Front Matter

Front Matter

Vito Tanzi
Published Date:
June 1984
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ISBN 9780939934331 (cloth)

ISBN 9780939934331 (paper)

© 1984 by the International Monetary Fund

Reprinted March 1986


Washington, D.C. 20431


The behavior of interest rates in major industrial countries affects capital movements and, consequently, exchange rates and trade flows. It may also influence the attitude of policymakers toward the growth of the money supply. The level of interest rates in these countries is a critical determinant of the cost of servicing the external debt of the developing countries. The Fund, in carrying out its purposes, is concerned with changes in interest rates, especially in connection with its surveillance over the exchange rate and debt policies of member countries. In support of the surveillance exercise through consultations under Article IV the Fund prepares a series of World Economic Outlook papers and, from time to time, it also undertakes analytical studies of interest rates in developing and developed countries.

During the past few years, interest rates in industrial countries have been higher and more variable than at any time over recent decades. Factors that have often been mentioned to explain this phenomenon are changes in inflationary expectations, taxation of interest income, deductibility of interest payments for tax purposes, and, of course, the effects of large fiscal deficits. Various research papers by the Fund staff have analyzed these issues, with particular emphasis on the roles of taxation and inflation in the determination of interest rates. In view of the importance of the subject to both policymakers and academicians, the Fund is making available the studies to a wider public audience through the present volume. It is my hope that they will contribute to an informed discussion of this important subject.

July 1984

J. de Larosière

Managing Director

International Monetary Fund


This volume has been prepared by the Fiscal Affairs Department of the Fund under the overall supervision of its Director, Vito Tanzi, with the assistance of Ved P. Gandhi, Chief of the Tax Policy Division. Its publication has been coordinated by Rasheed O. Khalid, Deputy Director.

Eight studies, attributed to specific authors, and an overview by the Fiscal Affairs Department comprise the volume. The overview represents a collective effort, with John H. Makin, Leif Mutén, Jitendra R. Modi, and Menachem Katz having contributed to it in addition to Vito Tanzi and Ved P. Gandhi. Furthermore, it has benefited from useful comments received from colleagues in other departments of the Fund. Of these contributors, Sheetal K. Chand, George F. Kopits, George von Furstenberg, Deena R. Khatkhate, and Vicente Galbis deserve special mention.

The manuscript has been put into publishable form and guided through all stages of production by Ella H. Wright, with assistance from Paul E. Gleason. The Graphics Section of the Fund made a substantial contribution in the design and production of the volume.

Special thanks are due to Sonia A. Piccinini and the secretaries of the Fiscal Affairs Department for numerous tasks cheerfully undertaken in connection with a succession of drafts which must have seemed interminable.

List of Papers


1 I nterest Rates and Tax Treatment of Interest Income and Expense

  • Fiscal Affairs Department


Surveys of the Literature

2 Recent Literature on the Impact of Taxation and Inflation on Interest Rates

  • Uri Ben-Zion

3 Recent Literature on the Impact of Taxation and Inflation on the International Financial Market

  • Uri Ben-Zion

U.S. Studies

4 Level and Volatility of U.S. Interest Rates: Roles of Expected Inflation, Real Rates, and Taxes

  • John H. Makin and Vito Tanzi

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

  • Vita Tanzi

6 Inflationary Expectations, Taxes, and the Demand for Money in the United States

  • Vito Tanzi

International Aspects

7 Inflation, Taxation, and the Rate of Interest in Eight Industrial Countries, 1961–82

  • Menachem Katz

8 Financial Market Taxation and International Capital Flows

  • Mario I. Blejer

9 Impact of Taxation on International Capital Flows: Some Empirical Results

  • Menachem Katz


Uri Ben-Zion is Professor on the Faculty of Industrial Engineering and Management at Technion-Israel Institute of Technology, Technion City, Israel. He holds a doctorate in economics from the University of Chicago. In the summer of 1982, Mr. Ben-Zion was a consultant to the Fiscal Affairs Department of the Fund.

Mario I. Blejer is a senior economist with the Fiscal Affairs Department of the Fund. He holds a doctorate in economics from the University of Chicago.

Menachem Katz is an economist with the Fiscal Affairs Department of the Fund. He holds a doctorate in economics from Columbia University.

John H. Makin is Professor of Economics at the University of Washington and a Research Associate with the National Bureau of Economic Research. He holds a doctorate in economics from the University of Chicago. In 1982–83 he was a consultant to the Fiscal Affairs Department of the Fund.

Vito Tanzi, Director of the Fiscal Affairs Department of the Fund, holds a doctorate in economics from Harvard University.


Vito Tanzi

To non-economists, economists may appear to be masters of a highly unified discipline. Economists themselves, however, like practitioners in other scientific fields, view their discipline as an archipelago in which each island is a different specialization. Thus, there are labor economists, monetary economists, fiscal economists, international trade economists, and so on. These specialists suffer from what is sometimes called the small-island syndrome: they come to know most of what goes on in their own area of interest but little of what goes on in others. Two groups of economists defy this characterization. One consists of generalists who use basic economic tools in their routine work but are often too busy to learn any one branch in depth. These economists do not have the time and/or the inclination to make professional contributions to economic literature. The second group consists of the giants of the field, who are able to make contributions to several branches but rarely acquire a detailed institutional knowledge of the various specializations, so that their contributions are predominantly theoretical.

The situation described above has obvious advantages: with specialization comes detailed knowledge and, thus, progress, as was so eloquently explained by Adam Smith two centuries ago. But there are costs, too. Some problems cannot be neatly assigned to one branch of economics, since they cut across various branches. These problems may go unnoticed and unsolved if each specialist continues to see the world myopically. This book deals with some problems that fall, so to speak, through the cracks between several specializations. More specifically, it deals with issues that are of mutual interest to fiscal economists, to monetary economists, and to specialists in international finance. The book explores some links among the three important branches of economics in which these specialists work.

The study of monetary-fiscal links in closed and open economies is a new and exciting area of research in economics. It is an area still occupied by few economists and one that the staff of the Fund can claim to have been among the first to explore. It is to be hoped that the papers presented in this book will be seen as a useful contribution. However, like other papers written by those who have explored new fields, these papers may raise more questions than they answer.

What are some examples of these monetary-fiscal links? A few are mentioned in this introduction. It is generally assumed that the market rate of interest is one of the independent variables that determine the quantity of money that individuals wish to hold; most quantitative, as well as theoretical, papers have utilized that rate. But what if interest income is taxed? Shouldn’t one then adjust the market rate for the effect of the tax? After all, the opportunity cost of holding money in that case is the net-of-tax interest rate. What this means is that tax policy may have an immediate effect on the demand for money. As obvious and as important as this point is, no study done outside the Fund has vet paid attention to it. What if the rate of inflation raises the nominal interest rate, and thus the tax payments on interest income, to such an extent that the net-of-tax interest rate falls below the expected rate of inflation? Wouldn’t one then witness a substitution between money and real assets or goods? Here is another example of a link between fiscal and monetary economics.

Several decades ago, Fisher theorized that, when there is inflation, the nominal rate of interest will increase by as much as the expected rate of inflation. But being essentially a monetary economist, Fisher ignored the effect of taxes. In the mid-1970s, three papers published at about the same time—one of which was written in the Fund—advanced the important hypothesis that, in such a situation, the nominal rate of interest would have to rise by more than the expected rate of inflation.1 This Fisher-cum-taxes hypothesis is now generally accepted in the literature and has received recent empirical backing.

Finally, what happens if, because of a variety of factors. investors are more likely to have to pay taxes on interest income earned on domestic financial assets than on foreign ones? Or what happens if the tax treatment of interest income in different countries is different? This is, again, an important area that had received little attention (perhaps because it fell through the cracks between the three branches of economics) and one in which a good share of the work done so far has been done in the Fund. It is an area with obvious important implications, since it affects capital movements as well as theoretical conclusions reached when these lax effects are ignored, such as interest rate parity. These are just some of the issues discussed in this volume.

The volume is made up of nine studies, some dealing with purely theoretical aspects, others with purely empirical ones, and still others dealing with both. Part I consists of a rather lengthy paper that touches on many theoretical, as well as policy, issues arising out of the tax treatment of interest income and expense. In a way, all the other papers are inputs into this one. Thus, the busy reader who has to budget his time would be advised to read this paper. To my knowledge, this is the only published source in which information from many industrial countries on the legal treatment of interest income and expense has been compiled. Given the complexity of tax laws, this was not an easy task.


Part I includes four major sections. Section I is an introduction. Section II summarizes the main differences in the tax treatment of interest income and payments and of foreign exchange gains and losses among 16 industrial countries. These differences are shown to be substantial. For example, some countries allow unlimited deductions on interest paid on consumer loans; others do not. Some allow unlimited deductions for mortgage payments; others do not. If the Fisher-cum-taxes hypothesis has empirical validity, these different legal treatments are likely to result in different pressures on interest rates and, eventually, in capital movements. As it turns out, the U.S. tax treatment of interest expense is among the most generous. This treatment implies that U.S. borrowers are willing to pay higher rates than they would if there were a less generous treatment. Thus, interest rates may tend to be higher in the United States than elsewhere. Capital may therefore be attracted to the United States from other countries, and capital outflows may, in turn, raise interest rates in other countries. Although no firm conclusions can be drawn about the empirical significance of these effects, some educated guesses are offered.

Section III provides a detailed theoretical discussion of the Fisher effect. It argues that in the real world, the situation is not as simple as is assumed by the early literature on the Fisher effect, with or without taxes. In fact, the Fisher hypothesis is postulated under the assumption that the real rate of interest does not change over time or when inflationary expectations are changing. But this assumption cannot be maintained, as is indicated by several recent studies showing that factors such as changes in the rate of inflation itself, in economic activity, in the price of energy, in the productivity of capital, in the tax laws, in the variance of the rate of inflation, and so on may change the real rate of interest. Of course, if the real rate of interest changes, the simple one-to-one relation between the nominal rate of interest and the expected rate of inflation will not hold even when taxes are ignored. Section III also contains a brief discussion of proposals that would remove the tax effect of interest rates. Some of these are politically unrealistic, some administratively in feasible. One proposal that would seem administratively feasible and that might have a political chance is for nondeductibility of interest expense connected with consumer loans. This proposal would contribute to the reduction of the fiscal deficit in the United States, would have beneficial effects on capital formation, and would reduce interest rates. Its effect on the rate of interest might, however, not be very significant.

Section IV extends the discussion to an international setting. Differential tax treatment of interest income and expense is shown to affect the levels of interest rates and to induce capital flows across countries. The role of differential tax rates on foreign exchange gains and losses, as compared with interest income and expense, in determining nominal interest rate differentials is discussed. Other issues discussed include policies of monetary restraint and the volatility of interest rates since 1979. Section V summarizes many of the conclusions.


Part II of the book is divided into three sections. The first is made up of two chapters that survey the literature. The second contains three chapters dealing with the American scene, and the third section contains three chapters dealing with the international scene.

The two literature survey papers concentrate, respectively, on a closed economy (Chapter 2) and an open economy (Chapter 3). Chapter 2 examines the recent contributions on the relationship between inflation and interest rates in a world with taxation. It surveys several extensions of the basic Fisherian theory, including real balance effects, substitution effects, personal income tax effects, and effects associated with corporate income taxes and capital gains taxation. It also describes a recent formulation of a general equilibrium model. Various empirical studies for the United States and other countries are surveyed. Overall, the studies surveyed point to the need for more explicit recognition of the fact that economic behavior of lenders and borrowers is governed by net-of-tax interest rates, prices, and incomes. The paper concludes with an agenda for research which points toward the integration of tax policies into traditional analyses of effects of monetary policy.

Chapter 3 shows that although extensive literature exists on the interrelationship between inflation rates, interest rates, and exchange rates and on the effects of these three variables on international capital movements, most of this literature has not considered the impact of taxes and of differential taxation across countries. The few articles that have done so are reviewed. It is shown that taxes play a crucial role in the determination of capital mobility and that the assumptions regarding the tax treatment of foreign interest income are of particular importance.

The second section of Part II includes three studies, all of which deal with the United States. The first of these—Chapter 4—analyzes the factors that have affected the level and volatility of interest rates in the United States. The most important among these factors are the following: (a) expected inflation; (b) stage of the business cycle; (c) changes in the fiscal deficit; (d) unanticipated changes in the money supply; (e) tax treatment of interest income, interest expense, and depreciation; and (f) uncertainty about the rate of inflation. The role of each of these factors is discussed. It is argued that (a) a higher expected rate of inflation, (b) greater economic activity, (c) a larger Fiscal deficit, and (d) an unanticipated fall in the rate of increase of the money supply unambiguously increase the rate of interest. The effects of taxes and inflation uncertainty are more ambiguous.

Taxation of interest income and exemption of interest expense from taxation both raise the interest rate. This impact is reduced, but not eliminated, by taxes on noninterest income. These taxes force an individual to invest a larger share of his loanable funds in financial assets, thus depressing his rate of return. It is concluded that taxes generally have a positive net effect on interest rates. Inflation uncertainty increases the rate of return expected by lenders, but it also decreases the demand for funds by borrowers. Therefore, the net effect of inflation uncertainty is ambiguous. The theoretical section also shows that tax effects magnify the volatility of nominal interest rates arising from fluctuations of expected inflation and real interest rates.

The paper develops an econometric model to test the results derived from the theoretical analysis. The rate of interest on treasury bills is correlated with expected inflation, economic activity, unanticipated changes in the money supply, and fiscal deficits. An extremely good fit is derived. The model is shown to explain well the behavior of interest rates from the early 1960s through the end of 1981. Previous studies have not been as successful at explaining the behavior of interest rates during the volatile period since October 1979.

Chapter 5 considers some equity aspects of the tax treatment of interest income and expense. It points out that income taxes are not proportional, but progressive. As a consequence, even if there should be a full adjustment of the interest rate to the effects of taxes and inflation (i.e., even if the Fisher-cum-taxes hypothesis were validated), the interest rate would adjust for some average tax rate. Therefore, it would be too high for some taxpayers (those with low marginal tax rates) and too low for others (those with above-average marginal tax rates). As lenders, the first group would gain, the second would lose. The results for borrowers would be exactly the reverse. Thus, to determine whether a given income class gains or loses during inflation, one needs to consider whether the class is a net lender or borrower. The analysis shows that the U.S. middle classes were the net gainers, since they were net borrowers. The paper also attempts to determine whether the government gained or lost from this tax treatment of interest incomes and expenses. It is shown that when inflation became very high, the government gained.

Chapter 6 deals with a theoretical issue that also has some practical relevance. This is the issue of whether the demand for money in a country such as the United Slates is affected only by the rate of interest, as is normally argued, or by both the rate of interest and inflationary expectations. The paper argues that in the absence of taxes on income and of institutional constraints on interest rates, only interest rates would be relevant, since the rate of interest would generally exceed the rate of inflationary expectations and would tints be the relevant opportunity cost of holding money. However, when, in the presence of inflation, interest rates are constrained, as they are in developing countries and/or when interest income is taxed, then inflationary expectations, rather than the rate of interest, may be the main variable influencing the demand for money. The paper emphasizes that, until recently in the United Slates, the net-of-tax rate of return on financial assets was often lower than the rate of expected inflation (a situation that has obviously changed). Therefore, it became convenient for people to get out of both money and financial assets and into real goods (gold, houses, etc.). The paper tests the hypothesis that inflationary expectations, rather than the rate of interest, were the major determinant of the demand for money in the United States over the past two decades. The empirical tests validate this hypothesis.

The third section of Part II includes three chapters, all dealing with international aspects. Chapter 7 attempts to test the Fisher hypothesis for eight industrial countries, using a consistent methodology for estimating inflationary expectations. It is shown that, generally, interest rates adjusted for expected inflation (as provided by the method used to determine it) but lagged behind actual price changes. Some evidence of tax effects on interest rates was also found.

Chapter 8, which is a purely theoretical paper, analyzes the relationships between inflation, interest rates, and exchange rates when the role of taxes is taken into account. It incorporates tax considerations into a unified analytical framework. The basic premise of the analysis is that the presence of taxes induces portfolio shifts aimed at restoring equality between the expected net returns on domestic and foreign assets. Four main results are obtained: (1) Identical rates of taxation across countries do not prevent capital flows and changes in real interest rates when inflation rates differ. (2) Differences in tax rates are conducive to differentials in real after-tax rates of interest. In general, higher tax rates result in lower real interest rates, even if rates of inflation are identical across countries. (3) Under purchasing power parity, increases in the inflation rate of the high-tax country result in a capital inflow and in a reduced real rate of interest. They may also induce two-way capital flows if exchange gains are taxed at a lower rate than interest income. (4) When the exchange rate is determined by interest parity, departures from purchasing power parity and the variability of the exchange rate are proportional to the differences between tax rates.

While Chapter 8 is a purely theoretical paper. Chapter 9 is a purely empirical one. It attempts to show how tax factors may have affected international capital flows. First, an analysis of seven industrial countries indicates that short-term foreign exchange gains may be effectively taxed at lower rates than long-term gains. If this empirical result is correct, it is somewhat surprising. Second, it shows how differential tax treatment by the United Slates of interest income and foreign exchange gains realized after 12 months can lead to simultaneous capital flows in opposite directions. However. this happens only rarely.

As was stated at the beginning, the book will probably raise more questions than it will answer. Some readers are likely to disagree with parts of it. However, they will find it difficult to disagree with two of the book’s basic conclusions. First, the role of taxes in areas such as monetary economies and international finance cannot be ignored by economists working in those areas who seek to deal effectively with the real world. Too many monetary economists and specialists in international finance still go about their work as if they had never heard about taxation. Second, in a world where taxation is so predominant, the idea that inflation changes just nominal values, without affecting real values, is, as this book should make abundantly clear, a mere fiction. Unfortunately, one still sees much economic writing that perpetuates this fiction. It is to be hoped that this book will encourage a growing number of economists to concentrate on those areas where monetary economics, fiscal economics, and international finance intersect.

See Michael R. Darby, “The Financial and Tax Effects of Monetary Policy on Interest Rates,” Economic Inquiry (Long Beach, California), Vol. 13 (June 1975), pp. 266–74; Martin S, Feldstein, “Inflation, Income Taxes, and the Rate of Interest: A Theoretical Analysis.” American Economic Review (Nashville, Tennessee), Vol. 66 (December 1976), pp. 809–20; and Vito Tanzi, “Inflation, Indexation and Interest Income Taxation.” Quarterly Review, Banca Nasaonale del Lavoro (Rome), No, 116 (March 1976). pp. 64–76. The Tanzi paper was first issued as an unpublished paper in the Fund’s Fiscal Affairs Department on February 14, 1975).


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