Chapter

5 Inflation and the Incidence of Income Taxes on Interest Income in the United States, 1972–81

Editor(s):
Vito Tanzi
Published Date:
June 1984
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Inflation affects individuals and income classes in their roles as consumers, taxpayers, wage earners, savers, asset holders, lenders, borrowers, etc. Because of this multiplicity of influences, it is difficult, and perhaps impossible, to assess the total economic impact of inflation. For this reason, empirical studies have been limited to analyzing the impact of inflation on individuals or income classes specifically as consumers, savers, or wage earners. This partial approach, however, does not answer the question of whether the total impact of inflation is beneficial to individuals in particular income classes, but it provides information that can be useful for policy purposes. This paper, therefore, follows this partial approach and analyzes the impact of inflation on individuals in connection with the tax treatment of interest paid or received in the United States.

I. THEORETICAL BACKGROUND

When a country enters an inflationary period, the nominal rate of interest charged on loans must be increased if the lender’s real interest income and the borrower’s real cost of funds are to remain unchanged. More specifically, in a world without income taxes, an increase in the market interest rate equal to the rate of inflation would be sufficient to keep the real rate of return on loans (and their real cost to borrowers) at the preinflation level. However, income taxes complicate these simple conclusions. When interest income is subject to income taxes and interest payments are deductible expenses, the increase in the nominal rate has to be somewhat greater. During an inflationary period,1 the nominal or market rate of interest would have to be r* where

In this equation r* can be called the required interest rate; r is the interest rate that would prevail in the absence of inflation; a is the rate of inflation over the relevant period (assumed to be one year); and t is the rate at which the interest income of the individual is taxed. If this required rate of interest is established, the lender who receives it will be as well off or as badly off, depending on who he is, as in the noninflationary situation, provided that he does not suffer from money illusion.2 Equally, the borrower who pays the required rate r* will also be no better off nor worse off.

If income taxes with proportional rates are levied, the t in equation (1) will be fixed, so that the required rate r* will be the same for every taxpayer regardless of his income. Consequently, if such a rate is established, the real positions of lenders and borrowers will not change except in relation to loans that were contracted in the preinflationary era and that covered several years. However, in most countries income taxes are levied with progressive, rather than proportional, rates. This means that taxpayers at different income levels are taxed at different rates. It follows that equation (1) has to be rewritten as

where the i refers to a particular individual or income class. As ti depends on the income level, the required interest rate is no longer the same for all individuals. Consequently, no market rate could ever adjust to leave all lenders and borrowers in the same situation that existed before inflation.

If the market rate of interest should adjust fully for the rate of inflation and for, say, an average tax rate, it would be too high for some taxpayers and too low for others, depending on the income tax rate to which they were subject. More specifically, the higher the income of individuals (the higher their marginal tax rate), the higher needs to be the rate of interest that they have to receive as lenders—or that they have to pay as borrowers—in order for them to remain in the preinflationary real situation.3 However, ignoring risk and other factors that may influence individual loans, the interest rates that become established in the market are uniform for all taxpayers, so that some taxpayers are bound to gain (or lose) more than others.

In this paper, an attempt is made to obtain some general empirical estimates for individual taxpayers of gains and losses by income classes associated with the recent inflation (and the taxation of interest income) in the United States. The analysis is conducted in relation to the income classes for individual taxpayers shown in various issues of Statistics of Income: Individual Income Tax Returns (hereinafter referred to as Statistics of Income), a publication of the U.S. Internal Revenue Service. Thus, enterprises are ignored. The data to be analyzed pertain to the 1972–81 period. These were years when the rate of inflation increased sharply; therefore, they are particularly suitable for the kind of analysis pursued in the paper. The United States is used as an important and convenient example; however, the theory and the procedure are as applicable to other countries as they are to the United States.

The period analyzed is divided into two subperiods, 1972–74 and 1977–81. The reason for this is simply that the analysis is concerned with the effects of accelerating inflation on the incidence of income taxes on interest income. Inflation accelerated sharply over the 1972–74 period, but the sharp recession that followed brought about equally sharp declines in prices. However, this respite from inflation was of a short duration. The 1977–81 period was again a period of high and accelerating inflation, at least until 1980.

II. DETERMINATION OF REQUIRED RATES FOR THE UNITED STATES, 1972–74 and 1977–81

The consumer price index rose by 3.3 percent in 1972, by 6.2 percent in 1973, and by 11.0 percent in 1974. If interest income had not been taxed, the percentage changes—which correspond to the a in the two equations above—would have produced a rate of interest that would have left the lenders with zero real interest income. In other words, if the rate of interest had been exactly equal to the rate of inflation, the interest received by a lender would have been just sufficient to compensate him for the inflation-induced losses in the real value of the financial assets that he had loaned. Similarly, the interest that a borrower would have had to pay would have just balanced (for him) the decline in the real value of his liability. However, interest income was taxed, and the tax rates therefore varied, ceteris paribus, with the taxpayer’s level of income. Furthermore, interest payments were deducted as costs from gross income in the determination of taxable income. Thus, the value of these deductions (in terms of the reduction in tax liability) was closely and directly related to the income of the taxpayer.

Table 1 shows the effective average tax rates for 1972, 1973, and 1974—that is, the ratio of tax liabilities to adjusted gross income4—for the 24 income classes reported in the Statistics of Income. These average tax rates ranged from very low figures for low incomes to about 50 percent for very high incomes. When these rates are combined with the rate of inflation for each year in the expression

Table 1.Ratios of Tax Payments to Adjusted Gross Income, 1972–741
Adjusted Gross Income197219731974
(In thousands of U.S. dollars)(In percent)
Under 11.81.84.5
1–23.54.13.3
2–32.62.62.5
3–44.95.15.1
4–56.46.66.7
5–67.57.57.8
6–78.38.48.6
7–88.99.29.3
8–99.49.810.0
9–109.610.010.3
10–1110.110.410.6
11–1210.310.510.7
12–1310.610.911.1
13–1411.011.211.4
14–1511.411.511.7
15–2012.512.612.7
20–2514.414.314.5
25–3016.016.015.9
30–5019.119.018.9
50–10026.826.426.5
100–20034.634.434.9
200–50040.840.641.5
500–1,00045.445.745.6
Above 1,00045.746.849.2
Source: U.S. Internal Revenue Service, Statistics of Income–1972: Individual Income Tax Returns (Washington, 1974).

These ratios are called effective average tax rates (ti = Ti/AGIi).

Source: U.S. Internal Revenue Service, Statistics of Income–1972: Individual Income Tax Returns (Washington, 1974).

These ratios are called effective average tax rates (ti = Ti/AGIi).

for particular income classes, it is seen what rate of interest each class should have received if the result would be zero real interest income. Anything above these rates, which are shown in Table 2, would have left lenders with positive real interest income and anything below them would have left lenders with negative real interest income. Mutatis mutandis, borrowers who, given their income level, paid the rates indicated in Table 2 would have been paying a zero real interest rate on the borrowed capital. If they had paid more, they would have incurred positive real costs of borrowing, while they would have received net subsidies if they had paid less.

Table 2.Interest Rates Required to Provide Lenders with Zero Real Interest Income, 1972–741
Adjusted Gross Income197219731974
(In thousands of U.S. dollars)(In percent)
Under 13.366.3111.52
1–24.426.4711.38
2–33.396.3711.28
3–43.476.5311.59
4–53.536.6411.79
5–63.576.7011.93
6–73.606.7712.04
7–83.626.8312.13
8–93.646.8312.22
9–103.656.8912.26
10–113.676.9212.30
11–123.686.9312.32
12–133.696.9612.37
13–143.716.9812.42
14–153.737.0112.46
15–203.777.0912.60
20–253.867.2312.87
25–303.937.3813.08
30–504.087.6513.56
50–1004.518.4214.97
100–2005.059.4516.90
200–5005.5710.4418.80
500–1,0006.0411.6120.22
Above 1,0006.0811.6521.65
Sources: Table 1 and (for the rates of inflation) U.S. Council of Economic Advisers, Economic Report of the President (Washington, 1976).

The percentages in the table are obtained from the expression α/1 – ti. The rate of inflation a was 3.3 percent in 1972, 6.2 percent in 1973, and 11.0 percent in 1974.

Sources: Table 1 and (for the rates of inflation) U.S. Council of Economic Advisers, Economic Report of the President (Washington, 1976).

The percentages in the table are obtained from the expression α/1 – ti. The rate of inflation a was 3.3 percent in 1972, 6.2 percent in 1973, and 11.0 percent in 1974.

The ti rates used in these calculations are the effective average tax rates—that is, the ratio of tax payments to adjusted gross income for each income class. An alternative would be to use the ratio of tax payments to taxable income;5 still another would be to use the statutory marginal tax rates at which the incomes of given classes are taxed. These two alternatives would have substantially increased the values of ti, thus leading to much higher α1ti ratios. These two alternatives could be defended on the assumption that interest income is a marginal income, so that it is taxed at the marginal rate to which an individual is subject; this is true because most exemptions and deductions apply to other income sources (wages, salaries, etc.). There is some validity to this argument, especially in inflationary situations when nominal interest income is likely to increase by a far greater percentage than wage and salary income;6 thus, the higher marginal income is likely to be taxed at higher-than-average rates. After deliberating over these alternatives, the author decided to select the more conservative one. Therefore, the effective average tax rates were used in this analysis.

Tables 3 and 4 provide the same information for 1977–81 as Tables 1 and 2 provide for 1972–74. It should be noted that the breakdown in adjusted gross income is slightly different in the two sets of tables, so that the two sets could not be combined into one table.

Table 3.Ratios of Tax Payments to Adjusted Gross Income, 1977–81
Adjusted Gross Income19771978197919801981
(In thousands of U.S. dollars)(In percent)
2–42.232.061.792.132.33
4–65.125.234.784.714.71
6–86.846.997.087.137.09
8–108.088.338.058.047.90
10–129.179.569.439.449.42
12–1410.4110.5410.2610.5110.60
14–1611.1111.4511.0911.2911.44
16–1811.8512.0911.8112.1812.13
18–2012.5112.7112.2712.6812.87
20–2513.6513.6413.1613.4713.78
25–3015.3415.3514.5314.7014.83
30–5018.5318.3817.4317.5517.63
50–10026.5326.0324.9024.5823.89
100–20035.1834.7133.6933.5832.27
200–50042.0141.5140.8940.2938.64
Above 50049.2347.4648.1146.5543.11
Source: U.S. Internal Revenue Service, Statistics of Income: Individual Income Tax Returns (Washington, several years).
Source: U.S. Internal Revenue Service, Statistics of Income: Individual Income Tax Returns (Washington, several years).
Table 4.Interest Rates Required to Provide Lenders with Zero Real Interest Income, 1977–811
Adjusted Gross Income19771978197919801981
(In thousands of U.S. dollars)(In percent)
2–46.657.8611.5113.7910.65
4–66.858.1311.8714.1710.91
6–86.988.2812.1614.5411.19
8–107.078.4012.2914.6811.29
10–127.168.5112.4814.9111.48
12–147.268.6112.5915.0911.63
14–167.318.7012.7115.2211.74
16–187.378.7612.8115.3711.84
18–207.438.8212.8815.4611.94
20–257.538.9213.0115.6012.06
25–307.689.1013.2215.8312.21
30–507.989.4313.6916.3712.63
50–1008.8510.4115.0517.9013.66
100–20010.0311.7917.0420.3315.35
200–50011.2113.1619.1222.6116.95
Above 50012.8014.6521.7825.2618.28
Source: Table 3 and (for the rate of inflation), U.S. Council of Economic Advisers, Economic Report of the President (Washington, 1982).

The percentages in the table are obtained from the expression α/1 – ti. The rate of inflation a was 6.5 percent in 1977, 7.7 percent in 1978, 11.3 percent in 1979, 13.5 percent in 1980, and 10.4 percent in 1981.

Source: Table 3 and (for the rate of inflation), U.S. Council of Economic Advisers, Economic Report of the President (Washington, 1982).

The percentages in the table are obtained from the expression α/1 – ti. The rate of inflation a was 6.5 percent in 1977, 7.7 percent in 1978, 11.3 percent in 1979, 13.5 percent in 1980, and 10.4 percent in 1981.

III. TAX INCIDENCE IN THE UNITED STATES

The 1972–74 period

In 1972, the α1ti ratio (calculated as described above) ranged from 3.4 percent for taxpayers with an adjusted gross income less than $1,000 to 6.1 percent for those with an adjusted gross income above $1 million. In 1973, the α1ti ratio ranged from 6.3 percent to 11.7 percent; in 1974, it ranged from 11.5 percent to 21.7 percent. It follows that, in order to have received a zero real income from a loan, a taxpayer in the lowest income class should have received a rate of interest of 3.4 percent in 1972, 6.3 percent in 1973, and 11.5 percent in 1974. A taxpayer in the highest income class should have received rates of 6.1 percent in 1972, 11.7 percent in 1973, and 21.7 percent in 1974. These are also the rates that would have left the borrowers with zero net interest costs.7

How do these estimated rates relate to actual rates? This is not an easy question to answer, as there is not just one rate but rather a whole spectrum of rates. Table 5 shows bond yields and interest rates on selected financial assets for 1972–81. In 1972, the rates shown ranged from 4 percent to over 7 percent; in 1973, they ranged from 5 percent to 8 percent; and in 1974, they ranged from 6 percent to about 10 percent. Relating these rates to those required for a zero real interest income (i.e., those in Table 2), it can be seen that, while in 1972 most taxpayers would have received positive interest incomes on new loans, in 1973 this became difficult for taxpayers with a high adjusted gross income, especially for those with an income of about $50,000, and in 1974 this became very difficult (and perhaps impossible) for practically everyone. In 1974, the rate of interest should have ranged from more than 11 percent for low-income groups to more than 21 percent for very-high-income groups (and for corporations), in order to leave them with a positive interest income. As, by 1974, interest rates were generally far below these levels, the income tax had obviously become a capital tax for all lenders, and particularly for those with a high income.8

Table 5.Interest Rates and Bond Yields, 1977–81(In percent per annum)
U.S. Government SecurityHigh-Grade

Municipal

Bonds

(Standard and

Poor’s)
Prime

Commercial

Paper of Four

to Six Months

Maturity
YearThree-month

treasury bills1
Three-year

issues2
Ten-year

bonds2
Corporate

Bond (Moody’s

Aaa)
19724.0715.855.637.215.274.69
19737.0416.926.307.445.188.15
19747.8867.816.998.576.099.87
19775.2656.697.428.025.565.61
19787.2218.298.418.735.907.99
197910.0419.729.449.636.3910.91
198011.50611.5511.4611.948.5112.29
198114.07714.4413.9114.1711.2314.76
Source: U.S. Council of Economic Advisers, Economic Report of the President (Washington, several years).

Rate on new issues within period; bank-discount basis.

Yields on the more actively traded issues adjusted to constant maturities by the U.S. Treasury.

Source: U.S. Council of Economic Advisers, Economic Report of the President (Washington, several years).

Rate on new issues within period; bank-discount basis.

Yields on the more actively traded issues adjusted to constant maturities by the U.S. Treasury.

The conclusions reached in the preceding paragraph relate to lenders, and the reverse is true for borrowers. Consequently, while in 1972 most of the borrowers paying the prevailing rates of interest had positive real costs of borrowing (as the interest rates that they paid exceeded the required rates shown in Table 2), by 1974 most borrowers were receiving (as borrowers) net capital subsidies.9

The 1977–81 period

Tables 4 and 5 provide the information needed for carrying out the same analysis as above for the 1977–81 period. Table 4 estimates the range of required rates for various income classes. In 1979 and 1980 those rates are shown to be particularly high. For example, taxpayers with an income above $100,000 needed to receive interest rates of over 20 percent to obtain a zero real rate. The comparison of these two tables shows clearly that the lenders that bought taxable financial instruments ended up with negative real rates and, if they were in high-income brackets, with sharply negative real rates. These high-income groups could reduce the “capital taxes” by buying tax-free bonds, but they could not escape these taxes completely. The situation dramatized by Tables 4 and 5 implies that the combination of inflation and high taxes on nominal income was to a large extent determining the allocation of savings in the market. In other words, it was causing an inevitable fragmentation of the financial market.

Taxpayers may be lenders, borrowers, or both. Within each income class, borrowers or lenders may predominate. Therefore, whether an income class gains or loses from the tax treatment of the lending and borrowing activities of its members in an inflationary situation depends on the net balance between borrowing and lending. As lenders, individuals receive interest payments from individual borrowers, banks and other financial intermediaries, corporations, and federal, state, and local governments, as well as from foreign sources. As borrowers, individuals pay interest to individual lenders, banks and other financial intermediaries, corporations, and, to a much lesser extent, to governments and foreign lenders. To the extent that these flows (i.e., interest paid or received by individuals) are reported and are taxable, they are reflected in data from the U.S. Internal Revenue Service, used in the calculation of Tables 6 and 7. Before considering these tables, a few comments should be made about the U.S. Internal Revenue Service’s interest statistics.

Table 6.Net Differences Between interest Received and Paid by Amount of Adjusted Gross Income, 1972–74
Adjusted Gross Income197219731974
(In thousands of U.S. dollars)(In millions of U.S. dollars)
Under 1147.3143.4192.8
1–2497.3476.9483.7
2–3836.5983.8918.1
3–41,102.11,210.61,399.0
4–5995.21,081.81,523.0
5–6911.5951.01,348.2
6–7675.9737.31,161.9
7–8285.1540.5732.9
8–9–36.9121.6440.7
9–10–357.0–56.1496.7
10–11–269.2–203.0–49.3
11–12–596.7–425.5–261.3
12–13–662.8–570.5–294.4
13–14–632.8–488.2–610.8
14–15–701.0–771.7–614.8
15–20–2,603.7–3,373.3–3,777.4
20–25–901.1–1,645.7–2,122.8
25–30–90.7–249.3–606.2
30–50525.1544.9597.1
50–100453.1543.91,106.9
100–200186.8258.0513.5
200–50068.894.5204.8
500–1,00013.532.651.2
Above 1,00010.924.032.3
Total interest received6,709.17,744.811,202.8
Total interest paid–6,851.9–7,783.3–8,337.0
Net balance–142.8–38.52,865.8
Source: Same as Table 1.
Source: Same as Table 1.
Table 7.Net Differences Between Interest Received and Paid by Amount of Adjusted Gross Income, 1977–81
Adjusted Gross Income19771978197919801981
(In thousands of U.S. dollars)(In millions of U.S. dollars)
Under 2129.0242.9204.9317.0692.5
2–4313.3291.9360.9564.3723.4
4–61,802.31,920.31,974.62.087.22,446.2
6–82,650.12,972.12,949.03,293.33,855.4
8–102,800.72,768.63,251.23,884.64,786.5
10–121,919.52,114.32,575.93,483.34,919.2
12–141,066.91,599.81,772.32,921.44,125.2
14–16433.4298.2542.92,064.33,176.4
16–18–507.4–415.8200.21,308.32,421.1
18–20–1,240.1–1,217.7–827.0259.01,928.6
20–25–3,758.2–5,049.3–4,569.4–2,113.51,043.2
25–30–2,451.8–4,203.0–5,240.0–4,184.4–2,683.5
30–50–2,232.4–5.087.6–8,503.6–9,660.7–6,374.3
50–100720.086.5372.31,785.83,323.8
100–200457.2375.5509.51,389.82,593.4
200–500234.0259.8455.0868.21,570.6
Above 500112.3131.7381.7647.31,021.1
Total interest

received
48,250.354,943.867,481.995,173.0131,905.5
Total interest paid–45,801.4–57,855.3–71,071.7–86,257.9–102,339.6
Net balance2,448.9–2,911.5–3,589.88,915.129,565.9
Source: Same as Table 3.
Source: Same as Table 3.

In Tables 6 and 7, interest received refers to the taxable portion of interest received on bonds, debentures, notes, mortgages, personal loans, bank deposits, and savings accounts.10 It is important to note that these figures exclude the interest on tax-exempt state and local government obligations, as this income does not have to be reported on U.S. tax returns.11 The figures also exclude interest received by individuals who do not file tax returns. Interest paid, on the other hand, includes interest paid on personal debts, mortgages, bank loans, and installment purchases of real or personal property. It does not, however, include interest paid or money borrowed to buy tax-exempt securities, single premium life insurance, and endowment contracts. Furthermore, interest relating to income from businesses, royalties, and rents is deducted directly from the specific income so that it is not reflected in the data.

Tables 6 and 7 lead to some interesting conclusions. First, consider total interest received and paid. The two tables indicate that, while in 1972 and 1973 these two totals were very close, they started diverging by considerable amounts in 1974. In that year total interest received exceeded total interest paid by almost $3 billion. In 1977 this was still true although the difference had been reduced to about $2.5 billion. In 1978 and 1979 interest paid came to exceed interest received by $3 billion to $3.6 billion. However, in 1980 and 1981 interest received came to exceed interest paid by very large amounts—$8.9 billion in 1980 and $29.6 billion in 1981.

Tables 6 and 7 also show, for each class and for each of the years under consideration, the net difference between the total interest income received by that class and the total interest deductions claimed by that class. This net difference indicates whether the class as a whole was a net lender or a net borrower. In 1972, all the classes with an adjusted gross income of less than $8,000 or more than $30,000 were net lenders, while those with an adjusted gross income greater than $8,000 but less than $30,000 were net borrowers. In 1973, the net borrowers were those with an adjusted gross income of more than $9,000 but less than $30,000; all others were net lenders. In 1974, the net borrowers were those with an adjusted gross income of more than $10,000 but less than $30,000; all others were net lenders. In the 1977–81 period, fewer and fewer income classes were net borrowers. By 1981 only the income classes between $25,000 and $50,000 were net borrowers.

For these classes, interest deductions related to home ownership must have been particularly significant. As a consequence of the tax treatment of interest income and interest deductions, these groups received substantial capital subsidies. The interest payments that they made were far less than what would have been required to leave them with a zero real cost of borrowing. In both their lending and borrowing activities, they clearly gained from inflation. On the other hand, the other classes—the lower-income and higher-income classes—were subject to substantial capital taxes. For the very-high-income classes, these capital taxes may have exceeded 10 percent of the principal and they were very significant for the low-income classes as well. For this group, the interest income received was far below what would have been required to compensate an individual for the inflation-induced erosion of a loan.12

IV. NET BALANCE VIS-À-VIS THE U.S. GOVERNMENT

The preceding section has dealt with gains and losses among income classes related to the tax treatment of interest income during an inflationary situation. This section considers some gains or losses accruing to the U.S. Government as a consequence of the tax treatment of interest income and deductions. The Government gains from the taxation of interest income but loses from the deductions allowed for interest payments.13 The question is whether, on balance, the Government was a gainer or a loser over the 1972–81 period.

The method followed is a simple one. The net positions of the income classes vis-à-vis interest income (the figures in Tables 6 and 7) were multiplied by the average tax rates (shown in Table 1). If the net position of a class was that of a creditor (i.e., if interest received exceeded interest paid), then the multiplication of the net income by the effective average tax rate gave a net positive tax payment. However, if the net position was that of a debtor (interest paid exceeded interest received), the multiplication of the average tax rate by the net deduction gave an estimate of the taxes lost by the Government. The results are shown in Tables 8 and 9.

Table 8.Net Balance Vis-à-vis the U.S. Government 1972–74
Adjusted Gross Income197219731974
(In thousands of U.S. dollars)(In millions of U.S. dollars)
Under 12.62.68.7
1–217.419.616.0
2–321.725.623.0
3–454.061.771.3
4–563.771.4102.0
5–668.471.3105.1
6–756.161.999.9
7–825.449.768.2
8–9–3.511.944.1
9–10–34.3–5.651.2
10–11–27.2–21.1–5.2
11–12–61.5–44.7–28.0
12–13–70.3–62.2–32.7
13–14–69.6–54.7–69.6
14–15–79.9–88.7–71.9
15–20–325.5–425.0–479.7
20–25–129.8–235.3–307.8
25–30–14.5–39.9–96.4
30–50100.3103.5112.8
50–100121.4143.6293.3
100–20064.688.8179.2
200–50028.138.485.0
500–1,0006.114.923.3
Above 1,0005.011.215.9
Net balance–181.4–201.1207.7
Source: Same as Table 1.
Source: Same as Table 1.
Table 9.Net Balance Vis-à-vis the U.S. Government 1977–81
Adjusted Gross Income19771978197919801981
(In thousands of

U.S. dollars)
(In millions of U.S. dollars)
Under 2–18.20–45.67–44.19–78.19–123.97
2–47.006.016.4712.0416.89
4–692.19100.4794.2998.29115.27
6–8181.22207.71208.91234.72273.48
8–10226.35230.71261.66312.47378.18
10–12176.06202.22242.95328.73463.60
12–14111.06168.65181.85306.97437.27
14–1648.1634.1460.18233.10363.44
16–18–60.12–50.2823.64159.30293.57
18–20–155.17–154.71–101.5132.84248.21
20–25–512.88–688.81–601.48–284.72143.80
25–30–376.03–645.32–761.43–614.96–398.04
30–50–413.59–935.18–1,482.52–1,695.92–1,123.81
50–100191.0222.5292.70439.03794.05
100–200160.82130.34171.64466.74836.85
200–50098.31107.84186.07349.80606.85
Above 50055.2862.50183.63301.31440.15
Net balance–188.5–1,246.9–1,277.1601.63,765.8
Source: Tables 1, 4, and 7.
Source: Tables 1, 4, and 7.

In 1972, the value of the interest deductions in terms of tax reductions amounted to $816.2 million, while the value of the tax payments was $634.8 million. As a consequence, the net loss in tax revenue to the Government associated with the tax treatment of interest income was $181.4 million. In 1973, the tax reduction associated with net deductions was $977.2 million while the value of tax payments was $776.1 million, so that the net loss to the Government in terms of forgone tax revenue was $201.1 million. In 1974, however, there was a drastic change in the net balance. In fact, while the value of the deductions rose to $1,091.3 million, that of tax payments also rose to $1,299.0 million; the Government became a net gainer by $207.7 million. Between 1973 and 1974, there was a net change of about $400 million in the position of the taxpayers vis-à-vis the Government. Consequently, the Government was definitely a gainer from inflation in this context.14 The slowdown in the rate of inflation that characterized the period following 1974 again changed the net balance. In 1977–79 the Government was a net loser from this slowdown in the inflation rate, but the rapid acceleration of prices in 1980 and 1981 again changed the net balance. By 1981 the Government was gaining about $3.8 billion a year.

V. CONCLUDING REMARKS

Inflation benefits or harms individuals in many ways, some of which are obvious while others are much less so. It is not easy to determine whether, on balance, an individual or an income class gains or loses. This paper deals with just one way in which inflation affects income classes. It attempts to show to what extent income classes have gained or lost because of the tax treatment of interest income and interest payments during the inflationary period of 1972–81. The main beneficiaries are seen to be the middle-income classes, which are more likely to have substantial deductions related to their home mortgages. It is also shown that, with respect to the tax treatment of interest income, the U.S. Government was a net gainer from accelerating inflation. Thus, the tax treatment of interest income per se resulted in a redistribution of income in favor of the middle-income classes and the Government. It needs to be emphasized that the results obtained relate to income classes rather than to individuals. Within each class, some individuals gained or lost more than others.

The redistributional effects emphasized in this paper would be removed, or at least reduced in intensity, if the part of interest income that was taxed and the part of interest payments that was deducted as a cost were equal to the real rate of interest. This alternative appears to be an attractive theoretical recommendation, which has received support from some authors. However, the practical and administrative implications of such a policy have not yet been given the attention that they deserve. Until these practical implications are defined, the theoretical recommendation should be kept in abeyance.

See Vito Tanzi, “Inflation, Indexation, and Interest Income Taxation,” Quarterly Review, Banca Nazionale del Lavoro (Rome), No. 116 (March 1976), pp. 64–76; Michael R. Darby, “The Financial and Tax Effects of Monetary Policy on Interest Rates,” Economic Inquiry (Long Beach, California), Vol. 13 (June 1975), pp. 266–740; Martin Feldstein, “Inflation, Income Taxes, and the Rate of Interest: A Theoretical Analysis,” American Economic Review (Nashville, Tennessee), Vol. 66 (December 1976), pp. 809–20.

If the individual suffers from money illusion, his subjective evaluation of the situation may cause him to lose his objectivity and he may feel better or worse off than he actually is. Also, it must be reiterated that these statements concern the individual only in relation to his lending and borrowing activities. Inflation obviously affects him in other ways, so that the total effect of inflation may be either beneficial or damaging to him.

Throughout this paper, it is assumed that interest paid is a deductible expense in relation to the determination of taxable income.

Adjusted gross income is defined as gross income from all sources that is subject to tax and is adjusted to reflect allowances for business expenses.

Taxable income is defined as adjusted gross income minus personal deductions and personal exemptions.

Furthermore, it can be argued that lending comes mainly from saving, which is a residual. This line of argument relies on the assumption that it is the marginal, and not the average, rate that is more important in determining whether individuals save or lend.

For corporations that are taxed at approximately 50 percent, the α1ti ratio would have been 6.6 percent in 1972, 12.4 percent in 1973, and 22.0 percent in 1974.

The rates shown in Table 5 relate to new loans. Lenders (or borrowers) of money in earlier years were probably receiving (or paying) somewhat lower rates.

To the extent that the corporate sector is a net borrower, it must also have gained from the tax treatment of interest income between 1972 and 1974.

U.S. Internal Revenue Service, Statistics of Income, 1972: Individual Income Tax Returns (Washington, 1974), p. 277.

In 1974, interest paid by state and local governments amounted to $9.4 billion. About half of this was received by banks. See Survey of Current Business (U.S. Department of Commerce, Washington), Vol. 56 (January 1976), Table 17, p. 44, and U.S. Advisory Commission on Intergovernmental Relations, Understanding the Market for State and Local Debt (Washington, 1976).

These conclusions apply to classes as a whole. Within each class some taxpayers are net debtors and some are net creditors. Therefore, the above conclusions do not necessarily apply to each individual.

As the tax rates vary for the incomes of the various classes, whether the U.S. Government gains or loses depends to a large extent on where the interest income and the interest deductions accrue.

It should again be emphasized that these are very partial conclusions. They relate strictly to the tax treatment of interest income.

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