Working Paper: CEPR ID: DP10847
Authors: Daria Finocchiaro; Giovanni Lombardo; Caterina Mendicino; Philippe Weil
Abstract: This paper revisits the equilibrium and welfare effects of long-run inflation in the presence of distortionary taxes and financial constraints. Expected inflation interacts with corporate taxation through the deductibility of i) capital expenditures at historical value and ii) interest payments on debt. Through the first channel, inflation increases firms? taxable profits and further distorts their investment decisions. Through the second, expected inflation affects the effective real interest rate negatively, relaxes firms? financial constraints and stimulates investment. We show that, in the presence of collateralized debt, the second effect dominates. Therefore, in contrast to earlier literature, we find that when the tax code creates an advantage of debt financing, a positive rate of long-run inflation is beneficial in terms of welfare as it mitigates the financial distortion and spurs capital accumulation.
Keywords: credit frictions; Friedman rule; optimal monetary policy; tax benefits of debt
JEL Codes: E31; E43; E44; E52; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| expected inflation (E31) | corporate taxation (K34) |
| expected inflation (E31) | taxable profits (H25) |
| taxable profits (H25) | investment decisions (G11) |
| expected inflation (E31) | effective real interest rate (E43) |
| effective real interest rate (E43) | financial constraints (H60) |
| financial constraints (H60) | investment (G31) |
| expected inflation (E31) | welfare (I38) |
| corporate taxation (K34) | investment choices (G11) |
| positive long-run inflation (E31) | financial distortions (F65) |
| positive long-run inflation (E31) | capital accumulation (E22) |
| optimal inflation rate (E31) | monopolistic distortion (L12) |