Tax Distortions from Inflation: What are They? How to Deal with Them?

TaxDistortionsfromInflation:WhatareThey?HowtoDealwithThem? SebastianBeer,MarkGriffiths,andAlexanderKlemm WP/23/18 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate. TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. 2023 JAN ©2023InternationalMonetaryFundWP/23/18 IMFWorkingPaper FiscalAffairsDepartment TaxDistortionsfromInflation:WhatareThey?HowtoDealwithThem?PreparedbySebastianBeer,MarkGriffiths,andAlexanderKlemm* AuthorizedfordistributionbyAlexanderKlemm January2023 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate.TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. ABSTRACT:Expectedinflationhasfewrealeffectsinpurelyprivateeconomies,butthisisnotthecasewhenthetaxsystemisnotneutralwithrespecttoinflation.Inpractice,taxsystemsarenotneutral—thoughsomehaveattemptedtobesointhepast—andthispaperprovidesacomprehensiveoverviewofthemostrelevantnon-neutralitiesdrawingbothonexistingliteratureandshowingnewillustrationsandevidenceoftheeffects.Thepapershows,forexample,howtaxinginflationarygainscanhavetremendousimpactoneffectivetaxrates—evenatrelativelylowratesofinflation.Italsoshowshowpartialadjustment—foronlysometypesofincomes—cancreateadditionaldistortions.Anewempiricalanalysisrevealshowtheerosionofthevalueofdepreciationallowancesthroughinflationaffectsinvestment.Finallythepaperdiscussespolicyoptionstoaddresssuchnon-neutralities. RECOMMENDEDCITATION:Beer,Sebastian,MarkGriffiths,andAlexanderKlemm,2023,“TaxDistortionsfromInflation:WhataretheyandHowtoDealwiththem?,”IMFWorkingPapers23/18. JELClassificationNumbers: H20,E31. Keywords: Taxpolicy;inflation;bracketcreep. Authors’E-MailAddresses: sbeer@imf.org,mgriffiths@imf.org,aklemm@imf.org *TheauthorswouldliketothankYongquanCao,RuuddeMooij,AndreaLemgruber,SimonNaitram,aswellasIMFandNIPFPseminarparticipants,forvaluablecommentsandAieshwaryaDavisforresearchassistance. Contents Glossary3 Introduction4 Non-adjustmentoftheParametersoftheTaxSystem5 SpecificTaxes,Fees,andPenalties6 FixedInterestRates6 Thresholds7 SolutionstotheErosionofSpecificTaxesandThresholds9 TimingIssues10 LagsinCollectionsandRefunds10 PoliciestoAddressTimingIssues10 TaxationofNominalHouseholdIncome11 SavingsIncome11 TaxationofCapitalGains13 HumanCapital15 SolutionstoTaxationofInflationaryHouseholdIncome16 TaxationofNominalProfits16 Depreciation17 DebtBias20 EmpiricalAnalysisoftheInflationaryTaxEffectonInvestment24 InteractionbetweenCorporateandHouseholdIncome26 SolutionstoTaxationofInflationaryProfits27 Conclusions28 References31 BOX 1.Value-AddedTaxChangesandInflation5 FIGURES 1.EffectiveTaxRatesonRealSavingsReturns13 2.TheImpactofInflationontheTradeOffBetweenCapitalGainsandDistributions15 3.TheImpactofInflationontheNPVofDepreciation18 4.DistributionofDepreciationRates19 5.EffectiveTaxRatesasaFunctionofInflation22 6.CriticalDebtSharesasaFunctionofDepreciationRates24 TABLES 1.AdjustmentofIncomeTaxThresholds8 2.TheImpactofInflationonInvestment26 Glossary CIT CorporateIncomeTax EATR EffectiveAverageTaxRates EMTR EffectiveMarginalTaxRate ETR EffectiveTaxRate ICT InformationandCommunicationTechnology IP IntellectualProperty NPV NetPresentValue VAT Value-addedTax Introduction Inflationratesaroundtheworldhaverisen.Inflationinadvancedeconomieshasreacheditshighestrateinfortyyears,increasingfrom3.1percentin2021toanestimated7.2percentin2022.Inemergingmarketanddevelopingeconomies,inflationin2022isexpectedtoreach9.9percent(IMF2022a).Whiletherehasbeenconsiderablediscussionoftherelativerolesofmonetaryandfiscalpolicy(quantitativeeasing,fiscalstimulustofightthepandemicandafterwards)versussupplyshocks(Russia’sinvasionofUkraine,andfoodandenergypriceincreases)incausinginflation,lessattentionhasbeengiventothereversequestion.Whatimpactdoeshigherinflationhaveonfiscalaggregatesandthestanceoffiscalpolicy,butalsohowdoesinflationinteractwiththetaxsystem,whatdistortionsdoesthisgiveriseto,andhowmighttheybecorrected?Thispaperconsidersthelattersetofquestions.Itdrawsheavilyonliteraturefromthe1970sand1980s,1whenthistopicwaslaststudiedindetail,probablybecauseinflationstartedcomingdownsoonafter,atleastinadvancedeconomies.However,thispapershowsthattheimpactofinflationontaxrevenues,marginaltaxrates,andeffectivetaxratesisnotnegligible,evenatlowerinflationrates. Insimplemodelsofaprivatemarketeconomywithfullmarketclearing,changesinnominalvariablessuchasthemoneysupplyandthegeneralpricelevel—atleastwhenanticipated—shouldnothavesignificantrealeffects.Whileincreasesinthemoneysupplymayhaveshort-runrealeffectsduetowageorpricerigidities,inthelong-runwagesandpricesadjust,andagentsbasetheirdecisionsonrealorrelativepricesand—abstractingawayfromhysteresiseffects—therealequilibriumisunchanged(Friedman1968).Withfullyflexiblepricestheargumentsforneutralityarestronger.Eveni