Download International ramifications of US tax-policy changes

Journal of Policy Modeling
25 (2003) 825–835
International ramifications of US
tax-policy changes
Charles L. Ballard a,∗ , Kiwon Kang b
a Department
b International
of Economics, Michigan State University, East Lansing, MI 48824-1038, USA
Studies and Programs, Michigan State University, East Lansing, MI 48824-1035, USA
Abstract
We integrate trade modeling and tax modeling, by evaluating the international spillover
effects of changes in US tax policy. We use a static computational general-equilibrium
model that divides the world into four regions, with data for 1995 from the Global Trade
Analysis Project. We incorporate a labor/leisure choice and international cross-ownership of
assets. Our simulations suggest that unilateral elimination of US capital taxation generates
welfare gains for the United States. If the other regions do not respond to the US policy
change, they suffer welfare losses. However, if all regions eliminate capital taxes, welfare
gains accrue for the entire world.
© 2003 Society for Policy Modeling. Published by Elsevier Inc. All rights reserved.
Keywords: Tax policy; Trade policy; General-equilibrium modeling
1. Introduction
In 2002, the Bush administration imposed protective tariffs on steel imports.
This led to a storm of protest from around the world. At the same time, the administration was developing proposals that would include the complete exclusion of
dividend income from the individual income tax. Although the tax proposals were
criticized domestically, they elicited relatively little comment in other countries.
This difference in international reaction suggests that foreign governments may
believe that they are unaffected by tax-policy changes in the United States. How∗
Corresponding author. Tel.: +1-517-353-2961; fax: +1-517-432-1068.
E-mail addresses: [email protected] (C.L. Ballard), [email protected] (K. Kang).
0161-8938/$ – see front matter © 2003 Society for Policy Modeling.
doi:10.1016/S0161-8938(03)00071-1
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C.L. Ballard, K. Kang / Journal of Policy Modeling 25 (2003) 825–835
ever, the simulations presented in this paper imply that the international spillovers
of domestic tax changes can be quite substantial.
The academic literature has focused attention on proposals that would lead to
reform of the taxation of capital income. Although they differ in some important details, many of the proposals point toward reduced taxation of capital generally (and
corporate capital in particular), and toward increased consumption taxation. Some
papers have employed closed-economy models.1 However, as the world economy
becomes increasingly integrated, it becomes increasingly appropriate to focus on
international issues, and some papers have used open-economy models to analyze
the effects of tax-policy changes. These include Whalley (1980), Goulder, Shoven,
and Whalley (1983), and Thalmann, Goulder, and DeLorme (1996). We continue
in that tradition. We use a static computational general-equilibrium model that
divides the world into four regions. The data are from the Global Trade Analysis
Project for 1995. Our model incorporates a labor/leisure choice and international
cross-ownership of assets, and we pay special attention to the calibration of the
labor–supply decision and the international portfolio–allocation decision. Our simulations suggest that unilateral elimination of US capital taxation would generate
sizeable capital inflows. This policy encourages more efficient use of the capital
stock. Although the policy generates negative effects on the terms of trade, its
overall effect is to create welfare gains for the United States. If the other regions
do not respond to the US policy change, they suffer welfare losses. However, if all
regions eliminate capital taxes, welfare gains accrue for the entire world.
2. Description of the simulation model
The basic framework for our research is the computational general-equilibrium
model of Rutherford (1998), which uses data from the Global Trade Analysis
Project (GTAP), described by Hertel and Tsigas (1996). This database represents
1995 transactions for global production, trade flows, trade barriers, and domestic
consumption taxes, and measures them in 1995 US dollars. In this paper, we use
an aggregated version of the GTAP database, with five commodities (agriculture,
primary materials, durable manufactures, non-durable manufactures, and services)
and four regions (the United States, the European Union, Japan, and the Rest of
the World).
In some respects, the core model used here is similar to the standard GTAP
model. First, the model is static.2 Second, trade is based on the Armington as1 For example, see Fullerton, Shoven, and Whalley (1983), Jorgenson and Wilcoxen (1997), and
Altig, Auerbach, Kotlikoff, Smetters, and Walliser (2001).
2 The model described here has the same time frame as the well-known model of Harberger (1962),
which is sometimes called a “medium-run” model. Since there is no capital accumulation, our model
is not a long-run model. However, our model allows reallocation of the existing world capital stock
among all sectors in the world. Thus, it is not truly a short-run model, either.
C.L. Ballard, K. Kang / Journal of Policy Modeling 25 (2003) 825–835
827
sumption: Commodities are distinguished by their place of origin. (see Armington
(1969)).
However, our model differs from the standard GTAP model in some important
ways. First, the model incorporates a labor/leisure choice. Thus, the income tax is
distortionary in our model. In addition, consumption taxes have an effect on the
real wage rate, even if the net-of-tax nominal wage rate is unaffected. Our model
also captures this effect of consumption taxes on labor supply. Second, the model
incorporates a new method for calibrating international capital flows. In our model,
investors hold internationally diversified portfolios. Domestic and foreign assets
are assumed to be imperfect substitutes. As a result of changes in relative rates of
return, consumers alter the fractions of their financial wealth held in assets from
different countries.
A representative agent determines final demand in each region, according to
a nested utility structure. On the first level, the consumer chooses the shares of
domestic and foreign assets. The asset-substitution elasticities are calibrated on the
basis of the elasticity of demand for domestic capital with respect to the ratio of the
domestic and foreign rental rates, which is taken from the econometric literature.
On the second level, the consumer maximizes a CES aggregation of consumption
and leisure. The elasticities of substitution between consumption and leisure are
calibrated on the basis of labor-supply elasticities, which are taken from the econometric literature. On the third level, the consumer maximizes utility from aggregate
consumption of goods, which is represented by a CES aggregation of consumption
of goods from each sector. On the fourth level, the consumer decides whether the
purchases in each sector should be at home or abroad. This choice is governed
by Armington elasticities of substitution between domestic and imported goods in
each sector. On the fifth level, the consumer allocates aggregate consumption of
imported goods in each sector among the imported goods from different regions.
See Kang (2002) for the relevant algebra for all levels of the consumer’s decision.
The primary factors, labor and capital, are combined according to a CES
value-added function. Labor inputs are assumed to be mobile between production
sectors, but not internationally. Capital inputs are assumed to be mobile across
sectors and regions.
3. Parameter selection and model calibration
We employ the technique of calibration to impose a desired set of elasticities
upon the model. Some of the most important demand-side parameters are summarized in Table 1.
The elasticity of substitution between consumption and leisure is calculated on
the basis of the uncompensated labor–supply elasticity and the “time–endowment
ratio.”3 In turn, the time–endowment ratio is monotonically related to the total3 The time–endowment ratio is the ratio of the consumer’s endowment of time and the amount of
labor supplied in the base case. See Ballard (2000) for discussion.
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Table 1
Parameter values
Time–endowment ratio
Elasticities of substitution between:
Consumption and leisure
Domestic and foreign assets
US
EU, Japan, ROW
1.32
1.35–1.41
1.13
1.92–2.01
0.92–1.08
1.38–1.53
income elasticity of labor supply. We specify values of the labor-supply elasticities, and then solve for the values of the time–endowment ratio and the elasticity
of substitution that are consistent with those elasticities. Based on the econometric
literature, our central-case values are 0.15 for the uncompensated labor-supply
elasticity and −0.1 for the total-income elasticity, although we also perform sensitivity analysis.
Second, we calibrate the asset-substitution elasticity, which plays an important
role in an open-economy model. Previous papers have employed fairly arbitrary
assumptions regarding this parameter. Gravelle and Smetters (1998) assume the
asset-substitution elasticity to be 3.0, and Thalmann et al. (1996) assume it to be 4.0.
We calibrate this parameter. The equation for the elasticity of demand for domestic
capital with respect to the ratio of domestic and foreign rental rates is derived from
the consumer’s utility maximization. This elasticity can be calibrated, based on
values of the elasticities of demand for capital at home and abroad, which are taken
from the econometric literature. That literature includes Altshuler, Grubert, and
Newlon (1998), Boskin and Gale (1987), Grubert and Mutti (2000), and Slemrod
(1990). Using these estimates as the basis for our calibration, we take the central
values of the asset-substitution elasticity in the US and other regions to be 2.0 and
1.5, respectively, although we also perform sensitivity analysis. For more details
on our calibration procedures, see Kang (2002) and Ballard and Kang (2001).
We use the SALTER elasticities of substitution as our central values for the
Armington elasticities between domestic goods and imported goods. (see Jomini
et al. (1991)). The values of the elasticity of substitution between goods from
different foreign countries are set at twice the values of the elasticity of substitution
between domestic goods and the aggregated foreign good. The sector-specific
SALTER trade elasticities are shown in Table 2.
Table 2
The SALTER trade elasticities
Sector
Domestic and imported goods
Different imported goods
Agriculture
Primary materials
Durable manufactures
Non-durable manufactures
Services
2.43
2.60
3.40
2.75
2.05
4.86
5.20
6.80
5.50
4.10
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Table 3
Factor tax rates (%)
Sector
US
EU
Japan
Capital
taxes
Labor
taxes
Capital
taxes
Labor
taxes
Capital
taxes
Labor
taxes
Agriculture
Primary materials
Durable manufactures
Non-durable manufactures
Services
8.53
22.26
93.11
53.01
30.00
12.57
13.38
13.15
13.24
17.32
18.05
27.74
43.45
41.19
33.69
48.50
48.50
59.45
50.50
51.28
34.69
21.18
31.95
34.73
34.85
18.20
22.61
23.42
24.09
24.18
Overall
35.74
16.27
33.57
51.66
34.25
22.59
Sources: see Ballard and Kang (2001).
The effective tax rates on capital in the United States are calculated as the ratio
of capital tax liabilities to net payments to capital.4 For the United States, the
August 1998 Survey of Current Business (SCB) gives us data on the net-of-tax
capital income and capital tax liabilities. The effective tax rates on labor income in
the United States are calculated as the ratio of labor-tax liabilities to net payments
to labor. The data on labor-tax liabilities as well as the net-of-factor-tax returns
to labor are provided by the August 1998 SCB, and by unpublished worksheets
from the National Income Division. For details on the data, see Kang (2002) and
Ballard and Kang (2001).
We calculate tax rates for the European Union and Japan on a similar basis. (For a
detailed discussion, see Ballard and Kang, 2001.) Table 3 shows the factor-tax rates
for the US, the European Union, and Japan. The overall tax rates on capital income
are not very different across regions. However, there is tremendous variation among
the regions in the capital-tax rates in different sectors. The labor-tax rates are also
significantly different across regions. Nevertheless, the intuition for our results
does not depend critically on the tax-rate data. Sensitivity analyses indicate that
the basic character of the results is not affected by changes in the initial tax rates.
4. Simulation results
Many of the proposals for tax reform point toward reduced taxation of capital
income and increased consumption taxation. We consider here the extreme case
of complete elimination of capital-income taxes.5
4 Thus, we calculate the average tax rate, and then assume that marginal tax rates are equal to the
average rates. This is the procedure used by Harberger (1962) and many others. An alternative would
be to calculate marginal effective tax rates, based on data and assumptions regarding variables such as
depreciation schedules, nominal tax rates, and discount rates, and then to assume that the average tax
rates are equal to the marginal rates. One of our reasons for choosing the former approach is that the
data requirements for the latter approach are very formidable in a global model such as ours.
5 We motivated this paper by referring to the Bush administration’s proposal to cut dividend
taxes. That proposal moves in the direction of the policy simulated in this paper, although the
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The reduction in US capital taxes raises the relative after-tax returns on USlocated capital. This leads to a reallocation of global capital, with more of the
world’s capital stock being located in the United States. Under our central-case
parameters, the overall US capital stock is increased by 8.5%. The largest increase
in capital in the US is in the durable-manufacturing sector, because this sector
faced the highest capital-tax burden before the policy change. However, capital in
US agriculture decreases, because agriculture loses its tax-preferred position.
International spillovers also occur through terms-of-trade effects. As a result
of the policy change, there are decreases in both export prices and import prices.
However, the reduction in US export prices is larger than the reduction in US
import prices, and this causes a 1.5% deterioration in the terms of trade for the
United States. This negative terms-of-trade effect reduces the US welfare gains
from the elimination of domestic distortions.
The tax-policy changes lead to a 2% increase in the overall US output level. The
policy changes cause US consumption to rise by 1.1%,6 and they lead to welfare
gains. These welfare gains are about $98 billion per year in 1995 dollars, which
amounts to about 1.4% of GDP.7
The change in welfare for the US can be explained through three channels.
First, the equalization of capital-tax rates leads to a more efficient allocation of
the US capital stock. Second, the policy change leads to capital inflows. Finally,
the policy change has a negative effect on the terms of trade. Welfare improves
because the positive effects dominate the negative terms-of-trade effect.
When one country initiates a policy change, there will also be effects on the
allocation of resources around the world. The US tax policy raises the after-tax
returns on US-located capital, which benefits foreigners who own such capital. On
the other hand, the higher returns in the United States lead to a reallocation of capital
from the foreign economies to the United States. The reduction in foreign-located
capital has a negative effect on the welfare of the foreign economies. The latter
negative effects are larger than the former positive effects, so that the overall
effect on the foreign economies through the capital market is negative. Due to
the elimination of US capital taxes, the terms of trade for foreign economies are
improved. However, the positive terms-of-trade effects for the foreign economies
dividend-exclusion proposal is not nearly as large. Many of our results would carry over to a variety of other policies for capital-tax reduction, including the proposed dividend exclusion. Of course,
however, the efficiency effects will be smaller when the policy is smaller. Note that the Bush proposal
is part of an overall plan for tax reduction, which would lead to an increase in the budget deficit of the
Federal government. Our simulations abstract from the deficit issue, because we assume that consumption taxes are used to maintain budget balance. Also, much of the debate over the dividend proposal
has been motivated by distributional concerns, but we model each region as having a representative
consumer. Thus, we do not incorporate distributional considerations.
6 The increase in US output is much larger than the increase in US consumption, because US exports
are greatly stimulated by the change in the terms of trade.
7 We measure the welfare gains by the equivalent variation. The percentage increase in welfare
is larger than the percentage increase in consumption. This is because, when we use our central-case
labor-supply elasticities, the decrease in the real net wage rate leads to an increase in leisure.
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831
Table 4
Selected effects of the tax-policy change
US
Output by sector (% changes)
Agriculture
Primary materials
Durable manufactures
Non-durable manufactures
Services
Overall
Imports by sector (% changes)
Agriculture
Primary materials
Durable manufactures
Non-durable manufactures
Services
Overall
EU
Japan
ROW
3.14
5.93
19.17
7.34
0.34
−0.39
−0.52
−1.09
−0.53
−0.41
−0.69
−0.81
−1.28
−0.80
−0.75
−0.16
−0.78
−1.63
−1.11
−0.34
2.02
−0.54
−0.84
−0.93
11.76
5.31
−3.99
−1.72
−2.56
−0.80
−0.75
0.09
0.53
−0.41
−0.93
−0.81
0.79
0.24
−0.42
−0.83
−0.87
−0.47
−0.51
0.31
1.67
−0.47
−0.53
−0.60
1.13
−0.52
−0.76
−0.66
Equivalent variation (US$ billions)
98.34
−32.98
−31.06
−42.04
Equivalent variation (as % of GDP)
1.38
−0.42
−0.61
−0.51
Consumption (% changes)
are dominated by the negative capital-market effects. As a result, there is lower
consumption and lower welfare in the foreign economies. Some details of the
effects of the US policy change on the domestic and foreign economies are reported
in Table 4. Additional details can be found in Kang (2002) and Ballard and Kang
(2001).
Next, we conduct sensitivity analyses for the key parameters. As the Armington
elasticities between domestic goods and imports for the US become larger, the
terms-of-trade effects become smaller. In other words, as imports become closer
substitutes with domestically produced goods in the US, the terms-of-trade loss in
the US becomes smaller. The more sensitive domestic consumers are, the greater is
the shift into domestically produced goods, and hence the greater are the decreases
in import prices.8
We also conduct a sensitivity analysis with respect to the asset-substitution
elasticities, which determine the degree of international capital mobility. Under the
US tax-policy changes, as the asset-substitution elasticity becomes larger, there are
more capital inflows into the United States. If the elasticity is doubled, the capital
stock located in the US will increase by 11.9%, relative to the base case. This
8 This differs from the result in Brown (1987). She evaluates the terms-of-trade effects of a tariff,
and shows that the terms-of-trade effects would increase in magnitude, as the elasticity of substitution
between domestic and imported goods becomes larger. However, we find that the terms-of-trade effects
are smaller when the elasticity of substitution is larger. This difference comes from the fact that imposing
a tariff drives the export price up, whereas eliminating capital taxation drives it down.
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compares with an increase of 8.5% when the central-case parameters are used.
Additional results are available on request, for a variety of parameter combinations.
Next, we examine the effects of changing the uncompensated labor-supply elasticity, ␩L , and the total-income elasticity of labor supply, ␩I . After the US policy
changes, the prices of consumer goods in the US are increased, because consumption taxes are used to replace the lost revenue. Because of the price increases, the
real wage rate is depressed. As long as ␩L is positive, the decreased real wage
will lead to a decrease in labor supply. Labor supply is also affected through the
income effect, which is controlled by ␩I . After the policy changes, the consumer’s
net capital income is larger. Because of this, the consumer supplies less labor.
Thus, higher absolute values of ␩L and ␩I are associated with larger decreases in
labor supply. When the labor-supply reduction is greater, US output and consumption are smaller, all else equal. However, this is also associated with an increase
in leisure. These two influences affect welfare in opposite directions. When all
of these influences are included, the welfare gains for the US are smaller when
the labor-supply elasticities are larger in absolute value. However, the magnitudes
of these effects are relatively small. Capital inflows and the improvement in the
efficiency of use of the capital stock are more important than labor-supply effects,
in determining the welfare gains.
We also conduct sensitivity analysis with respect to the size of the unilateral
US Policy change. Fig. 1 plots the equivalent variations for the US for policy
changes of different sizes, assuming that the other regions do not change their
policies. As the size of the policy change increases, the welfare gain increases,
although at a diminishing rate. The welfare gain reaches a maximum at a 140%
reduction in US capital taxes, but it falls sharply after that. If the US were to
reduce its capital taxes by 180%, it would actually suffer welfare losses. This is
because the continued reduction in capital-tax rates leads to a need for ever-greater
Fig. 1. Welfare gains as function of the size of policy change.
C.L. Ballard, K. Kang / Journal of Policy Modeling 25 (2003) 825–835
833
Fig. 2. Welfare effects of unilateral and multilateral Policy change.
increases in the consumption taxes that are used to replace the lost revenues. As
the consumption-tax rates increase, their distortionary effects become dramatically
larger. We conclude that, if other countries don’t respond, the optimal strategy for
the United States is actually to subsidize capital.
Finally, we consider the case of multilateral Policy changes, in which all of
the other regions also eliminate their capital taxes. Fig. 2 compares the effects
of unilateral and multilateral Policy changes. A unilateral Policy change by the
US produces a welfare gain only for the United States. In the multilateral case,
where capital taxes are eliminated throughout the world, the entire world enjoys
welfare gains, because the multilateral policy changes encourage more efficient
use of capital everywhere.
5. Conclusion
If a country were to try to beggar its neighbors through restrictive tariffs and quotas, it would certainly meet with objections from other countries. The international
spillover effects of tax-policy changes may be just as important as the effects of
changes in commercial policies, even though tax changes do not typically generate
nearly as much reaction from abroad. This may be, in part, because relatively little
research has been directed at the international spillovers of tax-policy changes. In
this paper, we have described a global trade model, in which domestic tax-policy
changes have international spillover effects. We employ improved techniques for
calibrating the labor-supply elasticities and the elasticities of substitution between
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the assets of different regions. We find that unilateral elimination of US capital taxation generates welfare gains for the United States. The tax-policy changes improve
the efficiency of the allocation of the domestic capital stock, and they generate capital inflows. Conversely, foreign economies experience welfare losses. However,
when all regions remove their capital taxes, the entire world experiences a welfare
gain.
These results suggest that policy-makers would be well advised to pay more
attention to the international ramifications of tax-policy changes. However, the
results also point to a very important difference between restrictive trade policies
and capital tax cuts. If restrictive trade policies lead to a cycle of retaliation, the
results can be disastrous, as in the case of the Smoot–Hawley tariffs of 1930.
However, if a capital tax cut in one country leads to “retaliation”, whereby other
countries also cut their capital taxes, our simulations suggest that all regions of the
world would gain.
Acknowledgments
We are grateful for helpful comments from Antonio Maria Costa, four anonymous referees, and participants in the Fourth Annual Conference on Global Economic Analysis, Purdue University, June 27–29, 2001. Errors are our responsibility.
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