Arnold Harberger's famous 1962 article on corporate tax incidence

This semester I am teaching Survey of International Taxation (a 3-hour class on U.S. international tax law) and Corporate and International Tax Policy (a 2-hour seminar on main issues in these fields).  In the latter class, tomorrow we will be discussing corporate tax incidence, with Arnold Harberger's famous 1962 article on the topic offering an analytical starting point.

Harberger, of course, is among the leading candidates for the title of "greatest living economist who has not won the Nobel Prize."  And the incidence article is surely one of his two signature contributions (the other being "Harberger triangles" and the welfare loss from monopoly).

As I discuss in my book Decoding the U.S. Corporate Tax, there are many things that, with the benefit of fifty years' hindsight (and changes in both economies and legal institutions), one could view as understandably dated in Harberger's corporate tax incidence article.  For example, it treats the corporate tax as creating two business sectors, the corporate one that is taxed and the non-corporate one that is not taxed.  Today, we might say instead that there are two (and indeed more than two) distinct business tax regimes, and that the corporate one - counting both the firm and shareholder levels, as well as all tax rules that apply distinctively to corporations (e.g., the tax-free reorganization rules and various compensation rules) - is sometimes worse from a tax standpoint, and sometimes better.  (The "better" scenario would be more common, of course, if there were a greater spread between the top individual rate and the corporate rate.)

Also, the article avowedly has no theory as to why some businesses are incorporated while others aren't, and adopts the concededly over-simplifying assumption that the corporate tax is, in effect, a special levy on all business sectors other than agriculture and real estate.  Economists writing about corporate tax incidence today find it necessary to consider business sectors with a mix of corporate and non-corporate firms, and are more likely to model the split as reflecting, say publicly traded versus private, and perhaps as turning on the trade-off between self-owned entrepreneurial and public markets-funded managerial systems of internal governance.

What I regard as the article's greatest and most lasting insight is as follows. Taxing the normal return to capital income - an important part of the corporate tax  base, although rents and owner-employees' undistributed labor income are also important - might initially seem to raise incidental / distributional issues that are not distinctively interesting here in particular.  Since high-income individuals save both absolutely and proportionately more than others, the incidence of such a tax will clearly be progressive in a static, one-country scenario, where saving is inelastic.  By contrast, if saving is highly elastic, and drops significantly in the presence of a tax on capital income, the bottom line may change.  E.g., high-income individuals' marginal pre-tax return to saving may go up, and workers' productivity / wages may decline by reason of the reduction in capital investment.  But again, this is too familiar an analysis to be especially interesting in the setting of taxing corporate income in particular.

Harberger 1962's great insight was that all this may change when, because there are both corporate and non-corporate business sectors, only some capital income is being taxed.  In his particular model, savers generally bear the tax, but only for a peculiar and idiosyncratic reason.  It just happens to be the case, in his model, that the non-corporate sectors (agriculture and real estate) are less able to substitute between capital and labor as productive inputs than the corporate sectors.  So, when the corporate income tax drives capital from the corporate to the non-corporate sectors, the demand for labor increases more in the former than it declines in the latter.  So workers "win" and business owners who must pay them "lose."

No one today would think that this particular analysis gives us the answer about corporate tax incidence in 2015.  Indeed, Harberger is among those who completely rejects its current applicability.  But what remains true and important in Harberger 1962 is the point that differentially taxing capital income, depending on firms' business structure, has unpredictable incidence effects that one cannot really understand without a better grasp than anyone in the world actually has about the determinants, and both the tax and non-tax consequences, of the business structure choice.

Unfortunately, this is an insight that Harberger himself may have lost sight of later on, when he argued that rising capital mobility meant the corporate tax was now borne by workers.  This is certainly plausible, and it may be right, but the very point of tax and business heterogeneity that Harberger 1962 emphasizes means that further evaluation is needed and that, until we have a convincing model (which may be unattainable given the sheer messiness of the underlying realities) significant uncertainty may remain.