Wedges, and Capital Formation

This paper focuses on how inflation interacts with taxes and interest rates to affect capital formation.1 It uses a simple credit-market framework to explain how inflation magnifies the distorting effects of taxation when the tax treatment of interest income and expense is not fully indexed to inflation.2 The distortion involves a real tax wedge consisting of the difference between the real interest rate fully taxed investors must pay when they borrow to invest and the real after-tax interest rate that savers earn. This asymmetry in the way that fully taxed investors and savers are affected by income taxes leads to an increase in inflation increasing the real tax wedge in credit markets. Either eliminating inflation or indexing the tax treatment of interest income and deductible interest expense to inflation would reduce this real tax wedge and consequently increase private saving and business capital formation. Eliminating inflation or its induced tax effects on interest rates would decrease nominal rates for two reasons: Absent inflation, interest rates would not contain an inflation premium; hence, nominal interest rates would be lower. Furthermore, if there were no inflation, or if the tax treatment of interest income and deductible interest expense were indexed, nominal interest rates would fall because saving as a function of the interest rate would tend to increase. With the higher after-tax returns that would result from removing the tax on the inflation premium in nominal interest rates, savers would save more. An increased supply of saving would in turn lower before-tax real interest rates and thereby stimulate the business investment. Not everyone would benefit from eliminating the inflation-induced tax distortion in credit markets, however. Although eliminating inflation or indexing the taxes on interest income and expense would raise private saving and nonresidential investment, governments and homeowners would face higher real borrowing costs and real interest outlays. This would happen because aftertax real interest rates are not only the effective real rates that savers earn; they are also the effective real rates at which the government and homeowners borrow. Fully taxed borrowers borrow at a before-tax real interest rate, but the government borrows at an after-tax real rate because its interest payments to the public add to the income on which it collects taxes. Homeowners also borrow at an after-tax real rate. They are not taxed on the real benefits from living in their homes, which are effectively income, and in the United States, unlike some other countries, their related interest costs can generally be deducted from taxable income. In summary, either eliminating inflation or indexing the tax treatment of interest income and expense to inflation would stimulate private saving and, in turn, business investment, but it would decrease tax receipts on interest income and the tax deductions that subsidize home ownership.