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Taxation and inflation: a new explanation for current account imbalances

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  • Tamim Bayoumi
  • Joseph Gagnon

Abstract

In a world of mobile capital, the current system of nominal interest taxation implies that the cost of capital and the return to saving in each country are strongly and negatively correlated with the rate of inflation. It follows that a country's net foreign asset position (and its current account balance) ought to be negatively correlated with its inflation rate. The magnitude of these effects is shown to be large, both theoretically and empirically. For OECD countries, cross-sectional regressions confirm that inflation rates are good predictors of current accounts, even after controlling for business cycles and government budget deficits. These results imply that existing current account imbalances largely reflect tax distortions rather than an optimal allocation of world savings.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 420.

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Date of creation: 1992
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Handle: RePEc:fip:fedgif:420

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Related research

Keywords: International finance ; Balance of payments;

References

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  1. Hartman, David G, 1979. "Taxation and the Effects of Inflation on the Real Capital Stock in an Open Economy," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 20(2), pages 417-25, June.
  2. Sinn, Hans-Werner, 1991. "The non-neutrality of inflation for international capital movements," Munich Reprints in Economics 19843, University of Munich, Department of Economics.
  3. Howard, David H. & Johnson, Karen H., 1982. "Interest rates, inflation, and taxes : The foreign connection," Economics Letters, Elsevier, vol. 9(2), pages 181-184.
  4. Auerbach, Alan J, 1983. "Taxation, Corporate Financial Policy and the Cost of Capital," Journal of Economic Literature, American Economic Association, vol. 21(3), pages 905-40, September.
  5. Tanzi, Vito, 1980. "Inflationary Expectations, Economic Activity, Taxes, and Interest Rates," American Economic Review, American Economic Association, vol. 70(1), pages 12-21, March.
  6. Garry J. Schinasi, 1986. "Taxation of capital gains on foreign exchange transactions and the non- neutrality of changes in anticipated inflation," International Finance Discussion Papers 280, Board of Governors of the Federal Reserve System (U.S.).
  7. David H. Howard & Karen H. Johnson, 1983. "Purchasing power parity and real after tax interest rate arbitrage," International Finance Discussion Papers 222, Board of Governors of the Federal Reserve System (U.S.).
  8. Martin Feldstein, 1983. "Inflation, Income Taxes, and the Rate of Interest: A Theoretical Analysis," NBER Chapters, in: Inflation, Tax Rules, and Capital Formation, pages 28-43 National Bureau of Economic Research, Inc.
  9. Joe Peek & James A. Wilcox, 1984. "The Degree of Fiscal Illusion in Interest Rates: Some Direct Estimates," NBER Working Papers 1358, National Bureau of Economic Research, Inc.
  10. Tobin, James, 1969. "A General Equilibrium Approach to Monetary Theory," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 1(1), pages 15-29, February.
  11. Melvin, Michael, 1982. "Expected Inflation, Taxation, and Interest Rates: The Delusion of Fiscal Illusion," American Economic Review, American Economic Association, vol. 72(4), pages 841-45, September.
  12. Carlson, John A, 1979. "Expected Inflation and Interest Rates," Economic Inquiry, Western Economic Association International, vol. 17(4), pages 597-608, October.
  13. Hans-Werner Sinn, 1991. "Taxation and the Cost of Capital: The "Old" View, the "New" View and Another View," NBER Working Papers 3501, National Bureau of Economic Research, Inc.
  14. BenZion, Uri & Weinblatt, J., 1984. "Purchasing power, interest rate parities and the modified Fisher effect in presence of tax agreements," Journal of International Money and Finance, Elsevier, vol. 3(1), pages 67-73, April.
  15. David W.R. Gruen, 1991. "The Effect of Steady Inflation on Interest Rates and the Real Exchange Rate in a World with Free Capital Flows," RBA Research Discussion Papers rdp9101, Reserve Bank of Australia.
  16. Hansson, Ingemar & Stuart, Charles, 1986. "The Fisher Hypothesis and International Capital Markets," Journal of Political Economy, University of Chicago Press, vol. 94(6), pages 1330-37, December.
  17. Hodder, James E & Senbet, Lemma W, 1990. " International Capital Structure Equilibrium," Journal of Finance, American Finance Association, vol. 45(5), pages 1495-1516, December.
  18. Darby, Michael R, 1975. "The Financial and Tax Effects of Monetary Policy on Interest Rates," Economic Inquiry, Western Economic Association International, vol. 13(2), pages 266-76, June.
  19. McClure, J. Harold, 1990. "Forward rate biases and inconsistencies with tax-modified fisher conditions," Economics Letters, Elsevier, vol. 32(1), pages 49-51, January.
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