Capital Income Tax Reform and the Japanese Economy (Very Preliminary and Incomplete)

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1 Capital Income Tax Reform and the Japanese Economy (Very Preliminary and Incomplete) Gary Hansen (UCLA), Selo İmrohoroğlu (USC), Nao Sudo (BoJ) December 22, 2015 Keio University December 22, 2015 Keio University 1 /

2 Introduction Capital Income Tax and the Japanese Economy Less is More? In April 2014, the Japanese government announced plans to gradually reduce the corporate income tax rate from 35% to 25% In April 2015, the government reduced the tax rate by 3.29% from an effective rate of 35% In this paper, we study the impact of a lower capital income tax rate on the Japanese economy. We present long run and short run effects on the economy. We also provide a welfare analysis. December 22, 2015 Keio University 2 /

3 Introduction Capital Income Tax and the Japanese Economy Where Are We Now? Net debt to GDP ratio at about 150% in 2015 Dependency ratio projected to rise from 40% in 2013 to 92% in 2092 We study the long run impact of the proposed policies and also document the short run effects from 2015 to 2050 December 22, 2015 Keio University 3 /

4 Introduction Fundamental Problem 1: Aging Population to to Figure : Dependency Ratios December 22, 2015 Keio University 4 /

5 Introduction Fundamental Problem 2: High Debt Figure : Net Debt to GNP Ratio December 22, 2015 Keio University 5 /

6 Introduction Implications of Aging Population Fukawa and Sato (2009), consistent with İmrohoroğlu, Kitao and Yamada (2015) 0.25 G/Y TR/Y Figure : Government Expenditures to GNP Ratios December 22, 2015 Keio University 6 /

7 Introduction What We Do Formulate and calibrate a neoclassical growth model of Japan. What is the effect on the Japanese economy from a reduction in the capital income tax rate? Both in the long run, and, especially in the short run. Are there welfare gains? What is the optimal capital income tax rate in this environment? How does the economy look like if the optimal tax policy is implemented? December 22, 2015 Keio University 7 /

8 Introduction What We Do Hayashi and Prescott (2002), Chen, İmrohoroğlu and İmrohoroğlu (2006), Hansen and İmrohoroğlu (2013) Standard growth model. Characterize how model performs from Take as exogenous TFP, tax rates, government consumption, transfers and population. Use observed values Use model to forecast from 2015 and beyond; perfect foresight and also MIT simulations. Government projections for population to Forecasts of Fukawa and Sato (2009) of G /Y and TR/Y to [Consistent with independent projections of İmrohoroğlu, Kitao, and Yamada (2013)] December 22, 2015 Keio University 8 /

9 Introduction Features of Model Endogenous labor choice consumption and labor income taxes are distorting labor supply Capital income tax distorts the saving decision When reduced, investment rises, capital accumulates faster, output increases. Produce unanticipated simulations. December 22, 2015 Keio University 9 /

10 Introduction Related Literature İmrohoroğlu and Sudo (2011): Will a 15% consumption tax or a growth miracle save Japan? No. Doi, Hoshi and Okimoto (2011): Combination of reforms. Hoshi and Ito (2015): Back-of-the-envelope calculations. İmrohoroğlu and Hansen (2015): Given the projected increases in government expenditures and the decline in working age population, how high must the consumption tax rate go to achieve fiscal sustainability? Very, very high. İmrohoroğlu, Kitao, and Yamada (2015): Accounting exercise to measure which policies/outcomes help achieve fiscal sustainability. Pension reform, increase in FLFP. Braun and Joines (2015): Raise co-pay for the elderly to the level of working age people. Kitao (2015): Raise normal retirement age to 70. December 22, 2015 Keio University 10 /

11 Model Economy Model: Government Budget G t +TR t +B t = η t q t B t+1 + τ c,t C t + τ h,t W t h t +τ k,t (r t δ)k t + τ b,t (1 q t 1 )B t. December 22, 2015 Keio University 11 /

12 Model Economy Implementation of Tax Increases. τ c,t = { τ B c,t if t < T 1 (B s /Y s b max for all s t) τ c + π if T 1 t < T 2 (B s /Y s > b max for some s t and B t /Y t > b) τ c if t T 2 (B t /Y t b), π is chosen as the smallest increment that leads to the activation of the second trigger (convergence to steady state). TR t = TR B t for t < T 1 TR t = TR t 0.08Y B t for t T 1 December 22, 2015 Keio University 12 /

13 Model Economy Model: Household s Problem max t=0 subject to β t N t [logc t α h1+1/ψ t 1+1/ψ + φlog(µ t +B t+1 )] (1+ τ c,t )C t + η t K t+1 +q t η t B t+1 = (1 τ h,t )W t h t +[(1+(1 τ k,t )(r t δ)]k t +[1 (1 q t 1 )τ b,t ]B t +TR t, December 22, 2015 Keio University 13 /

14 Model Economy Model: Firm s Problem N t Y t = A t (N t K t ) θ (N t h t ) 1 θ N t+1 K t+1 = (1 δ)n t K t +N t X t A t+1 = γ t A t December 22, 2015 Keio University 14 /

15 Model Economy Stationary Equilibrium Conditions Given a per capita variable Z t we obtain its detrended counterpart z t = Z t A 1/(1 θ) t. First order conditions and market clearing conditions combine to give 10 equations in 10 unknowns {c t,x t,h t,y t,k t+1,b t+1,d t,q t,w t,r t } for each period t. Computation Objective: Find value for k 1 such that sequence converges to steady state. December 22, 2015 Keio University 15 /

16 Calibration Population and Labor Input N t = working age population between the ages of 20 and 69 Use actual values for Use official projections for Population constant after 2060 h t is employment per working age population multiplied by average weekly hours worked divided by 98 (discretionary hours available per week). December 22, 2015 Keio University 16 /

17 Calibration National Accounts: Hayashi and Prescott (2002) Table : Adjustments to National Account Measurements C = Private Consumption Expenditures I = Private Gross Investment + Change in Inventories + Net Exports + Net Factor Payments from Abroad G = Government Final Consumption Expenditures + General Government Gross Capital Formation + Government Net Land Purchases Book Value Depreciation of Government Capital Y = C +I +G December 22, 2015 Keio University 17 /

18 Calibration Government Accounts Public health expenditures in Japan are included in G t. TR t, includes social benefits (other than those in kind, which are in G t,) that are mostly public pensions, plus other current net transfers minus net indirect taxes. 8% of output is added to TR t since modeling of flat tax rates ignores deductions and exemptions. December 22, 2015 Keio University 18 /

19 Calibration Tax Rates τ h,t, are average marginal labor income tax rates estimated by Gunji and Miyazaki (2011). Last value is for 2007 and we assume that this remains constant thereafter. τ k,t, is constructed following methodology in Hayashi and Prescott (2002). Last value is for December 22, 2015 Keio University 19 /

20 Calibration Tax Rates, continued Tax Rate on Consumption, τ c,t 0% % % % % 2017 and beyond, until it endogenously rises to achieve fiscal sustainability Tax Rate on Bond Interest, τ b, 20% for all time periods. December 22, 2015 Keio University 20 /

21 Calibration Tax Rates, continued Consumption Tax Rate Labor Income Tax Rate Capital Income Tax Rate Figure : Tax Rates December 22, 2015 Keio University 21 /

22 Calibration Technology Parameters A t = Y t /(K θ t h1 θ t ). θ = , which is the average value from γ t = A t+1 /A t, comes from the actual data between 1981 and γ t = θ for 2015 and beyond. δ = , which is the average value from December 22, 2015 Keio University 22 /

23 Calibration Preference Parameters Five preference parameters, β, α, ψ, φ, and µ. µ = µ t /A 1/(1 θ) t = 1.1. ψ = 0.5, the Frisch elasticity of labor supply estimated by Chetty et al (2012). December 22, 2015 Keio University 23 /

24 Calibration Preference Parameters, continued For β, α, and φ, use equilibrium conditions to obtain a value for each year, and then average over the sample: β t = (1+τ c,t+1 )γ 1/(1 θ) t c t+1 (1+τ c,t )c t [1+(1 τ k,t+1 ) ( )] θ y t+1 k t+1 δ α t = h 1/ψ t (1 τ h,t )(1 θ)y t (1+τ c,t )c t h t [ q t γ 1/(1 θ) ] t φ t = η t (µ+b t+1 ) β t [1 (1 q t )τ b,t+1 ] (1+ τ c,t )c t (1+τ c,t+1 )c t+1. December 22, 2015 Keio University 24 /

25 Calibration Bond Price Need empirical counterpart to q t : q t = B t+1 /F t (B t+1 +P t+1 )/F t+1. B t is beginning of period debt. P t is interest payments made in period t. F t is the GNP deflator. December 22, 2015 Keio University 25 /

26 Calibration Structural Parameters Table : Calibration of Structural Parameters Parameter Value θ Data Average δ Data Average β FOC, α FOC, ψ 0.5 Chetty et al (2012) φ 0.12 FOC, µ 1.1 fit q t for December 22, 2015 Keio University 26 /

27 Quantitative Experiments Steady State Analysis Long Run Comparison Reducing the Capital Income Tax Rate Unanticipated reduction in τ k from 35% to 30% in 2015 to 25% in 2015 to 0% in 2015 We report long run results with higher capital income tax rates for comparison December 22, 2015 Keio University 27 /

28 Quantitative Experiments Steady State Analysis Long Run Comparisons Changing the Capital Income Tax Rate τ k K H Y C τ c December 22, 2015 Keio University 28 /

29 Quantitative Experiments Steady State Analysis Long Run Comparisons Laffer Curves: Capital Income Tax steady state revenue ψ = 0.1 ψ = 0.5 ψ = capital income tax rate December 22, 2015 Keio University 29 /

30 Quantitative Experiments Short Run Analysis Transition Paths Capital Stock τ = 0.34 k τ k = 0.30 τ k = 0.25 τ k = 0 2 capital stock December 22, 2015 Keio University 30 /

31 Quantitative Experiments Short Run Analysis Transition Paths Labor Input labor input τ k = 0.34 τ k = 0.30 τ k = 0.25 τ k = December 22, 2015 Keio University 31 /

32 Quantitative Experiments Short Run Analysis Transition Paths Output τ = 0.34 k τ k = 0.30 τ = 0.25 k τ = 0 k 7 output December 22, 2015 Keio University 32 /

33 Quantitative Experiments Short Run Analysis Transition Paths Investment τ = 0.34 k τ k = 0.30 τ k = 0.25 τ k = 0 2 investment December 22, 2015 Keio University 33 /

34 Quantitative Experiments Short Run Analysis Transition Paths Consumption τ = 0.34 k τ k = 0.30 τ k = 0.25 τ k = consumption December 22, 2015 Keio University 34 /

35 Quantitative Experiments Short Run Analysis Transition Paths Debt to Output Ratio debt to output ratio τ k = 0.34 τ k = 0.30 τ k = 0.25 τ k = December 22, 2015 Keio University 35 /

36 Quantitative Experiments Short Run Analysis Transition Paths Consumption Tax Rate τ = 0.34 k τ = 0.30 k τ = 0.25 k τ = 0 k consumption tax rate December 22, 2015 Keio University 36 /

37 Quantitative Experiments Short Run Analysis Short Run Analysis: Path of K Reducing the Capital Income Tax Rate: The Next Ten Years τ k = 0.34 τ k = 0.30 τ k = 0.25 τ k = December 22, 2015 Keio University 37 /

38 Quantitative Experiments Short Run Analysis Short Run Analysis: Path of H Reducing the Capital Income Tax Rate: The Next Ten Years τ k = 0.34 τ k = 0.30 τ k = 0.25 τ k = December 22, 2015 Keio University 38 /

39 Quantitative Experiments Short Run Analysis Short Run Analysis: Path of Y Reducing the Capital Income Tax Rate: The Next Ten Years τ k = 0.34 τ k = 0.30 τ k = 0.25 τ k = December 22, 2015 Keio University 39 /

40 Quantitative Experiments Short Run Analysis Welfare Gains CEV relative to the baseline transition with τ k = 34% τ k CEV December 22, 2015 Keio University 40 /

41 Sensitivity Analysis Sensitivity to various assumptions TBD Frisch elasticity 0.1 and 1.0 Bonds are not in the utility function Small, open economy December 22, 2015 Keio University 41 /

42 Conclusion Conclusions What We Did High debt to output ratio combined with looming public expenditures due to rapid societal aging Use the standard growth model to measure the impact of a lower capital income tax on the Japanese economy December 22, 2015 Keio University 42 /

43 Conclusion Conclusions Long Run Results Sizable gains in aggregate capital, output and consumption K rises 10.3% with τ k = 0.25 and 34.8% with τ k = 0 Y rises 3.9% with τ k = 0.25 and 12.1% with τ k = 0 C rises 3.0% with τ k = 0.25 and 8.1% with τ k = 0 December 22, 2015 Keio University 43 /

44 Conclusion Conclusions Short Run Results Relative to the baseline transition of no change in the capital income tax rate of 34%, there are significant gains in aggregate capital in the short run. For example, in 2020, K is 4.5% higher if τ k = 0.25 and 18.8% higher if τ k = 0, relative to their values under the baseline policy of τ k = December 22, 2015 Keio University /

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