INFLATION INDUCED TAX DISTORTIONS

Almost all taxes distort incentives, cause people to alter their behavior, and lead to a less efficient allocation of the economy’s resources. Many taxes, however, become even more problematic in the presence of inflation. The reason is that lawmakers often fail to take inflation into account when writing the tax laws. Economists who have studied .the tax code conclude that inflation tends to raise the tax burden on income earned from savings.

One example of how inflation discourages saying is the tax treatment of capital gains-the profits made by selling an asset for more than its purchase price. Suppose that in 1980 you used some of your savings to buy stock in Microsoft Corporation for $10 and that in 2005 you sold the stock for $50.

Another example is the tax treatment of interest income. The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation. To see the effects of this policy, consider the numerical example in Table 1. The table compares two economies, both of which tax interest income at a rate of 25 percent. In Economy A. inflation is zero, and the nominal and real interest races are both 4 percent. In this case, the 25 percent tax on interest income reduces the real interest rate from 4 percent to 3 percent. In Economy B, the real interest rate is .again 4 percent, but the inflation rate is 8 percent. As a result of the Fisher effect, the nominal interest rate is 12 percent. Because the income tax treats this entire 12 percent interest as income, the government takes 25 percent of it, leaving an after-tax nominal interest rate of only 9 percent and an after real interest rate of only 1 percent. In this case, the 25 percent tax on interest income reduces the real interest rate from 4 percent to 1 percent. Because the after-tax real interest rate provides the incentive to save, saving is much less attractive in the economy with inflation (Economy B) than in the economy with stable prices (Economy A).

TABLE 1 How Inflation Raises the Tax Burden on Saving

The taxes on nominal capital gains and on nominal interest income are two examples of how the tax code interacts with inflation. There are many others. Because of these inflation-induced tax changes, higher inflation tends to discourage people from saving. Recall that the econcrny’s saving provides the resources for investment, which in turn is a key ingredient to long-run economic growth.

Thus, when inflation raises the tax burden on saving, it tends to depress the economy’s long-run growth rate. There is,however, no consensus among economists about the size of this effect.  One solution to this problem, other than eliminating inflation. is to index the tax system. That is, the tax laws could be rewritten to take account of the effects of inflation. In the case of capital gains, for example, the tax code could adjust the purchase price using a price index and assess the tax only on the real gain.

In an ideal world, the tax laws would be written so that inflation would not alter anyone’s real tax liability. In the world in which we live, however, tax laws are far from perfect. More complete indexation would probably be desirable, but it would further complicate a tax code that many people already consider too complex.