Working Paper: NBER ID: w1350
Authors: John H. Makin
Abstract: This paper demonstrates that different rates of taxation on interest income and exchange gains may bias results of hypothesis testing regarding critical aspects of exchange rate behavior. Two problems are discussed specifically. First, it is shown that omission of tax considerations may bias tests of the uncovered interest parity condition toward acceptance of a "risk premium" hypothesis, conditional on exchange market efficiency. Second it is shown that a rational solution for the exchange rate conditions the relationship between an exchange rate and its determinants on two regimes: (1) tax rates on interest income and foreign exchange gains and losses at home and abroad and (2) the degree of foreign exchange market intervention and sterilization of its effects on the monetary base practiced by central banks.
Keywords: exchange rates; taxation; interest income; foreign exchange gains; monetary policy
JEL Codes: F31; H21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| tax rates on interest income (E43) | exchange rate behavior (F31) |
| tax considerations omitted (H29) | biased tests of uncovered interest parity condition (F31) |
| tax rates on interest income and foreign exchange gains (F38) | relationship between exchange rates and their determinants (F31) |
| changing tax rates (H29) | inadequate empirical specifications of exchange rate equations (C51) |
| tax policy (H20) | exchange rate volatility (F31) |