Tax distortions from inflation: What are they? How to deal with them?*

¹ Key contributions include Diamond (1975), King (1977, chapter 8), Aaron 1976).

* The views expressed in this paper are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. 

² The same can also hold for the spending side if real public spending is not neutral with respect to inflation (for example, if spending items such as government wages or public pensions do not rise one for one with prices).

³ Keen (1998) provides a broader discussion of specific versus ad valorem excises. Even absent externalities, there can be interesting tradeoffs, at least when competition is imperfect, or goods vary in quality. For identical goods, under perfect competition, there is no difference in specific or ad valorem taxes. Under a monopoly, however, ad valorem taxes can be shown to lead to both higher consumer welfare and profits. Results are ambiguous under oligopolistic competition. Considering goods of variable quality, specific taxes create stronger incentives to improve goods’ quality.

⁴ We have not found current examples of foreign-currency excises. Foreign-currency tariffs are also exceedingly rare, but there are some examples (e.g., East African Community).

⁵ Some countries (e.g., United States, Austria) link the rate to a flexible benchmark, such as the central bank’s policy rate, plus a fixed surcharge, which provides some protection against inflation, as interest rates will generally be higher in inflationary times. Other countries adjust such rates rarely (e.g., Germany requires revisions only once every three years and only since 2021), making it more likely that the rate does not reflect changes in the inflationary environment.

⁶ We found flat rate systems without general personal allowances, credits, or threshold in only 7 jurisdictions: Armenia, Bulgaria, Georgia, Hungary, Montenegro, Ukraine, and Uzbekistan.

⁷ This may not hold anymore, as the UK system has more brackets now than at the time of the study, including because of a provision to phase out the personal allowance for incomes above around £100,000.

⁸ In practice this assumption may not hold, and even in general equilibrium models it often does not hold in the presence of taxation (see Feldstein, 1976). Nevertheless, this is a useful starting point, if one wants to show that even in an otherwise fully adjusting economy, the tax system creates distortions.

⁹ Another aspect is that unexpected inflation will have potentially very large effects on capital gains. Fixed income assets and liabilities would immediately lose value. Related gains would typically remain untaxed unless realized.

¹⁰ See pwc Capital Gains Tax Rates.

¹¹ Auerbach (1991) suggested a capital gains tax with no such effect, where taxation is based on the number of years an asset is held and a statutory rate of return, not on the true capital gain. Such a tax has not been tried in practice.

¹² Note that the NPV in the absence of tax is completely independent of the inflation rate, because inflation cancels out of the fraction. This is expected, given the argument that expected inflation should not affect real decisions such as investment.

¹³ A review of tax laws revealed that Botswana, Chile, Colombia, Cyprus, the Dominican Republic, Israel, Mexico, Luxembourg, and Portugal provided relief for inflationary capital gains, while the United Kingdom and Ireland did so in the past.

¹⁴ Some countries have lower rates for small businesses or low profits, and the thresholds for those should of course be adjusted as discussed in the previous section.

¹⁵ This also holds for depreciation methods other than declining balance, as long as the total nominal amount to be deducted equals the cost of the asset. If, for example, straight line depreciation is used, the formula for the present value changes to: 

¹⁶ The choice of a rate of 5 percent is supported by Reis (2021) who reports that the 10-year ahead expectation of US stock returns was around 5 percent in 2019 (and higher before). Real returns will of course vary across sectors and countries, partly depending on underlying risk.

¹⁷ Differentiating (2) with respect to ϕ we obtain: The critical values are given by setting this equation equal to zero and solving for the depreciation rate, which gives 

¹⁸ Data are taken from the OECD’s effective tax rate database, which provides information on A for a hypothetical low interest (5 percent) and low inflation (2 percent) environment. The implied declining balance tax rates are calculated from A using 

¹⁹ This follows from rewriting the first-order condition as  where β is the capital share in total costs of production and C summarizes irrelevant constants. Combining this expression with the assumption that total real demand remains unchanged d = β ln(K) + (1 – β) ln(L) and differentiating K with respect to inflation gives equation (13).

²⁰ That is taxes on dividends, capital gains, and interest. In terms of the Devereux-Griffith model this implies that the discount rate r is equal to the nominal interest rate i, and the factor that values dividends g equals 1. This assumption can be justified because the investor might be a tax-exempt pension fund, tax-favoured foreign investor, or simply because we wish to focus on the corporate side of taxation.

²¹ The calculation is closely related to the framework discussed here. One difference is that in the Devereux-Griffith model, first-year depreciation is instantaneous, so that firms only need to fund 1 – τϕ of an investment. The resulting tax rates are thus defined as  and Another point is that in the Devereux-Griffith model, investment is a one period perturbation of the capital stock with subsequent sale, while in the Klemm version it is a permanent investment that is allowed to depreciate; however, under a range of reasonable assumptions all approaches lead to the same first order conditions. A minor point is that Devereux and Griffith (2003) define A as the NPV of the tax saving from depreciation allowances, but for consistency with our definition above, our A is simply the NPV of depreciation allowances, and hence we multiply it by the tax rate τ to obtain the tax saving.

²² The negative debt-finance EMTR with extremely high absolute value is caused by dividing by a denominator (the cost of capital) that is very close to zero. The resulting figure is thus somewhat unintuitive, which is, however, a common phenomenon with this measure. The negative rate means that a marginal investment turns out to have a tax loss (because the interest and depreciation deductions are greater than the profit). Such a tax loss can be used to reduce taxes from other activities or in the future. In the absence of other profits, the tax rate is bound by zero, because revenue authorities do not pay out tax refunds on tax losses.

²³ The ACE does not achieve full symmetry, because the interest rate on debt will be firm specific and could be different (and often higher) than the notional rate on equity. A solution that achieves full symmetry is the allowance for corporate capital, which denies the standard interest deduction, and instead applies the same notional interest rate to equity and debt (Kleinbard, 2005).

²⁴ One could argue for adjusting thresholds in line with average wage increases, thereby keeping the tax rate the same for the average earner and in relation to the average earner. However, this would mean a reduction in real taxes as real incomes rise – certainly a policy option, but one that goes beyond inflation neutrality.