Alexander Klemm The views expressed in this presentation are of the authors and do not necessarily represent the views of the IMF its Executive Board or IMF management Inflation and Taxation ID: 1017984
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1. Inflation and TaxationOctober 16, 2022Alexander Klemm“The views expressed in this presentation are of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.”
2. Inflation and TaxationIntroductionFixed Parameters of the Tax SystemInflationary GainsTiming Issues
3. Inflation has risen and the impact on taxes is noticeable…People may notice real increases in tax bills fromPaying taxes on high nominal capital gainsRising marginal tax rates from bracket creepReduced purchasing power from tax refundsEasy to notice with high inflation, but raises deeper questionsWhat is the impact of non-neutrality w.r.t. inflation, and will lowering inflation be sufficient to address this?What would a neutral system be like, and what is the impact of addressing inflation only partially (e.g., only for capital gains)? Many answers in quite old literature (Diamond, 1975)
4. …raising deep questions about tax system design.Many more interactions between inflation and tax, which I will not cover:Aggregate demandTax increases disinflationaryPrices and costsInflationaryBut important not to confuse impact on price level with impact on structural inflationInflation “tax”Metaphorical use to describe cost of inflationSeigniorage—alternative to rather than form of tax
5. Even expected inflation has real effects under nonneutral tax systems.Expected (and not hyper) inflation in pure market economy: Prices (including interest) adjust, agents make decisions based on real pricesMinor real implications: Reduced holding of cashMenu costsPossibly low in digitalized eraNonneutral tax systemFixed parameters of the tax system (e.g., “bracket creep”)Taxation of inflationary gainsTiming issues (e.g., depreciation, payment deadlines)
6. Tax and InflationIntroductionFixed Parameters of the Tax SystemInflationary GainsTiming Issues
7. Fixed parameters in the tax system create problems…Specific excises, fees (and fines)Good reason some excises are specific rather than ad valorem (e.g., addressing externalities)Imperfect fix: set in foreign currencyTaxes that are percentages with fixed thresholds“Bracket creep”VAT thresholdno country adjusts for inflationThresholds for simplified, alternative minimum taxes, etc.
8. …but the solution is trivialAdjust excises, thresholds etc. with inflationPolitically bracket creep might be convenient as hidden tax increaseFor some excises/tariffs switch to ad valoremNot an option for Pigouvian taxes on goods with high price volatility
9. Tax and InflationIntroductionFixed Parameters of the Tax SystemInflationary GainsTiming Issues
10. Taxing nominal gains causes distortions…Imagine an asset that pays some real returnIf inflation rises, nominal returns riseThe effective tax rate of real tax / real return rises as a result!Even for relatively low rates of inflation, the effect is notableEffective Tax Rates on Real Savings ReturnsNotes: Assumed tax rate of 25 percent.
11. …which compound over time.Effect smaller on assets with capital gains (as only taxed on realization)N.B. in case of interest, there is a corresponding saving on borrower’s side. Assumptions: tax rate: 25 percent, real return: 6 percent, real discount rate: 0 percent. For the 10-year bond, all net interest receipts are assumed to be reinvested at the same conditions. Source: Authors’ calculations.
12. Partial solutions create further problemsSome countries tax only real capital gainsAchieves neutral capital gains tax……but even greater preference for capital gains over distributions!
13. Tax and InflationIntroductionFixed Parameters of the Tax SystemInflationary GainsTiming Issues
14. Timing of the payments can create problems…Many taxes are paid with delay (e.g., small business might pay months after the end of the business year)Reduced real value of taxes (Tanzi, 1977)Fixed penalties for late payment could be eroded by inflationTime saving could exceed penaltyPenalty interest rates sometimes fixed in lawIncentive to delay payments(incentive to overpay taxes when inflation is low, and a symmetric rate is applied)
15. …or timing of deductions…Cost of goods soldMain issue: DeprecationInvestment usually depreciated over various yearsValue of future depreciation allowance eroded by inflation
16. Policy solutionsFixed parameters of tax systemInflation-adjust thresholds, allowances, specific excisesAlso, any penalties Use variable—not fixed—interest rates for late paymentsTaxation of inflationary gainsEither fully adjust system…… or don’t, but avoid adjusting just selected types of incomes (e.g., capital gains)Timing of tax paymentsReduce delaysWHT, PAYE, advance income tax paymentsInflation-adjust paymentsDepreciation allowancesCash-flow tax, ACEUplift for stock of undepreciated capital