would still differ between the two 

countries because of the nontraded capital goods such as 

structures. It is also necessary to distinguish between trade 

in machines, which reflects comparative advantage in 

production, from capital flowsl which reflect differences in 

.rates of return and asset preferences. 
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expenditure variable in the commodity demand equations of A resiA B dents is YA - SB + SA, and in commodity demands by B residents, 

B A it is YA - SA + SB. 

Finally, foreign sector demand for A's tradable goods will 

depend upon relative prices in Country B and on the B scale variable described above, while A's demand for imports are determined 

by relative prices in A and the scale variable in A. An explicit 

balance of payments equation is not necessary, since it is implicit in the derivation of the scale ~ariable.~Expenditures in a 

country, including the demand for imports, can exceed output when 

foreigners choose to invest in it, and conversely, if a country 

wants to increase its net foreign investment, national production 

must be greater than domestic expenditures. This is identical to 

the standard formulation in which the U.S. current account must 

be in surplus when U.S. investment abroad rises. Tax policy 

changes which increase proportionally the returns from all forms 

of saving will increase the U.S. current account surplus. Specification of this saving behavior represents another important 

aspect of the model. 

3 Equilibrium conditions explicitly included in the model are 

that quantity supplied equal quantity demanded domestically in 

the nontraded sector, and that quantity supplied equal the sum 

of quantities demanded in both foreign and domestic-markets 

for traded goods. Since the system is comprised of ten goods,

market balance equations for only nine of them need be 

included. 
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Savings by residents of each country are assumed to depend on 

income and on rates of return after taxes both at the corporate 

and personal level. Savers in any country can invest both in 

domestic real capital or in capital abroad. Although foreign and 

domestic investment are not regarded as perfect substitutes, an 

increase in after-tax returns in one location relative to another 

will attract more investment from both foreign and domestic 

savers. 

The two savings functions in Country A are represented as 

A A where iAand iB are the percentage rates of return after tax at 

both the corporate and personal level obtained by A savers from 

investments in A and B, respectively. The percentage rate of 

return is derived from the after-tax value marginal product of 

capital, r, divided by the price of capital, which in this model a 

will be a weighted average of the prices of the five goods which 

represent capital. The symbol used for this capital price index 

is CPI. 
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However, the savings equations must distinguish between 

after-tax returns received by A and B investors in the same locaA B tion, e.g., between iAand iA, because in general they will be 

subject to different rates of personal tax on identical investments. The percentage return to capital after taxation at the 

personal level, i,, must be modified to recognize what tax is 

relevant to savers. The return iA can appear without change in 

A’s saving equations, to represent the return received by A 

savers who invest in A. To find the appropriate expression for B 

savers, first derive the after corporate tax percentage rate of 

A A return in terms of i, which is iA/(l-tp). Therefore, B investors 

who invest in A receive iA= iA(l-tp)/(l-tp), B A B A where t: is the 

personal tax paid by B residents. 

B This substitution for iA is straightforward when there is a 

A single personal level of tax, tp, in A. In fact there are 

sectoral differences, because differing portions of investment 

income are taxable at the personal level, particularly because of 

the exemption of homeowners returns. Therefore, there is not a 

A unique tp. In the implementation of the model, the U.S. personal 

tax rate on income earned in the traded goods sector is used to 

determine the corporate level income received by foreign inves-
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tors. That choice is appropriate because foreigners would choose 

to invest in the sector with the highest after corporate tax 

return; if domestic savers are to receive the same return in all 

sectors, then foreigners will find it most profitable to invest 

in the sector with the highest U.S. personal tax rate. 4 

Given projected changes in saving of the form shown above, 

the change in nominal investment in A is equal to asA ^A + (l-a)SA, -B 

where a is the share of the capital stock owned by A residents, 

and a carat denotes the percentage change in a variable. In the 

steady state assumed in this analysis, the rate of growth of the 

real capital stock is constant and equal to the sum of exogenous 

growth of the labor force and Harrod-neutral productivity growth. 

This means that in the steady state any increase in investment 

must be proportional to the increase in the capital stock. That 

is, in the steady state, 

A 

where SA/CPIA is nominal investment in A divided by the price of 

capital goods, and c is the exogenous steady state rate of 

growth. This permits us to determine the change in the capital A A A 

stock from one steady state to another as KA = SA - CPI. There A 

is 'an analogous equilibrium condition for KR' 

4 This scenario implicitly assumes that foreign investment does 

not exceed overall investment requirements in the traded goods 

sector. 
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Supplies of the two labor inputs, unskilled and skilled 

labor, are derived from simple model of investment in human 

capital. Unskilled workers acquire human capital by undergoing 

training at the beginning of their careers. The training process 

requires no capital or other labor inputs, and workers undergoing 

training produce no output. 

L = (1-st) N (7) 

H = (1-st) h N 

where st is the share of the labor force in training, h is the 

amount of human capital per worker, and N is the total labor 

force. The amount of human capital per worker, and in turn the 

share of the labor force in training in the steady state, respond 

to changes in the ratio of skilled to unskilled wages and to the 

real interest rate. This aspect of the model is described more 

fully in Appendix C. 
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111. Parameterization of the Model 

The behavioral equations and market balance conditions 

explained above comprise the theoretical model used to analyze 

changes in U.S. taxation of capital income at both the corporate 

and personal level. The model contains a relatively small number 

of sectors and is solved in differential form so that analytical 

solutions could be derived from it. However the purpose of this 

paper is to evaluate the quantitative significance of certain 

effects rather than simply their direction. Empirical simulations are therefore necessary, which is equivalent to solving the 

model analytically and putting in empirical parameters. A summary of the necessary data and parameter values is presented 

here. (Appendix A gives examples of some of the basic equations 

in differential form.) 

The three aggregate goods produced in each country were 

created from the 85 sector input output table of the United 

States. Non-traded goods and services, XNA, basically were considered to be utilities, construction, transporation and communication, wholesale and retail trade, social and personal services, 

finance, banking and real estate, and government. U.S. net export 

goodsf essentially were grains, chemicals, and machinery. 

U.S. net import goods, XIA, included many consumer durables and 

nondurables. 
-17-

Allocations of factor inputs across industries are based upon 

the direct and indirect factor requirements necessary to produce 

current levels of output. Industry value added is only broken 

into capital and labor returns, and consequently a further calculation is necessary to determine skilled and unskilled labor 

utilization. Industry employment data is multiplied by the 

annualized minimum wage to indicate the return to unskilled labor 

in an industry, and the remainder of labor value added is attributed to skilled labor. By assuming that wage rates across 

industries are identical, these value added figures also can be 

used to infer the physical allocation of resources. tJith respect 

to general statements which characterize U.S. industry, the nontraded sector has above average capital requirements, unskilled 

labor requirements well above average, and skilled labor requirements well below average. The export sector has skilled labor 

requirements well above average, and unskilled labor requirements 

well below average, while the import sector is slightly less 

skill intensive and slightly more unskilled l’abor intensive than 

exports. 

Partial elasticities of substitution between capital and 

unskilled labor, unskilled labor and skilled labor, and capital 

and skilled labor are based on estimates reported in Hammerseh 

and Grant (1980). The values applied to all industries in the 
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study are: KL 

=o 

LS = .60, and uKs = .OS. In other words, a 

very low degree of substitution between capital and skilled labor 

is assumed relative to the other trade-offs in factor usage. 

Demand elasticities are generated from the assumption of 

utility tree functions of the following form: 

If this nested utility function is CES in form, then as shown by 

Armington (19691, own and cross-price elasticities of demand can 

be derived directly from information regarding expenditure shares 

and elasticities of substitution at different levels of the . 

utility tree. (The details of this derivation are presented in 

Appendix B.) 

To form a consistent aggregate such as X1 requires that XIA 

and XIB have identical income elasticities of demand. A stronger 

condition is imposed here, that all income elasticities equal 

one. The elasticity Qf substitution between the two traded goods 

in the same utility tree is assumed to be 3, the corresponding 

elasticity between the three general categories XI! X2 and XN is 

assumed to be 1.25, and the elasticity of demand for all current 
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consumption as an aggregate is -1. As examples of what these 

values imply with respect to more commonly estimated parameters, 

the import elasticity of demand in the U.S. for XIB equals -2.69, 

and the elasticity of demand for U.S. exports of X2* to the rest 

of the world equals -2.79. 

The savings elasticities are computed in a manner analogous 

to the commodity demand elasticities. Given the Armington separability assumption for foreign and domestic assets within the 

overall savings branch, two key parameters must be specified, 

the elasticity of substitution between foreign and domestic 

investment, U , and the elasticity of overall saving with respect . 

to the weighted worldwide after tax rate of return, '. Because 

these parameter values are not well established, a range of estimates is used: U equal to zero, one, three and three hundred; 

and equal to 0.0 and 0.4. The two extreme values of represent no substitutability between U.S. and foreign investment, and 

to virtually perfect substitutability: the intermediate values 

correspond to the elasticity of substitution between U.S. and 

foreign goods, and a still smaller value. The overall saving 

elasticity values correspond to the cases of zero interest 

elasticity of savings, and to 0.4, the value estimated by Boskin. 

Tax rates at the business level are average effective rates, 

not marginal tax rates calculated from hypothetical investments 

and statutory provisions, which would be conceptually more 
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appropriate. The estimates used are based on the effective tax 

rates computed by Ballard, et a1 (1982). The tax rates reflect 

corporate income and property taxes as a share of total capital 

income. Personal tax rates reflect both marginal tax rates for 

capital income and the percentage of income after business-level 

taxation that is taxable at the personal level. This latter 

percentage is based both on distribution rate of corporations, 

and special factors in certain sectors such as the exemption from 

tax of the return to owner-occupied housing. 

IV. Empirical Estimates of the Incidence of Capital Taxes 

Two different policies are simulated, a reduction in the. 

corporate income tax rate and a reduction in the personal tax 

. rate on capital income. In both cases attention is focused on 

the change in the real return to capital and the change in the 

capital stock. The former change is related to traditional 

measures of tax incidence, while the latter is of interest in 

assessing the effectiveness of capital tax incentives in 

increasing capital formation. 

I. 

A. Effects of a Reduction in thqcorporate Income Tax 

In Table 1 (following page 33) the effects of a corporate 

income tax reduction which results in a one percent decrease in 

the cost of capital economy wide are reported for seven different 
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situations. Because corporate income is a much bigger part of 

total capital returns in the two traded goods sectors, the 

decrease in the corporate income tax has a differential effect 

across sectors, although this difference is not as great as is 

found in the more traditional formulation where a corporate and a 

noncorporate sector are used. In the projections reported here, 

the percentage change in the cost of capital is 1.363 in the two 

traded goods sectors, and 0.774 in the nontraded goods sector. 

Therefore, the estimated results reflect the incidence of a 

general tax on capital income, as well as the differential effect 

across sectors. 

A few polar cases motivated by the analysis of Harberger 

(1983) provide useful points of comparison in assessing the simulation results to be reported. First, consider the case where 

production of all goods requires only two factors, labor and 

capital, and where capital is completely immobile internationally 

and no net saving occurs. The imposition of a general tax on 

capital in all sectors of the economy will yield the familiar 

result that capital bears 100 percent of the tax burden: that is, 

the reduction in capital income will exactly equal the tax paid 

on capital income. 

If, instead, the tax on capital income applies only to the 

two traded goods and not tovthe nontraded goods, and if the country faces fixed commodity prices internationally, then the loss 
-22-

to capital can exceed the amount of the tax revenue collected. 

The reason for this outcome is that, unless the two traded goods 

have exactly the same factor requirements, the zero profit condition will determine a unique relationship between traded goods 

prices and gross factor costs (Samuelson 19531, The after-tax 

return to capital therefore falls by the per unit tax on capital, 

The lower return also is earned on capital utilized in the 

nontraded sector. Consequently, total capital income will 

decline by more than the increase in taxes paid by capital in the 

traded goods sector. 

Finally, if perfect mobility of capital internationally is 

assumed,, and the country is too small to affect returns to 

capital, the pattern of incidence essentially is reversed. The 

tax will cause capital to flow out of the country until the 

initial return is restored. Since prices are fixed in the traded 

goods sector, the zero profit conditions require that real wages 

decline. Consequently, labor loses from the imposition of a tax 

on capital. If there were no nontraded sector, the loss to labor 

would equal the amount of tax revenue collected from capital, 

since production costs must fall by that amount for U.S. producers to continue to sell at given international prices. The 

existence of a nontraded sector would mean that labor employed 

there also loses from reduced wages, and labor income would fall 

by more than the amount of capital taxes collected. 
-23-

These conclusions are particularly strong because of the 

small country assumption with respect to commodity prices and 

capital returns, as well as the simplified two factor production 

structure. The patterns of incidence suggested by these simple 

cases can be observed in the polar cases in the simulation 

results derived from the more general model developed here. Tax 

incidence is measured as the change in the after-tax return to 

capital divided by the change in corporate and personal tax on 

capital income per unit of capital. On the first line of Table 

I, the incidence measure TI1 is calculated with respect to 

capital used in the United States, while the measure reported on 

the second line, T12, is in terms of capital owned by U.S. 

residents. On lines three through six of the table, percentage 

changes in the real return to capital are reported, since they 

are the relevant determinants of international capital flows. 

Also, percentage changes in the U.S. capital stock and in savings 

behavior are shown. 

One polar case is shown in column one, represented by the 

assumption of a fixed capital stock and no international capital 

mobility. The tax incidence estimate is 1.004, which indicates 

that capital owners receive almost exactly all of the benefit 

from the corporate tax reduction. This result is similar to the 

closed economy estimates of Harberger, although the current 
-24-

figures apply to a situation where international trade in goods 

is possible. The possibility of incidence much greater than 100 

percent suggested in the polar case above is not realized. This 

is so, in part, because the United States is a sufficiently large 

country in international commodity markets, and its goods differ 

from those produced elsewhere, so that it does not face fixed 

prices. For the United States, a decrease in corporate taxes 

will reduce costs in the traded goods sector more than in the 

non-traded sector. Prices of traded goods will fall in world 

markets, and there will be a shift in demand away from non-traded 

goods. This decreases the gross return to capital relative to 

labor. Also, since production requires three factor inputs, and 

there is a low degree of substitutability between capital and 

skilled labor, some of the burden of the corporate income tax is 

shifted to skilled labor. 

The second column shows the case where the capital stock is 

no longer fixed. Saving is possible and is assumed to increase 

when the real return to capital rises. Capital remains immobile 

internationally, though. In this situation a much smaller share 

of the benefit from a corporate tax reduction accrues to capital, 

only 25 percent. The result differs from column one since the 

U.S. capital stock grows and the greater availability of capital -. 

drives down its relative return, a result similar to what 

Ballentine observed. 
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The next four columns of Table 1 represent cases where 

international capital flows are incorporated into the model. The 

polar case is represented by the figures in column seven, where 

there is near perfect capital mobility internationally and where 

saving again is sensitive to the after tax rate of return. The 

estimates show that the estimated incidence measure is only .055, 

and consequently labor receives most of the benefit from the 

corporate tax reduction. The effect on capital would be even 

smaller if the United States were smaller relative to the rest of 

the world. 

The contrasting pattern of incidence in columns one and seven 

results from changing two initial conditions, the assumptions of 

no international capital mobility and no saving. In terms of the 

relative importance of these two factors, the substitutability 

between U.S. and foreign assets possible with international capital flows dominates the general interest sensitivity of saving. 

In other words, the primary reason Si rises is the reallocation 

of savings away from B assets to A assets. 

n 

The figures reported in columns three, four and five demonstrate that the importance of capital flows does not d'isappeai: 

even when the assumed degree of asset substitution is reduced 

substantially, and set equal to the value attributed to the sub-
-26-

stitutability of U.S. versus foreign goods, or even lower. The 

net inflow of capital from abroad is smaller and the benefit to 

U.S. capital owners is larger than when capital is highly mobile. 

The reallocation of A's savings away from B assets to A assets 

A still continues to be the dominant reason that SA is positive. 

Key implications of this analysis are that even with moderate 

values of the potential substitutability between foreign and 

domestic assets, capital bears little of the burden of the corporate income tax. This is true even when there is no interest 

sensitivity of savings. Additionally, a corporate tax cut will 

lead to an increase in the stock of capital available in the 

United States. The source of this increase should not be 

regarded simply as foreign controlled investment. Rather, U.S. 

investors reduce their foreign investment and instead invest at 

home. Foreigners do increase their investment in the United 

B States, and in fact, SA appears much larger in percentage terms 

A than SA. However, given the much larger base from which S: is 

measured, even in the most extreme case of near perfect 

international capital mobility, roughly 60 percent of the 

additional funds invested in the United States are provided by 

U.S. savers. 
-27-

B. Effects of a Reduction in Personal Taxes on Capital

Income 

In Table 2 the effects of a reduction in the personal income 

tax on capital earnings are reported for the same seven situations shown'in Table 1. The simulations assume that the 

reduction in personal taxes reduces the cost of capital by one 

percent for a given after-tax return. Again, the sectoral 

effects on capital costs are not uniform, and in fact are 

remarkably similar to the values reported for the corporate tax 

cut. Here, the cost of capital declines 1.363 percent in the two 

traded goods sectors and 0.808 percent in the non-traded sector. 

The decline in the cost of capital is greater for the traded 

goods sectors, because in those industries a larger share of 

capital income is distributed and subject to taxation at the 

personal level. In column one, the case of an economy with a 

fixed capital stock and no international capital mobility is 

shown. The incidence estimate differs slightly from the case of 

the corporate tax reduction, because the cost of capital impacts 

are distributed somewhat differently across the three sectors. 

Figures in column two again represent the case where saving 

is possible and assumed to be interest sensitive, but no international capital mobility is allowed. The benefit to capital 

owners is reduced substantially as the capital stock grows. That 
-28-

the results from these two cases are so similar in Tables 1 and 2 

confirms the conventional view that in a situation of long run 

equilibrium for a closed economy, it makes little difference 

whether capital incentives are provided at the corporate or 

personal level. 

Once international capital mobility is introduced, the similarity between the personal and corporate tax reductions vanishes. 

The extreme case of near perfect capital mobility combined with 

interest sensitive savings is shown in column seven. The gain to 

U.S. capitalists is 1.88 times the loss in tax revenue. The fact 

that capital may bear more than 100 percent of the burden of a tax 

on capital income has been suggested in several other situations, 

but the principal reason it is observed here will be shown to rest 

on the different taxation of the returns to domestic and foreign 

investors, and the correspondingly different portfolios they hold. 

Also in this case, as in some of the others, a decline in the U.S. 

capital stock is observed. In other words, the personal tax cut 

results in a large transfer to U.S. capital. owners, but funds 

available for investment in the United States decline. 

To explain this result, consider the two different sources of 

investment in the United States. U.S. investors increase their 

holdings of U.S. assets, as shown by the positive value obtained 

for Si but the increase is much smaller than in the zero mobility 

case. Furthermore foreigners choose to invest substantially less 

in the United States, as shown by the large negative value of SA.B 
-29-

A This foreign investment response occurs even when iA rises 

substantially, because the foreign investor is interested in iB 

A 

A and not iA. In particular, foreigners are not assumed to invest E 

in the same mix of assets as U.S. investors, but rather to 

concentrate their investment where the difference is greatest 

between the after tax return at the personal level relative to 

the corporate level. Even though the average return received by 

U.S. investors rises by more than the tax benefit provided, the 

after tax return to foreign investors falls because they do not 

hold an initial portfolio with the same mix of assets as U.S. 

savers. The return to capital at the corporate level declines in 

the traded goods sectors where foreign investment,is concentrated, because of the reallocation of capital to those industries. The cut in the U.S. personal tax rate results in a bigger 

disincentive for foreigners than would be the case if their optimal strategy were to hold the same assets as domestic investors. 

The loss to foreign investors explains why the two incidence 

measures reported in Table 2 differ. Foreign-owned capital used 

in the United States loses as a result of the U.S. tax cut at the 

personal level, and consequently the weighted average effect on 

all capital used in the United States is less favorable than for 

U.S .-owned capital. 
-30-

The explanation of incentives faced by foreigners investing 

in the United States is mirrored by the incentives Americans face 

in investing abroad. As shown in column seven, the percentage 

A increase of SA is twelve times greater than SA, which reflects B 

A the fact that the increase in i,A exceeds the increase in iA. 

This change in relative returns, which is more dramatic in the 

lower mobility cases, is partially attributable to the relative 

size of the two countries as explained above, where a given 

increment of investment will cause returns abroad to fall less 

rapidly than in the United States. Additionally, U.S. investment 

abroad will be concentrated in industries where foreign taxation 

at the personal level is high, in contrast to domestic investment 

which includes a significant component not taxed at.the personal 

level. U.S. investors in these foreign industries with smaller 

amounts of tax exempt income will benefit most from the U.S. 

personal tax cut, further contributing to an outflow of capital 

from the United States. 

With respect to the effects of this outflow of capital from 

the United States, the smaller the United States is relative to 

the rest of the world, the smaller the consequent reduction in 

returns abroad. The fact that i; declines by 0.248 percent when 

a U.S. tax reduction increases domestic after-tax returns by one 

percent (for a given pre-tax return) shows that U.S. policies do 
-31-

have a significant effect on world capital markets. Capital 

invested in the United States is estimated to represent 25 

percent of the free world total, a figure large enough for 

'foreigners to benefit from an increase in U.S. taxation of 

capital at the personal level, or to lose from a U.S. tax 

reduction. 

While an increase in the relative size of the United States 

tends to reduce the capital outflow from the United States, 

factor intensity differences in production tend to increase it. 

The personal tax cut increases the demand for capital most in the 

traded goods sectors, which require relatively less capital than 

the nontraded sector. Thus, the increase in the U.S. return to 

capital is smaller than it would be in the case of a neutral 

incentive across all sectors. 

Columns three, four and five show that these issues are reLevant even when a much smaller degree of international mobility 

is assumed. When the elasticity of substitution between U.S. and 

foreign assets is assigned a value of one, the U.S. capital stock 

rises by roughly half of the value obtained in a model with no 

international capital mobility. In other words, even with a very 

small degree of capital mobility internationally, the effectiveness of U.S. policies to spur capital formation through reductions in capital taxes at the personal level will be weakened 

substantially. 
-32-

Also worth noting is that with greater capital mobility, the 

^A domestic after-tax rates of return, iA and ii, tend to diverge 

further rather than equalize when there is a change in personal 

taxes in the United States. The reasons for the divergence is 

the different personal taxes born by foreign and domestic investors on the same investment return. For example, a cut in U.S. 

personal taxes will increase U.S. after-tax returns to domestic 

investors but will lower them to foreign investors because they 

receive no tax benefit from the U.S. personal tax cut and pre-tax 

returns decline in the United States. The resulting repatriation 

of capital then depresses after-tax returns abroad. 

V; Conclusions 

The results indicate that it takes much less than perfect 

capital mobility for international capital flows to substantially 

alter the impact of a domestic tax cut found in a standard model 

of a closed economy. Even with modest capital mobility, international shifts in capital will account for a significant part of . the increase in capital employed in the United States when corporate U.S. taxes are cut. This shift also means that U.S. 

after-tax returns to capital rise only slightly, and that labor 

receives most of the benefits of the tax reduction. 

-i 
-33-

In the case of a reduction in personal taxes on capital income, the potential benefits of larger domestic capital accumulation are greatly eroded by international capital mobility. U.S. 

savers are the primary beneficiaries of this tax reduction, but P 

because of sectoral differences in personal taxation, they find 

that average after-tax returns increase more abroad than in the 

United States. For similar reasons, foreign savers find that 

their average after-tax returns fall less abroad than in the 

United States. As a result of these incentives, capital 

available in the United States may even decline. 
-34-

Table 1 

Projected Effects of a Reduction 

in the Corporate Income Tax 

(Scaled to a one-percent change in the cost of capital) 

Variable 

TI1 

TI2 

^ Ai

A 

^ Ai B 

^B 

iA 

^ Bi B 

A 

a=O.O a=O.O a=f.O a=3.0 a=3.0 a=300 a=300 

rl=o.o rlto.4 n=o.4 n=o.o rl=o.4 rl=o.o rl=o.4 

1.004* .254 .240 ,261 .147 .I39 .055 

0 190 -223 .122 0139 .os5 

-857 .327 . .267 .286 .174 .164 .070 

.015 ,132 -040 .162 .068 

-267 .286 D 174 164 .070 

.ooo 0000 .015 .132 .040 .162 .068 

.171 .189 .183 .221 .225 .256 

.171 ,176 .142 .190 ,175 .2Q5 

-.095 -.NO -.m -.409 -.3a3 

.276 .466 .428 .562 .600 

,000 -.004 -.016 -073 -.016 -011 

* In this case, capital is assumed to be fixed in real terms. 
-35-

Table 2 

Projected Effects of a Reduction 

in Personal Taxes on Capital Income 

(Scaled to a one-percent change in the cost of capital) 

Variable 

TI1 

TI2 

^A 

iA 

^AiB 

*BiA 

^ Bi

B 

A 

u=O.O u=O.O ~=1.0 0=3.0 0=3.0 0=300 0=300 

q=o.o q=o.4 q=o.4 q=o.o q=o.4 q=o.o q-0.4 

1.074* .267 -480 1.878 .875 2.199 1.582 

-814 2.239 1.196 2.577 1.879 

.885 .337 -618 1.170 .845 1.237 1.101 

1.234 1.255 1.174 1.238 1,105 

-0735 -.183 -e508 -.116 -.252 

.ooo -000 -.11'9 -e098 -.179 -.115 -.248 

.177 .093 -.lo1 -014 -a125 -.076 

-177 -206 -.078 .171 -.096 .132 

.845 -203 1.186 .246 1.571 

-e678 -.263 -1.060 -.321 -1.492 

.ooo -.039 .018 -.046 .021 -.053 

* In this case, capital is assumed to be fixed in real terms. 
-36-

References 

Armington, P. 1969. A theory of demand for products distinguished 

by place of origin. International Monetary Fund Staff Papers

16: 159-77. 

Ballard, C., Fullerton, D., Shoven, J., and Whalley, J. 1982. 

Complete documentation of the U.S. general equilibrium

moddel, prepared for the Office of Tax Analysis, U.S. 

Treasury Department. 

Ballentine, G. 1978. The incidence of a corporation income tax in 

a growing economy. Journal of Political Economy 86:863-85. 

Batra, R. 1973. Studies in the pure theory of international 

trade. St. Martin's Press: New York. 

Boskin, M. 1978. Taxation, saving and the rate of interest. 

Journal of Political Economy 86, Part 2: S2-S27. 

Feldstein, M., and Horioka, C. 1980. Domestic savings and 

international capital flows. Economic Journal 90: 314-29. 

Goulder, L., Shoven, J., and Whalley, J. 1982. Domestic tax 

policy and the foreign sector. In Simulation methods in tax 

policy analysis, edited by M. Feldstein. National Bureau of 

Economic Research. University of Chicago Press: Chicago. 

Grant, J. 1979. Labor substitution in U.S. manufacturing. Ph.D. 

d-iss., Michigan State University. 

Hamermesch, D., and Grant,J. 1980. Econometric studies of laborlabor substitution and their implications. Journal of Human 

Resources 16: 518-42. 

Harberger, A. 1962. The incidence of the corporation income tax. 

Journal of Political Economy 70: 215-40. 
-37-

. 1978. Perspectives on capital and technology in less 

developed countries. In Contemporary Economic Analysis,

edited by M. Artis and R. Nobay. Croom Helm: London. 

. 1983. Corporate tax incidence in closed and open

economies. Paper presented to NBER Summer Institute in 

Taxation. 

Jones, R. 1965. The structure of simple general equilibrium

models. Journal of Political Economy 73: 557-72. 

Mutti, J., and Grubert, H. 1982. DISC and its effects. 

Forthcoming in The structure and evolution of trade policy,

edited by R. Baldwin and A. Krueger. National Bureau of 

Economic Research. University of Chicago Press: Chicago. 

Samuelson, P. 1953. Prices of factors and goods in general

equilibrium. Review of Economic Studies 21:l-20. 

. Vandendorpe, A. and Friedlaender, A. 1976. Differential 

incidence i'n the presence of initial distorting taxes. 

Journal of Public Economics 6: 205-229. 
-38-

APPENDIX A 

The Model in Differential Form 

The impact of changes in tax policy is computed by first 

casting the model in terms of percentage changes. The basic 

equations in the model have been described in the body of the 

paper. This appendix will present how some of the key equations 

appear in the model in differential form. 

(a) Zero Profit Equations 

Equation (1) above is the zero profit or price equation for 

industry XIA. The differential form of equation (1) is: 

where eij is the share of the value of output of good j attributable to factor i in country k. The use of a circumflex signifies 

the percentage change in a variable, although in the case of the 

tax variables it denotes dt./(l-t.). 1 1 

(b) Factor Demand Equations 

Equation (2) gives the input-output relation between 

commodity output and the demand for unskilled labor in country A. 

In differential form this equation is: 
-39-

A A 

UA2 A 0A .AN) 

LH + 'LN HN LH qA 

A A 

(WA - r A 

AA 0A (3 AN + , 

LN KN KL 

where Ai! is the share of the total stock of factor i used in the 

production of good j in country k and is the partial elasticity of substitution between factors i and j in the production of 

good m in country k. In this form, the impact of the tax 

changes on factor demand is explicit. 

(c) Commodity Demand 

A typical product demand equation in percentage change form, 

using good X in country A, DIA, is: 

A A A A 

DIA = EAlAlA PIA + EAlAlB PIB + EA1A2A PZA + EAlA2B P2B 

AB 

+ EAYA ( Y A YA - A B A YA - SB + SA YA - SB + SA YA - SB 4- SA 'A) A B 
^A ^A 

-40-

where the coefficients represent the elasticity of demand in 

Country A for XIA with respect to a change in the corresponding 

price shown. 

(d) Savings Functions 

The saving equations parallel to equations (4) and (5) for Si 

and Si are 

Si n = EAAA iA + EAAB iB + EAYA yA 

where EAAA and EAAB are the own and cross price elasticities of 

demand by A residents for assets in A and B. There are two 

parallel equations for saving by residents of B. 

, 
-41-

APPENDIX B 

Derivation of Elasticities and Cross Elasticities 

for Commodity and Asset Demand Functions 

The own and cross price elasticities in the differential form 

of the commodity demand equations are based on the Armington 

assumptons described in the text. For example, the own and cross 

elasticities of demand for XIA sold in Country A will be 

where SIA is the share of the budget spent on X1 which is allocated to SIA, '1 is the elasticity of substitution between X 1A 

and XIR, and N1 is the elasticity of demand for the aggregate 

commodity XI. 

The savings elasticities are computed in a manner analogous 

to the commodity demand elasticities. Given the Armington 

separability assumption for foreign and domestic assets within 

the overall savings branch, 

EAAA (1-d) uA + drl A 

EAAB = - (1-d) ( uA - rlA) 

where d is the share of saving by A resident allocated to A 

assets. 
-42-

APPENDIX C 

Investment in Human Capital 

The highly simplified version of the process of investment in 

human capital used in this paper rests on two equations to determine h and st. One equation corresponds to the decision by an 

individual to increase his human capital. This choice will be 

dependent on the change in the ratio of the returns to human 

capital relative to unskilled labor, any change in the interest 

rate, and the rate at which greater amounts of training time become necessary to generate successive increments in h. A second 

equation shows how the share of the labor force in training 

depends upon the absolute growth rate of the labor force, and on 

the training process to generate he 

Both equations, then, depend on the same basic behavioral 

relationship, which gives the amount of training time, T, that an 

average individual entering the labor force has to undertake in 

order-to attain a level of human capital h during his active 

career. We assume that this relationship has the form T = h'. 

The average individual will chQose the amount of training time T 

which maximizes the present value of his lifetime earnings, which 

is 
-43-

where i is the real interest rate and V is the total length of a 

career, including training. Maximizing the present value of 

lifetime earnings yields the condition 

q/i (e-iT - eiv) = (w+qh) eiTehE-1 

For given assumed initial values of q, i, w, h, V, and T, the 

corresponding E can be computed. Given this E, it is then possible to use the above optimizing condition to compute the percentage change in h resulting from a one-percent change in q, w, 

and i. 

The relationship between the share of the labor force in 

training, st, and h can be derived from the training productivity 

relationship, T = he. In the case of a stationary labor force 

with equal entry and exit, st is simply equal to T/V. If the 

labor force is growing, then st>T/V, because the recent entrants, 

who are the ones in training, represent a larger share of the 

total. 
-44-

Some of the assumptions used in calculating the response 

parameters are that workers initially spend ten percent of a 40-

year work life in training, that the labor force is growing at 

one percent annually, that roughly 12 percent of the labor force 

is in training, and, based on the labor value added decomposition 

described earlier, the ratio of skilled to unskilled wages is 

1.46. Given these values, a one-percent change in the ratio of 

skilled to unskilled wages is projected to lead to an increase in 

h of .075 percent, while an increase in the interest rate of one 

percent causes a decline in h of .167 percent.