Public Finance, 2nd Edition

set of assumptions to prefer is unclear, especially since the CGE models are

highly simplistic representations of actual economies despite their mathemat-

ical complexity.

DYNAMIC TAX INCIDENCE

The early models of tax incidence were static, one-period models. Dynamic

models were sure to follow, however, because the dynamic analysis of tax

incidence has three huge advantages over static analysis.

First, and foremost, a dynamic model can track the evolution of the

capital stock in response to tax policies. Changes in the capital stock through

time aVect the marginal products of capital, labor, and all other factors of

production, which determine the real returns to the factors in a competitive

environment. These capital-induced changes in the returns to factors over

time tend to swamp any direct short-run eVects that tax policies might have

on factor returns.

Second, a dynamic model can consider intergenerational tax and expend-

iture incidenceÐthat is, the relative eVects of government policies on people

of diVerent ages, such as the young who are still working and the elderly who

are retired. Dynamic models have shown that these intergenerational eVects

can be very large and also very important to the evolution of the economy.

The third advantage, related to the second, is that a dynamic model can

analyze the incidence of the asset revaluations that immediately follow

changes in government policies. The asset revaluations occur because capital

is costly to adjust, so that capital assets of diVerent vintages are not perfect

substitutes in production. In fact, the short-run supply elasticities of many

kinds of capital are quite low. Therefore, as changes in tax policy change the

demands for diVerent kinds of capital, fairly large changes in capital prices

may be required in the short run to maintain equilibrium in the capital

markets. An example is an investment tax credit, which favors new capital

over existing (``old'') capital and thereby lowers the relative price of new

versus old capital. These asset revaluations matter in a dynamic context

because people of diVerent ages tend to hold diVerent proportions of old

and new capital. For example, the retired elderly have a much higher propor-

tion of claims to old capital in their portfolios than do the working young.

Dynamic tax analysis has suggested that the most important incidence eVect

of tax policy in the short run may well be the intergenerational transfers of

wealth through asset revaluations following the change in taxes. (We will

return to this point below.)

The two growth models most commonly used in dynamic incidence

analysis are the Ramsey model with an inWnitely lived representative con-

sumer and the overlapping generations (OLG) model with two or more

cohorts of Wnitely lived consumers. The Ramsey model appeared Wrst, but

606 DYNAMIC TAX INCIDENCE