The Tax Effect, and the Recent Behaviour of the After-tax Real Rate: Is It Too High?

Recent years have witnessed very high and volatile interest rates. This has stirred a debate among analysts as to whether observed interest rates are high by historical standards. Some analysts, focusing on the before-tax real rate, argue that if the observed nominal interest rate is corrected for the effect of expected (or actual) inflation, the ex ante (or ex post) real rate has been very high in recent years. Other analysts, however, note that it is also important to consider the effect of taxes on the behaviour of the nominal interest rate. Since real spending decisions in the economy are based on the after-tax real rate, it is more appropriate to focus on the behaviour of this latter real rate. Proponents of this view argue that the after-tax real interest rate observed since 1980 does not appear to be too high. At the center of the debate is an empirical issue of whether tax effects are fully recognized by investors. If the nominal interest rate does fully adjust to reflect the presence of an effective marginal tax rate on interest income, then it is more appropriate to look at the behaviour of the after-tax real interest rate. The theoretical proposition that nominal interest rates adjust to reflect the presence of taxes on interest income is intuitively appealing. As put by Michael R. Darby (1975), Martin Feldstein ( 1976) and Vito Tanzi (1976), the proposition states that, ceteris paribus, nominal interest rates will rise during an inflation by an amount which exceeds expected inflation enough to compensate lenders both for their expected loss of capital and for the taxation of interest income. Though this proposition is plausible,