Inflation Tax v. Tax-Modified Fisher Effect

Phil Kerpen writes:

The capital-gains tax can be thought of as two different taxes: a tax on real increases in asset values and a tax on nominal, inflationary increases in asset values. That inflation tax, levied on the phantom gains in asset values due to inflation, is one of the most unfair and economically destructive taxes the federal government levies. With inflation having nudged upward of late, there is a renewed urgency to repeal the tax.

This type of incomplete analysis is common. Might I suggest Mr. Kerpen ponder the 1975 Economic Inquiry paper by Michael Darby entitled The Financial and Tax effects of Monetary Policy on Interest Rates where he introduced the effect of taxes on the size of the Fisher effect – suggesting that that nominal interest rates should increase by more than the increase in expected inflation to compensate borrowers for a lower after-tax return since interest income is usually taxed as ordinary income.

As an example, suppose I borrow $100 from you with the intent of paying you a 4% real return before taxes. Let’s also assume we both have the same tax rate (t) equal to 20%. If inflation is zero, I pay you $4 per year and you pay the government $0.80 per year and thereby get a real return after taxes equal to $3.20. We’ll also assume my interest expense is deductible so my real after-tax cost of borrowing is $3.20.

Now, let’s change the example by assuming a 4% inflation rate and let nominal interest rate rise by the increase in inflation times 1/(1 – t), which implies a 9% nominal interest rate. I now pay you $9 in nominal interest income and your tax bill goes up to $1.80. With $7.20 in after-tax nominal income and a 4% erosion in your principle, your real after-tax income is still $3.20. I get a $1.80 deduction, which means my after-tax nominal expense is $7.20 and my after-tax real interest expense is still $3.20.

Of course, this simple inflation is neutral story may not fit the real world where tax rates differ and some interest expenses are not deductible. But also note that certain types of capital income get preferential tax treatment. The capital-gains tax currently is low and one can play all sorts of games to defer the payment of taxes on accrued capital gains. Kerpen’s calculation of the impact of the “inflation tax” strikes me as wildly biased.

Kerpen endorses what may be a sensible idea:

Fortunately, new legislation sponsored by Reps. Mike Pence (R., Ind.) and Eric Cantor (R., Va.), H.R. 6057, would repeal the inflation tax. The bill would index the tax basis for an asset to inflation, taxing only real gains, not inflation. With the burgeoning investor class making up more than half of voters, this basic fairness issue is sound politics as well as policy. Pence-Cantor is a bill that should become a law.

David Altig also likes this proposal. David also considers alternative means for resolving any potential inflation non-neutralities including monetary restraint:

That’s a fine point, and the Feldstein article does duly note that the appropriate way to analyze a tax rate reduction is to insist on revenue neutrality (at least in a present value sense). You may think that capital income taxes are just fine where they are. I won’t object (at least not here). But even so, is it really a good idea to use monetary policy to engineer tax policy? Isn’t the right approach to insulate statutory tax rates from the potential influence of inflation, and leave fiscal policy decisions to Congress?

Actually, I would prefer raising the tax rate on real capital gains so as to tax all forms of real income at the same rate. Otherwise, I concur with David.