The Welfare and Distributional Consequences of Corporate Tax Cuts in Open Economies
What this paper finds — and why it matters
Layer 1: Overview
This paper uses an open-economy heterogeneous-household model with incomplete markets to evaluate the welfare and distributional consequences of the U.S. Tax Cuts and Jobs Act (TCJA) of 2017 — which reduced the U.S. corporate tax rate from 35 to 21 percent — both within the U.S. and in affected trading partners. The model features three economies (the U.S., a small open economy calibrated to Canada, and the rest of the world), free capital flows, progressive income taxes, and idiosyncratic uninsurable labor income shocks generating empirically realistic wealth Gini coefficients (0.80 for the U.S., 0.70 for Canada). Three main results are established. First, the TCJA is regressive in the U.S. — under a permanent cut, the bottom 5 percent of U.S. households by wealth experience welfare losses of 0.10–0.26 percent of lifetime consumption, while the top 1 percent gain 0.92 percent — and generates an even more regressive outcome in trading partners, where approximately the bottom 80 percent of the small open economy’s wealth distribution experience welfare losses averaging 1.28 percent at the bottom decile against gains of 2.57 percent at the top. Second, whether U.S. wealth-poor households benefit depends critically on the persistence of the tax cut: under a permanent cut, households above approximately the bottom 5 percent of the U.S. wealth distribution gain (driven by wage increases from capital inflows), but under an anticipated partial reversal from 21 to 28 percent after 7 years, approximately the bottom 75 percent of U.S. households experience welfare losses because the temporary wage gain is dominated by a persistent increase in the public debt burden. Third, when the small open economy reciprocates by matching the U.S. corporate tax reduction to 21 percent, the domestic distributional consequence reverses: all wealth quintiles in the small open economy gain (Table 5, Panel B shows gains of 0.52–1.19 percent across all groups), with the gain being roughly progressive within the SOE — a result driven by the wage increase from capital inflows exceeding the financing cost, which falls primarily on the wealth-rich through higher top marginal tax rates.
Q1. What is the model structure and how are the three economies connected?
The paper extends the Aiyagari (1994) incomplete-markets heterogeneous-household model to an open-economy setting with three countries — the U.S., a small open economy (SOE) modeled as Canada, and the rest of the world (ROW) modeled with Canadian parameters — linked by free capital flows that equalize after-tax returns to capital across countries: (1 − τc^US)r^US = (1 − τc^SOE)r^SOE = (1 − τc^ROW)r^ROW = r^b. Households in each economy face idiosyncratic uninsurable productivity shocks (three states: low s₁ = 0.167, medium s₂ = 0.839, high s₃ = 5.087, with a persistent Markov transition matrix following Domeij and Heathcote 2004) and save in internationally traded capital and government bonds, subject to borrowing constraints calibrated to match wealth Gini coefficients. The fiscal rule follows Bohn (1998) with the residence-based tax revenue responding to the debt-to-GDP ratio to ensure stationarity, and the top marginal tax rate τ₁ adjusts endogenously when corporate tax revenues change (consistent with Mertens and Montiel Olea 2018’s evidence on tax instrument choice). The SOE size is 10 percent of the U.S., enabling the paper to capture the asymmetric spillover mechanism by which U.S. corporate tax policy creates large distributional consequences abroad without generating offsetting fiscal adjustments in the SOE.
Q2. What are the distributional effects of the permanent TCJA in the U.S. and SOE?
Under a permanent reduction from 35 to 21 percent in the U.S. corporate tax rate, the average U.S. welfare gain is +0.146 percent of lifetime consumption, but this masks a strongly regressive distribution: households in the bottom 5 percent of the U.S. wealth distribution experience welfare losses of −0.045 to −0.101 percent, while those in the top 1 percent gain +0.920 percent, with gains monotonically increasing through the wealth distribution above the 5th percentile; in the SOE, the average welfare effect is −0.392 percent, and the losses are far larger and more broadly distributed, with approximately the bottom 80 percent (up to the 75th–95th percentile boundary) experiencing losses ranging from −0.582 to −1.282 percent while the top 1 percent gains +2.566 percent (Table 3). The mechanism for the U.S. involves capital inflows that raise wages (benefiting labor-income-reliant poor households at least partially) offset by increased tax burden from debt accumulation; in the SOE, capital outflows depress wages more severely, and wealth-rich households in the SOE gain even more than their U.S. counterparts because SOE households face no increase in their domestic tax burden to finance the U.S. corporate tax cut, making the SOE spillover a “free lunch” for SOE capital owners.
Q3. Why does the permanence of the tax cut matter for lower-wealth U.S. households?
When the TCJA is anticipated to be partially reversed — from 21 percent back to 28 percent after 7 years — households in approximately the bottom 75 percent of the U.S. wealth distribution experience welfare losses averaging from −0.091 to −0.259 percent; under a permanent cut only approximately the bottom 5 percent suffer losses, so the reversal shifts the crossover point from the 5th to the 75th percentile of the wealth distribution (Table 4, Panel A). The mechanism is that under a temporary tax cut the capital inflow is short-lived and so the wage increase is limited in duration, while the increase in U.S. government debt is persistent — because the government finances the cut through debt issuance and the debt level remains elevated even after the reversal from 21 to 28 percent, the resulting higher tax burden on labor income persists and dominates the temporary wage benefit for wealth-poor households who primarily earn labor income. This result has a direct policy implication: the distributional case for extending or making permanent the TCJA’s corporate rate reduction is much stronger than for a time-limited cut, because the wage-raising channel — the main argument for the cut’s benefits to workers — operates only persistently.
Q4. What happens when the small open economy reciprocates with its own corporate tax cut?
When the SOE reduces its corporate tax rate to match the U.S. at 21 percent (from 38 percent) simultaneously with the TCJA, all wealth groups in the SOE experience welfare gains (Table 5, Panel B shows average gains of +0.524 to +1.190 percent across wealth groups), with the distributional effect being progressive within the SOE: the incremental gain from reciprocation compared to not reciprocating is +1.807 percent for the bottom 1 percent of the SOE wealth distribution and −1.376 percent for the top 1 percent (Table 5, Panel C). The reason the SOE reciprocation is progressive is that the capital inflow triggered by the SOE’s cut raises wages across the SOE (benefiting labor-income-reliant poor households), while the financing cost of the cut — through debt accumulation and the eventual increase in top marginal tax rates — falls disproportionately on wealthy households. The paper notes this result depends on the SOE’s small size: because the SOE is only 10 percent of the U.S., its corporate tax cut creates a better investment opportunity for all global capital owners but the financing cost falls entirely on SOE residents, creating a distributional asymmetry between who benefits (all capital owners globally) and who pays (SOE income-rich households domestically).
Q5. How does the model fit the pre-TCJA data and what are the calibration targets?
The model closely matches its calibration targets: capital-to-output ratios of 2.50–2.52 (target 2.50), debt-to-GDP ratios of 0.827–0.882 (targets from Jordà-Schularick-Taylor 2017), and wealth Gini coefficients of 0.82 for the U.S. (target 0.80, from Budría-Rodríguez et al. 2002) and 0.71 for the SOE (target 0.70, from Brzozowski et al. 2010); and generates an untargeted prediction that the U.S. is a net borrower and Canada a net lender, consistent with data (Table 2, Panel B). The discount factors are calibrated to β^US = 0.968 and β^SOE = 0.969 to match the capital-output ratio, and the borrowing constraints are set at ψ = −1.65 for the U.S. and ψ = −0.88 for the SOE/ROW to match their respective wealth Gini coefficients. The model abstracts from terms-of-trade effects (consistent with Hanson et al. 2021’s evidence that US-Canada terms of trade are unaffected by US corporate tax changes) and aggregate uncertainty beyond corporate tax changes, and the SOE is set at 10 percent of the U.S. economy by population size.
Q6. How do the results change under alternative fiscal financing assumptions?
The key qualitative results — regressivity of the TCJA in the U.S. and its greater regressivity in the SOE — are robust across alternative fiscal financing assumptions: when the corporate tax cut is financed by immediately increasing the residence-based tax (χ = 1) rather than by debt (χ = 0 in the baseline), the losses at the bottom of the U.S. distribution become larger (approximately the bottom 70 percent lose rather than the bottom 5 percent), and when progressivity of the income tax (τ₃) rather than the top marginal rate (τ₁) adjusts, the additional tax burden falls more on wealth-poor households, making the cut even more regressive. The SOE reciprocation result is also robust: Appendix C.3 shows that financing the SOE corporate tax cut through increases in the residence-based tax (χ^SOE = 1) reduces the welfare gains for all SOE households but preserves the progressive distributional pattern within the SOE, while appendices C.1–C.2 show that the results are linear in the size of the SOE’s tax cut (at 30 and 18 percent, the distributional pattern is similar in direction).
Key Concepts
open-economy Aiyagari model : the paper’s framework — an extension of the Aiyagari (1994) incomplete-markets model with heterogeneous households and idiosyncratic uninsurable labor shocks to an international setting with free capital flows — used to capture how corporate tax changes distribute welfare across the wealth distribution in multiple countries simultaneously.
consumption equivalent variation : the proportional change in lifetime consumption required to make a household in the counterfactual no-TCJA economy as well off as in the economy with the TCJA; the welfare metric used in Tables 3–5, measured in percent of lifetime consumption, conditional on wealth and productivity state at the time of implementation.
TCJA persistence channel : the mechanism by which the distributional effect of the corporate tax cut for lower-wealth U.S. households depends on whether the cut is permanent: a permanent cut sustains capital inflows and wage gains long enough to dominate the increased tax burden, while a temporary cut leaves only a persistent debt overhang with limited wage benefits, turning even the bottom 75 percent of U.S. households into net losers.
SOE reciprocation progressivity : the finding that a small open economy that matches the U.S. corporate tax reduction achieves a progressive domestic distributional outcome because the wage increase from capital inflows benefits all households but the financing cost (through higher top marginal tax rates) falls mainly on the wealthy; this mechanism is size-dependent and reverses the regressivity that the U.S. cut generates domestically.
Summary of a forthcoming paper, AI-assisted. Draft pending human review. See the linked original for the authoritative claims and full conditions.