Working Paper: NBER ID: w1355
Authors: John H. Makin
Abstract: This paper derives a reduced-form expression for an interestrate in an open economy by incorporating after tax covered interest parity conditions into a simple neo-classical macro model. The result clearly demonstrates that the relationship between an interest rate and variables used to explain it is conditional on income tax rates at home and abroad and presence or absence of capital gains tax treatment of foreign exchange gains or losses. Effects of non-indexation of tax treatment of depreciation and inventories may also play a role. Any change in effective tax rates over a sample period employed to estimate interest rate (or exchange rate) equations may cause deterioration in the fit of a fixed coefficient model. Efforts are underway to employ a random coefficients approach to address this problem.
Keywords: Interest Rates; Tax Policy; Open Economies; Fiscal Deficits
JEL Codes: E43; E62; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| expected inflation (E31) | expected aftertax real interest rate (E43) |
| unanticipated changes in the money supply (E49) | expected aftertax real interest rate (E43) |
| fiscal deficits (H68) | expected aftertax real interest rate (E43) |
| expected inflation (E31) | nominal interest rate (E43) |
| changes in tax rates (H29) | sensitivity of interest rates to expected inflation (E43) |
| higher capital gains tax rates (F38) | responsiveness of domestic interest rates to foreign inflation (E43) |
| tax treatment (H20) | nominal interest rates (E43) |
| expected inflation (E31) | nominal interest rates (E43) |