Capital income taxes seem to be passed on to workers and consumers through lower capital accumulation or higher price markups, or some combination thereof.
In What Do Aggregate Consumption Euler Equations Say About the Capital Income Tax Burden? (NBER Working Paper No. 10262), author Casey Mulligan asks what effect U.S. capital income taxes have on consumption growth and on capital markets. He looks first at data from 1947 to 1997 on capital income tax revenue per dollar of capital income, and on the "wedge" between the pretax return on assets and the marginal rate of substitution of consumption over time. He finds that the wedge is fairly constant -- meaning that consumption growth roughly tracked the expected pretax return on capital -- before the tax cut by President John F. Kennedy. After the Kennedy tax cut, though, the pretax return on capital and growth in consumption moved in different directions. In subsequent years, the two series moved together again, both declining during 1970-83 and increasing from 1983 to 1997.
Mulligan concludes that capital taxation drives a wedge between consumption growth and the expected pretax return on capital. His second (and related) conclusion is that capital taxes significantly distort capital markets, precisely because most of the medium- and long-term differences between expected consumption growth and the expected pretax capital return are linked to capital taxation.
Then Mulligan turns to the elasticity of capital supplied, which he considers a critical parameter for forecasting the impact of capital income taxes. Using 51 annual postwar observations, he estimates how consumption growth changes (that is, the elasticity of consumption growth) with changes in expected asset returns. His results are fairly similar whether "the asset" considered is commercial paper or the S&P 500 -- the supply elasticity of consumption is economically insignificant. But his results differ dramatically if the after-tax return on total capital is used instead: in that case, the elasticity of consumption growth is greater than one.
Finally, Mulligan ponders the strongly negative correlation between the pretax return on capital and the aftertax share of capital income. The simplest and "possibly naive" explanation, Mulligan writes, is that firms respond to capital taxation by moving up their capital demand curve, thereby passing along the capital tax. But economists have been reluctant to adopt this interpretation, because capital tax rates seem to be correlated with non-tax determinants of economic activity. "What would the correlation be," asks Mulligan, "if we could control for non-tax determinants of the business cycle?" Given the wedge between consumption growth and pretax capital returns, capital income taxes seem to be passed on to workers and consumers through lower capital accumulation or higher price markups, or some combination thereof, Mulligan concludes.
-- Carlos Lozada