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Mr. Dewald, an economist at the U.S. Department of State, completed the research for this paper while he was a consultant in the Research Department of the Fund. He is a graduate of Northwestern University and of the University of Minnesota. He was formerly Professor of Economics and Editor of the Journal of Money, Credit and Banking at the Ohio State University, Columbus. The author acknowledges helpful criticism from his colleagues in the Fiscal Affairs and Research Departments. Earlier versions of the paper were presented at the Congressional Budget Office, George Mason University, the Eastern Economic Association Meetings, Georgetown University, the Board of Governors of the U.S. Federal Reserve System, the Brookings Institution, the American University, George Washington University, the U.S. Department of the Treasury, and the Western Economic Association Meetings (in 1985).
The Fisher equation (1930) is r = i − π; the tax-adjusted Fisher equation is r = i(1 − τ) − π, or r = i − π/(l − τ). where r is the real interest rate, i is the nominal interest rate, τ is the tax rate, and π is the inflation rate. In general, authors have not made clear that these two tax-adjusted Fisher equations reflect quite different assumptions about the tax system, although in both cases di/d, π= 1/(1 − τ). This point is elaborated in Section II of the paper.
“By allowing deduction only of real interest cost and taxing only real interest income, the Treasury plan reduces the tax incentive to borrow and the tax penalty on lending and thereby helps to produce a drop in interest rates that will reduce deficits” (Makin (1985, p. 24)). “It [indexing] would. for example, by reducing interest cost on the public debt, reduce the U.S. fiscal deficit by $8 billion, and it would reduce the cost of borrowing for developing countries by considerable amounts” (Tanzi (1984, p. 27)).
The model without indexing is presented in Makin (1984). A comparable model is the basis of the analysis of interest indexation by the Institute for Research on the Economics of Taxation (see Schuyler (1985)).
Incongruously, Brenner and Venezia (1983) specified regime F in their study of investment duration.
“… If adjustments for inflation were made, lenders would require smaller interest premiums during inflation; as a result, the government could pay less interest on its debt” (Feldstein (1976b, p. 80)).
Stiglitz (1981) also shows that indexing would affect real rates.
To avoid further complicating the analysis, the tax rate can be thought of as including government revenue that is associated both with the issue of government demand debt and with the taxation of inflation premiums in interest rates paid by fully taxed borrowers.
The present paper does not account for the feedback effects of taxation and government deficits on wealth. In a world in which decision makers have infinite horizons, tax rate changes including indexation would not affect interest rates (see Barro (1984a, 1984b)), Deficits from whatever source would induce sufficient net private saving to be self-financing without affecting interest rates. At most, a decrease in tax rates and an increase in the deficit would have a distorting effect in increasing the current supply of output and then decreasing that supply later when tax rates were increased to finance the resultant debt. The introduction of indexing the tax treatment of interest might, however, affect the allocation of credit to particular borrowers, an effect that could have positive or negative effects on real growth. There is at best ambiguity with respect to the consequences that indexing would have for long-run growth and tax revenue. Thus, it has simply been assumed in the present analysis that inflation indexing of interest taxation would not affect real output and related tax revenue at all. although the issue merits study.
The deficit could be further increased because of forgone revenues associated with taxing the inflationary returns of fully taxed borrowers.
King and Fullerton (1984) in their study of capital income taxation found that, for the 1970 tax law, an increase in inflation from zero to 6.67 percent would increase the effective tax rates by 3.5 percentage points. Feldstein and Summers (1978) found a 3.3 percentage point increase in the effective tax rate per percentage-point increase in the inflation rate.