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Inflation, Capital Taxation, and Monetary Policy

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  • Martin Feldstein

Abstract

This paper discusses the effects of the interaction between inflation and the taxation of capital income. The principal conclusions are: (1) Inflation substantially increases the total effective tax rate on the income from capital used in the nonfinancial corporate sector. The total effective tax rate has risen from less than 60 percent in the mid-1960's to more than 70 percent in the late 1970's. (2) The higher effective tax rate reduces the real net rate of return to those who provide investment capital. In the late 19701s, the real net rate of return averaged less than three percent. (3) The interact ion between inflation and existing tax rules contributed to the fall in the ratio of share prices to real pretax earnings, or, equivalently, to the rise in the real cost to the firm of equity capital. (4) By reducing the real net return to investors and by widening the gap between the firms' cost of funds and the maximum return that they can afford to pay, the interaction between tax rates and inflation has depressed the rate of net investment in business fixed capital. (5) The failure to consider correctly the effects of the fiscal structure has caused observers to underestimate the expansionary character of monetary policy in the past two decades. (6) The goal of increasing investment while maintaining price stability can be achieved with tight money, a high real interest rate, and tax incentives for investment. A high real net-of-tax interest rate could reduce residential investment and other forms of consumer spending while the tax incentives offset the monetary effect for investment in business capital.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 0680.

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Date of creation: May 1981
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Publication status: published as Feldstein, Martin. "Inflation, Capital Taxation, and Monetary Policy." Inflation: Causes and Effects, edited by Robert E. Hall, pp. 153-167. Chicago: University of Chicago Press, (1982).
Handle: RePEc:nbr:nberwo:0680

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Cited by:
  1. Edge, Rochelle M. & Rudd, Jeremy B., 2007. "Taxation and the Taylor principle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 54(8), pages 2554-2567, November.
  2. David Altig & Charles T. Carlstrom, 1991. "Inflation, personal taxes, and real output: a dynamic analysis," Working Paper 9102, Federal Reserve Bank of Cleveland.
  3. Tobias Basse & Sebastian Reddemann, 2011. "Inflation and the dividend policy of US firms," Managerial Finance, Emerald Group Publishing, Emerald Group Publishing, vol. 37(1), pages 34-46, January.
  4. Heer, Burkhard & Sussmuth, Bernd, 2007. "Effects of inflation on wealth distribution: Do stock market participation fees and capital income taxation matter?," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 31(1), pages 277-303, January.
  5. Rochelle M. Edge & Jeremy B. Rudd, 2002. "Taxation and the Taylor principle," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2002-51, Board of Governors of the Federal Reserve System (U.S.).
  6. Amano, Robert A., 1998. "On the Optimal Seigniorage Hypothesis," Journal of Macroeconomics, Elsevier, Elsevier, vol. 20(2), pages 295-308, April.
  7. Panagiotis Chronis & Aspassia Strantzalou, 2008. "Monetary and Fiscal Policy Interaction: What is the Role of the Transaction Cost of the Tax System in Stabilisation Policies?," Working Papers, Bank of Greece 71, Bank of Greece.
  8. J. Bradford De Long, . "America's Peacetime Inflation: The 1970s," J. Bradford De Long's Working Papers _104, University of California at Berkeley, Economics Department.
  9. J. Bradford De Long, 1996. "America's Only Peacetime Inflation: The 1970s," NBER Historical Working Papers, National Bureau of Economic Research, Inc 0084, National Bureau of Economic Research, Inc.

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