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### Introduction — Context and motivation
- Inflation in advanced economies increased from 3.1 percent in 2021 to an estimated 7.2 percent in 2022.
- Inflation in emerging market and developing economies in 2022 is expected to reach 9.9 percent (IMF 2022a).
- Existing literature has focused on drivers of inflation; this paper examines the reverse question: how higher inflation affects fiscal aggregates, the stance of fiscal policy, and interactions with the tax system.
- The paper draws heavily on literature from the 1970s and 1980s and examines how inflation impacts:
  - tax revenues,
  - marginal tax rates, and
  - effective tax rates.
- Key insight: the impact of inflation on fiscal and tax outcomes is not negligible, even at lower inflation rates.

### Scope, approach, and mechanisms of tax non-neutrality
- Definitions and primary mechanisms:
  - Neutrality with respect to inflation: tax system’s impact on incentives and tax burdens does not change with inflation.
  - Main distortions:
    - (i) Failure to adjust nominal tax parameters (e.g., fixed nominal thresholds, specific taxes).
    - (ii) Timing effects: lags in collections and refunds.
    - (iii) Taxation of nominal rather than real gains and profits at household and corporate levels.
  - At the corporate level, taxation of nominal profits is imperfectly compensated by allowing deduction of nominal rather than real interest.
- Contributions:
  - Detailed description of each non-neutrality with literature and new illustrations/evidence.
  - Demonstrates large effects of taxing purely inflationary income gains on effective tax rates, even at relatively low inflation rates.
  - Shows partial inflation adjustments (adjusting only some income types) can create additional distortions.
  - Presents new empirical analysis showing erosion of depreciation allowances through inflation reduces investment.
  - Discusses policy options from targeted fixes to comprehensive tax reform.

### Box 1 — Value-Added Tax Changes and Inflation: VAT passthrough and nominal-parameter issues
- VAT rate changes and passthrough:
  - VAT rate changes may lead to one-off increases in the consumer price index but will not affect structural inflation.
  - Passthrough depends on price elasticities:
    - Infinite supply elasticity → full passthrough to consumer prices.
    - Finite supply elasticity or monopolistic markets → passthrough less than complete.
  - Empirical evidence (Benedek and others 2020, 17 Euro area countries, 1999–2013):
    - Full passthrough for changes in the standard rate.
    - 30 percent passthrough for changes in reduced rates.
    - No passthrough for reclassifications between rate categories.
    - Passthrough greater for durables than for non-durables.
  - Implication: targeted reduced rates are unlikely to address long-term inflation and may fail to reduce short-term inflationary pressures.

- Non-adjustment of nominal tax parameters:
  - Affected parameters include specific taxes, excises, lumpsum taxes, license fees, simplified fees, fines, fixed interest rates in tax law, and nominal thresholds.
  - Specific taxes/excises: inflation erodes real value, lowering real revenues and under-internalization of externalities.
  - Some countries denominate specific taxes in US dollars — partial protection but exposure to US inflation and exchange rate movements remains.
  - Fixed interest/penalty rates: real deterrent effects weaken as inflation rises; in very low/negative inflation, fixed rates can encourage overpayment when refunds carry the fixed rate.
  - Thresholds and bracket creep:
    - Full inflation indexation of thresholds, or a proportional (flat) income tax starting from zero income, avoids bracket creep.
    - Of 160 countries with data, 131 countries do not adjust thresholds regularly; only nine have explicit legal/administrative automatic adjustment processes.

- Solutions to erosion of specific taxes, penalties, and thresholds:
  - Index parameters to a reliable inflation measure; adjustment frequency depends on inflation rate:
    - Modest inflation → annual adjustment sufficient.
    - High inflation → more frequent adjustment.
  - For interest/penalty rates: define as a markup over inter-bank or government bond rate.
  - Specific taxes: fixing in a stable foreign currency offers partial protection; switching to ad valorem has broader consequences and often not advisable.
  - Political economy: automatic indexation is simple and transparent but can be politically framed as regressive; automatic adjustment maintains real progressivity.
  - If tax evasion rises with inflation, devote greater resources to tax compliance during high inflation.

### Box 1 — Timing issues, depreciation, and refunds
- Collection lags: taxes collected with delays are eroded in real terms by inflation; effect amplified where collection delays or inflation are large.
- Penalties and payment delays: index payments or employ variable penalty interest rates to maintain deterrent effects.
- Depreciation and loss carryforwards: historical-cost-based depreciation deductions and carried-forward losses are eroded by inflation.
- Policy responses:
  - Withholding taxes / pay-as-you-earn to tax income as earned.
  - Greater reliance on advance corporate income tax adjusted for inflation if based on historic profits.
  - More frequent asset revaluations or formulaic mechanisms reflecting inflation when full revaluation is costly.
  - Index tax payments for late payment and set penalty rates that do not fall in real terms.
  - Improve tax administration for electronic and more rapid payments.
  - Index depreciation allowances or allow full expensing upfront.

### Box 1 — Taxation of nominal household income: savings ETRs and formulas
- Fisher relation used: i = (1 + r)(1 + π) − 1.
- After-tax real return (source equation (2)):
  - Real after-tax return = r(1 − t) − tπ/(1 + π).
- Effective Tax Rate on real returns (source equation (3)):
  - ETR = t [1 + π/(r(1 + π))].
- Comparative properties:
  - ETR increases with inflation π and declines with real return r.
  - As inflation → ∞, ETR → t/r.
  - As r → ∞, ETR → statutory t.
- Numerical illustrations (assumed statutory tax rate = 25 percent):
  - With real rate of return 2 percent, ETR reaches 100 percent when inflation hits 6 percent.
  - With inflation at 2 percent and real return 2 percent, the ETR is doubled relative to statutory rate.
  - At current double-digit inflation in many advanced economies, ETR can far exceed 100 percent.
  - As real returns approach zero, ETR tends toward infinity; with negative real returns and inflation exceeding real return, tax is still due.

### Box 1 — Capital gains, realization timing, and lock-in
- Taxing nominal capital gains increases real tax burdens as inflation rises because nominal gains contain an inflation component.
- Taxation at realization creates a lock-in effect favoring unrealized capital gains over distributed income.
- Multi-period expression for an n-year investment (source formulation): after-tax value Vcapital gain = (1 + i)^g − t[(1 + i)^g − 1] = (1 − t)(1 + i)^g + t.
- Tax preference for capital gains rises with inflation and holding period; longer holding periods amplify the lock-in.
- Numerical illustration assumptions: tax rate 25 percent, real return 3 percent, real discount rate 0 percent, 10-year horizon:
  - At zero inflation, ETRs for distributing vs. capital gain assets are similar (28 percent vs. 25 percent).
  - Difference rises dramatically with inflation in favor of capital gains.
  - One-year investments show no difference between accrued vs. realized taxation; longer-term investments show higher ETRs because of compounded untaxed returns.

### Box 1 — Human capital
- Inflation does not change real cost of forgone earnings for education.
- Tax consequences for human capital arise only via bracket creep if thresholds are not indexed.
- Outright payments for education typically not deductible; no special inflation tax consequence beyond general tax system design.

### Box 1 — Solutions for household inflationary taxation
- Comprehensive solution: change tax bases to exclude inflationary gains (e.g., Diamond 1975 deduction of inflation rate on asset values).
- Partial/selected inflation adjustments can exacerbate distortions by favoring adjusted categories.
- Simplified relief (e.g., lower long-term capital gains rates) intensifies preference for capital gains.

### Box 1 — Corporate profits: timing lags, depreciation NPV, and debt bias
- Timing lags: when costs occur earlier than related sales, inflation can raise nominal profits and tax liabilities despite real losses.
- Depreciation allowances and NPV:
  - Declining balance NPV formula (source equation (9)): A(π) = φ / [(1 + r)(1 + π) − (1 − φ)], with φ the depreciation share > 0 and r the real discount rate.
  - Immediate expensing (φ = 1) yields NPV = 1; other schemes yield 0 < A < 1.
  - Marginal impact of inflation on A is negative (source equation (10)).
  - Empirical mean declining balance rates for 68 countries (2017–2020):
    - buildings: 10 percent,
    - tangible assets: 25 percent,
    - intangible assets: 38 percent.
- Investment effect example:
  - With corporate tax rate 22 percent, depreciation rate 25 percent, inflation 2 percent → semi-elasticity of capital = 0.42, implying optimal investment level decreases by 0.42 percent for a one-percentage point increase in inflation.
- Debt bias and inflation:
  - Interest deductibility creates a bias toward debt; inflation increases the tax advantage of debt because nominal tax-deductible interest rises with inflation.
  - Financial effect of issuing debt (source equation (16)) is increasing in inflation and reduces cost of capital for debt-financed investment.
  - Combined cost of capital depends on depreciation NPV and debt-finance effects (source equation (17)).
  - Optimal debt share s* (source equation (20)):
    - s* = A τ [ r + π/(1 + π) ].
    - Inflation raises optimal share of debt finance; effect stronger in high-tax environments.
  - Marginal increase in inflation has ambiguous effect on investment (source equation (22)); firm responses heterogeneous depending on agency costs and leverage.
  - Critical debt share s_c defined where marginal inflation leaves investment unchanged (source equation (23)); simulations show heterogeneous responses.

### Box 1 — Empirical analysis: inflationary tax effect on investment (country-level)
- Regression (source equation (24)) links growth rate of real asset stock to inflation π, statutory CIT rate τ, and their interaction.
- Data sources:
  - Net fixed asset stocks (manufacturing) 2000–2021 from OECD Annual National Accounts.
  - Inflation from IMF WEO.
  - Tax rates from OECD Corporate Tax Rates Database.
- Table 2 main estimates (dependent variable: percentage change of real asset stock; heteroscedasticity-robust standard errors in brackets):
  - CIT rate coefficients:
    - Construction: -0.156*** [0.038]
    - Intellectual property: -0.057 [0.081]
    - Machinery: -0.241*** [0.064]
    - ICT: -0.167 [0.236]
  - Inflation coefficients:
    - Construction: 0.109 [0.084]
    - Intellectual property: -0.195 [0.202]
    - Machinery: -0.111 [0.119]
    - ICT: -0.145 [0.800]
  - CIT rate * Inflation interaction:
    - Construction: -0.014* [0.008]
    - Intellectual property: -0.029* [0.017]
    - Machinery: -0.035** [0.017]
    - ICT: -0.043 [0.053]
  - Observations:
    - Construction 500,
    - Intellectual property 522,
    - Machinery 520,
    - ICT 401.
  - Adjusted R2:
    - Construction 0.561,
    - Intellectual property 0.448,
    - Machinery 0.63,
    - ICT 0.228.
- Interpretation:
  - Investments decrease between 0.06 percent (intellectual property) and 0.24 percent (machinery) in response to a one percentage point increase in the CIT rate when inflation at sample median 4 percent.
  - Negative and significant interaction terms for construction, intellectual property, and machinery indicate erosion of depreciation allowances outweighs debt-finance benefits for these asset types.
  - Example for machinery:
    - When price level increases by 2 percent annually, estimated semi-elasticity w.r.t. CIT = 0.17 percent (= -0.241 + 2×0.035).
    - At inflation 10 percent, semi-elasticity = 0.45 percent (= -0.241 − 6×0.035).

### Box 1 — Corporate solutions to inflationary taxation
- Fiscal-unit accounting: compute taxes in an inflation-adjusted unit of account (conversion yearly/quarterly/monthly/daily); addresses timing but costly and subject to manipulation.
- Country experiences:
  - Israel (law 1982): allowance for inflation applied to equity, depreciation calculated at end-of-year prices; complexity and loopholes; effectiveness not fully tested as inflation fell before full phase-in.
  - Brazil: monetary correction (1976) and “integral correction” (1987) variants used; tax treatment incomplete and some inflationary gains still taxed.
- Tax reform options yielding inflation neutrality:
  - R-based cash flow tax (Meade 1978): immediate expensing of investment and disregard of financial flows → neutral to inflation and to debt/equity mix.
  - Allowance for Corporate Equity (ACE): deductible notional interest on equity to align treatment of equity and debt; neutral to depreciation allowance erosion and inflation impacts.

### Conclusions — Overview of impacts
- Paper groups inflation impacts into three categories:
  - (1) Non-neutralities from tax parameters defined in nominal terms.
  - (2) Non-neutralities caused by timing issues.
  - (3) Distortions from tax bases defined in nominal terms so nominal rather than real income is taxed.
- Examples:
  - Specific taxes/fees: real revenues decline with inflation.
  - Fixed nominal interest charges: lower real rates as inflation rises, encouraging payment delays and weakening tax compliance.
  - Bracket creep: fixed nominal thresholds typically raise real tax burdens in progressive systems.

### Conclusions — Timing, nominal-base distortions, and net effects
- Timing issues:
  - Collection lags reduce real revenue; lags in refunds have opposite effects.
- Nominal-base distortions:
  - Taxation of nominal returns reduces after-tax real returns.
  - Taxation of nominal capital gains raises capital taxes and increases lock-in.
  - Depreciation allowances fixed in nominal terms lose real value, discouraging investment.
  - Inflation raises nominal debt interest payments, increasing deductibility and bias toward debt.
- Net revenue effects:
  - Effects can offset; general conclusion: inflation likely increases tax distortions for a given tax system.
  - Revenue gains from bracket creep (larger in progressive/high-income countries) need to be weighed against revenue losses from collection delays (important where tax administration is weaker or inflation higher).
  - Higher inflation reduces after-tax returns on saving but could lower cost of debt finance for investment.
  - Distortions can be large even at modest inflation rates.

### Conclusions — Policy recommendations and practical approach
- Narrow, technically straightforward solutions exist (e.g., indexation of thresholds) but may face political obstacles.
- Simpler measures to reduce timing-related distortions:
  - increased use of withholding taxes,
  - increasing advance corporate income tax payments,
  - more frequent asset revaluations (e.g., of house values for property tax).
- Broader reforms improving neutrality and efficiency:
  - corporate cash-flow taxes,
  - ACE systems that tax only economic rents and avoid distorting investment decisions.
- Consistency recommendation: when adjusting tax parameters, generally use the same inflation rate throughout (e.g., thresholds adjust with a general price level measure, not with wage increases).
- Practical indexation advice:
  - Use CPI inflation for indexing because the GDP deflator is available with a lag and subject to revision.
  - For corporate incomes, avoid multiple deflators for neutrality with respect to overall inflation; do not remove relative real valuation gains/losses from inputs whose prices change differently from general inflation.
- Deflation considerations:
  - Effects operate in opposite direction: reduce specific taxes/fees/thresholds, collection lags lessen, depreciation allowances too generous, nominal capital gains fall, real value of existing debt increases.
- Practical implementation:
  - Focus on distortions with high efficiency costs and simple solutions while pursuing policies to bring inflation down.
  - Guard against second-best problems and distributional impacts—compensating measures may be required.
  - If disinflation is slow, progressively design a more inflation-proof tax system.
  - Spending-side measures (e.g., government wages) were not considered but could warrant “inflation-proofing” as fixed nominal spending can lead to cuts in real government spending.

*Source: IMF Working Paper — Introduction, Box 1, and Conclusions (excerpt).*

### Introduction ...........................................................................................................

### Introduction

### Context and motivation
- Inflation in advanced economies increased from 3.1 percent in 2021 to an estimated 7.2 percent in 2022.
- Inflation in emerging market and developing economies in 2022 is expected to reach 9.9 percent (IMF 2022a).
- While much attention has focused on drivers of inflation (monetary and fiscal policy, supply shocks such as Russia’s invasion of Ukraine and food and energy price increases), less attention has been paid to the reverse question: how higher inflation affects fiscal aggregates, the stance of fiscal policy, and interactions with the tax system.

### Scope and approach of the paper
- Draws heavily on literature from the 1970s and 1980s when this topic was last studied in detail.
- Examines how inflation impacts:
  - tax revenues,
  - marginal tax rates, and
  - effective tax rates.
- Shows that the impact of inflation on these fiscal and tax outcomes is not negligible, even at lower inflation rates.

### Mechanisms of tax non-neutrality with respect to inflation
- Defines neutrality with respect to inflation: the tax system’s impact on incentives and tax burdens does not change with inflation (not to be conflated with broader neutrality such as across investment or labor supply).
- Main distortions identified:
  - (i) Failure to adjust parameters of the tax system in line with inflation (examples: thresholds fixed in nominal terms; specific taxes set in nominal amounts).
  - (ii) Timing effects: lags with which taxes are collected and refunds paid.
  - (iii) Taxation of nominal rather than real gains and profits at both:
    - (a) household level, and
    - (b) corporate level.
- At the corporate level, taxation of nominal profits is imperfectly (and often over-) compensated by allowing the deduction of nominal rather than real interest.

### Key findings and contributions highlighted
- The paper describes each non-neutrality in more detail, drawing on existing literature and providing new illustrations and evidence.
- Demonstrates that taxation of purely inflationary income gains can have a tremendous impact on effective tax rates—even at relatively low inflation rates.
- Shows that partial adjustment for inflation (adjusting only some income types) can create additional distortions.
- Presents a new empirical analysis showing that the erosion of the value of depreciation allowances through inflation reduces investment.
- Discusses a range of policy options to address tax non-neutralities due to inflation, from targeted measures for individual distortions to more comprehensive tax reforms that may also improve tax efficiency more generally.

### Additional links and scope exclusions
- Notes further links between inflation and tax that are outside the core scope of the paper:
  - seigniorage (sometimes called the inflation tax, used metaphorically here),
  - tax policy’s macroeconomic impact on aggregate demand and inflation,
  - immediate inflationary impact of consumption taxes such as VAT or sales taxes.
- Indicates Box 1 provides brief coverage of Value-Added Tax changes and inflation.

*Source: IMF Working Paper — Introduction (excerpt).*

### Box 1. Value-Added Tax Changes and Inflation

### Box 1. Value-Added Tax Changes and Inflation

### VAT rate changes and passthrough to consumer prices
- VAT rate changes may lead to one-off increases in the consumer price index but will not affect structural inflation.
- Degree of passthrough depends on price elasticities of supply and demand:
  - Infinite supply elasticity (perfect competition) → full passthrough to consumer prices.
  - Finite supply elasticity or monopolistic markets → passthrough less than complete; equilibrium price level changes and adjustment may not be instantaneous.
- Empirical evidence (Benedek and others 2020, 17 Euro area countries, 1999–2013):
  - Full passthrough for changes in the standard rate.
  - 30 percent passthrough for changes in reduced rates.
  - No passthrough for reclassifications between rate categories.
  - Passthrough greater for durables than for non-durables.
- Implication: targeted reduced rates on specific products are unlikely to address long-term inflation and may fail to reduce short-term inflationary pressures.

### Non-adjustment of nominal tax parameters: channels and consequences
- Types of fixed nominal parameters affected by inflation:
  - Specific taxes, excises, lumpsum taxes, license fees, simplified fees, fines, fixed interest rates in tax law, and nominal thresholds for registration or higher rate brackets.
- Specific taxes and excises:
  - Intended to internalize externalities by amount consumed (real quantity), but inflation erodes real value over time leading to lower real revenues and under-internalization.
  - Some countries define specific taxes in US dollars; this offers partial protection against local inflation but exposure remains to US inflation and exchange rate movements.
- Fixed interest/penalty rates:
  - Real value of fixed nominal penalty/interest rates is eroded in inflationary times, lowering deterrent effects and potentially creating a premium for late payment if legal rate < market returns.
  - In very low inflation/negative interest periods, fixed rates can encourage overpayment if refunds carry the fixed rate.
- Thresholds and bracket creep:
  - Nominally fixed income tax brackets and allowances lead to bracket creep: inflation shifts taxpayers into higher brackets and erodes tax-free personal allowances.
  - Full inflation indexation of thresholds, or a proportional (flat) income tax starting from zero income, avoids bracket creep.
  - Empirical finding: of 160 countries with data, 131 countries do not adjust thresholds regularly (almost every year); only nine have explicit legal/administrative automatic adjustment processes (Table 1 in source).

### Solutions to erosion of specific taxes, penalties, and thresholds
- Index parameters to a reliable inflation measure; frequency depends on inflation rate:
  - Modest inflation → annual adjustment sufficient.
  - High inflation → more frequent adjustment.
- For interest/penalty rates: define as a markup over inter-bank or government bond rate to prevent creating incentives for payment delays.
- Specific taxes:
  - Fixing in a stable foreign currency offers partial protection but requires adjustment for foreign inflation and exposes to exchange rate volatility.
  - Switching from specific to ad valorem may address inflation erosion but has broader economic consequences and often is not advisable.
- Political economy:
  - Automatic indexation is technically simple and more transparent but may be politically framed as regressive because upward threshold changes often benefit higher incomes; automatic adjustment maintains real progressivity and avoids stealth tax increases.
- If tax evasion increases with inflation, devote greater resources to tax compliance during high inflation.

### Timing issues: lags in collections, refunds, depreciation, and losses
- Collection lags:
  - Taxes collected with delays are eroded in real terms by inflation, especially where systems lack elasticity, collection delays are significant, or inflation is high.
- Penalties and payment delays:
  - Real deterrent effect weakens with inflation unless penalties adjust for inflation; indexing payments or employing variable penalty interest rates recommended.
- Depreciation and loss carryforwards:
  - Depreciation deductions based on historical cost lose real value over time; losses carried forward are eroded by inflation.
- Policies to address timing issues:
  - Introduce withholding taxes / pay-as-you-earn to tax income as earned.
  - Greater reliance on advance corporate income tax adjusted for inflation if based on historic profits.
  - More frequent asset revaluations or formulaic mechanisms reflecting inflation when full revaluation is costly.
  - Index tax payments for late payment and set penalty rates that do not fall in real terms.
  - Improve tax administration to encourage electronic and more rapid payments.
  - Index depreciation allowances or allow full expensing upfront.

### Taxation of nominal household income: savings income and effective tax rates (ETRs)
- Taxing nominal returns magnifies distortion when inflation π > 0 because nominal return i reflects real return r and inflation via the Fisher relation i = (1 + r)(1 + π) − 1.
- After-tax real return formula (source equation (2)) shows additional reduction beyond statutory t:
  - Real after-tax return = r(1 − t) − tπ/(1 + π).
- Effective Tax Rate on real returns (source equation (3)):
  - ETR = t [1 + π/(r(1 + π))].
  - ETR increases with inflation and declines with r; as inflation → ∞, ETR → t/r; as r → ∞, ETR → statutory t.
- Numerical illustrations (assumed statutory tax rate = 25 percent):
  - With real rate of return 2 percent, ETR reaches 100 percent when inflation hits 6 percent.
  - With inflation at 2 percent and real return 2 percent, the ETR is doubled relative to statutory rate.
  - At current double-digit inflation in many advanced economies, ETR can far exceed 100 percent.
  - Lower real returns imply much higher ETRs; as returns approach zero, ETR tends toward infinity; with negative real returns and inflation exceeding real return, tax is still due.

### Taxation of capital gains and realization/timing effects
- Capital gains taxed on nominal gains raise real tax burdens as inflation rises because nominal gains include inflation component.
- Taxation at realization (vs. periodic taxation of dividends/interest) creates:
  - A tax preference for capital gains and a lock-in effect delaying realization.
- Multi-period analysis (source equations (4)–(8)):
  - For an n-year investment, after-tax value Vcapital gain = (1 + i)^g − t[(1 + i)^g − 1] = (1 − t)(1 + i)^g + t.
  - Tax preference for capital gains rises with inflation; longer holding periods amplify distortion and lock-in.
- Numerical illustration (assumptions: tax rate 25 percent, real return 3 percent, real discount rate 0 percent, 10-year horizon):
  - At zero inflation, ETRs for distributing vs. capital gain assets are similar (28 percent vs. 25 percent), but the difference rises dramatically with inflation in favor of capital gains.
  - One-year investments show no difference between accrued vs. realized taxation; longer-term investments exhibit higher ETRs because of compounded untaxed returns.

### Human capital
- Inflation does not change the real cost of forgone earnings for education; tax consequences arise only via bracket creep if thresholds are not indexed.
- Outright payments for education are typically not deductible; no special inflation tax consequence specific to human capital beyond general tax system design.

### Solutions to taxation of inflationary household income
- Comprehensive solution requires changing tax bases to exclude inflationary gains (e.g., Diamond 1975 deduction of inflation rate on asset values).
- Partial, selective inflation adjustments (e.g., only capital gains) can exacerbate distortions by favoring adjusted categories.
- Simplified relief (e.g., lower long-term capital gains rates) similarly intensifies preference for capital gains.

### Taxation of nominal corporate profits: timing lags, depreciation, and debt bias
- Nominal profits can be distorted by timing differences between incurring costs and recognizing revenues; when costs occur earlier than related sales, inflation can boost nominal profits and tax liabilities despite real losses.
- Depreciation allowances:
  - Historical-cost-based depreciation allowances lose NPV with inflation.
  - Declining balance method NPV formula (source equation (9)): A(π) = φ / [(1 + r)(1 + π) − (1 − φ)] with φ the depreciation share > 0 and r the real discount rate.
  - Immediate expensing (φ = 1) yields NPV = 1; other schemes yield 0 < A < 1.
  - Marginal impact of inflation on A is negative (source equation (10)).
  - Empirical parameters: mean declining balance rates for 68 countries (2017–2020):
    - buildings: 10 percent,
    - tangible assets: 25 percent,
    - intangible assets: 38 percent.
- Investment effect:
  - Semi-elasticity example (source text): with corporate tax rate 22 percent, depreciation rate 25 percent, inflation 2 percent → semi-elasticity of capital = 0.42, implying optimal investment level decreases by 0.42 percent for a one-percentage point increase in inflation.
- Debt bias and inflation:
  - Interest deductibility creates debt finance preference; inflation increases the tax advantage of debt because nominal tax-deductible interest rises with inflation.
  - The financial effect of issuing debt (source equation (16)) is increasing in inflation and reduces cost of capital for debt-financed investment.
  - Combined cost of capital depends on depreciation NPV effects and debt-finance effects (source equation (17)).
  - Optimal debt share (with agency cost parameter γ) (source equation (20)):
    - s* = A τ [ r + π/(1 + π) ].
    - Inflation raises optimal share of debt finance; effect stronger in high-tax environments.
  - A marginal increase in inflation has ambiguous effect on investment (source equation (22)); firms with low agency costs or high leverage may increase investment, others may reduce it.
  - Critical debt share s_c defined where marginal inflation leaves investment unchanged (source equation (23)); simulations show heterogeneous firm responses.

### Empirical analysis: inflationary tax effect on investment (country-level)
- Regression specification (source equation (24)) relates growth rate of real asset stock to inflation π, statutory CIT rate τ, and their interaction.
- Data: net fixed asset stocks (manufacturing) 2000–2021 from OECD Annual National Accounts; inflation from IMF WEO; tax rates from OECD Corporate Tax Rates Database.
- Table 2 main estimates (dependent variable: percentage change of real asset stock; coefficients with heteroscedasticity-robust standard errors):
  - CIT rate coefficients:
    - Construction: -0.156*** [0.038]
    - Intellectual property: -0.057 [0.081]
    - Machinery: -0.241*** [0.064]
    - ICT: -0.167 [0.236]
  - Inflation coefficients:
    - Construction: 0.109 [0.084]
    - Intellectual property: -0.195 [0.202]
    - Machinery: -0.111 [0.119]
    - ICT: -0.145 [0.800]
  - CIT rate * Inflation interaction:
    - Construction: -0.014* [0.008]
    - Intellectual property: -0.029* [0.017]
    - Machinery: -0.035** [0.017]
    - ICT: -0.043 [0.053]
  - Observations: Construction 500, Intellectual property 522, Machinery 520, ICT 401.
  - Adjusted R2: 0.561, 0.448, 0.63, 0.228 respectively.
- Interpretation:
  - Investments decrease between 0.06 percent (intellectual property) and 0.24 percent (machinery) in response to a one percentage point increase in the CIT rate when inflation at median 4 percent in sample.
  - Interaction terms negative and significant for construction, intellectual property, and machinery → eroding depreciation allowances outweigh benefits from debt financing for these asset types.
  - Example: for machinery, when price level increases by 2 percent annually, estimated semi-elasticity with respect to CIT = 0.17 percent (= -0.241 + 2×0.035); at inflation 10 percent, semi-elasticity = 0.45 percent (= -0.241 − 6×0.035).

### Solutions to taxation of inflationary corporate profits
- Fiscal-unit accounting: compute taxes in an inflation-adjusted unit of account (conversion yearly/quarterly/monthly/daily); addresses timing but costly to administer and prone to manipulation.
- Country experiences:
  - Israel (law 1982): allowance for inflation applied to equity, depreciation calculated at end-of-year prices; complexity and loopholes noted; law effectiveness never fully tested as inflation fell before full phase-in.
  - Brazil: monetary correction (1976) and “integral correction” (1987) variants used for real income calculation; tax treatment incomplete and some inflationary gains (e.g., inventory gains) still taxed.
- Tax reform options that yield inflation neutrality:
  - R-based cash flow tax (Meade 1978): immediate expensing of investment and disregard of financial flows → neutral to inflation and to debt/equity mix.
  - Allowance for Corporate Equity (ACE): deductible notional interest on equity to align treatment of equity and debt; neutral to depreciation allowances and to inflationary impacts on them.

*Italic: Source: IMF Working Paper — Box 1. Value-Added Tax Changes and Inflation (from wpiea2023018-print-pdf).*

### Conclusions

### Conclusions

### Overview
- The paper grouped the impact of inflation on the tax system into three main categories: (1) non-neutralities from tax parameters defined in nominal rather than real terms; (2) non-neutralities caused by timing issues; and (3) distortions from tax bases defined in nominal terms so that nominal rather than real income is taxed.

### Non-neutralities from nominal tax parameters
- Specific taxes or fees: in real terms revenues decline with inflation.
- Fixed nominal interest rate charges on overdue payments: lower real rates as inflation rises, making payment delays less costly; could encourage payment delays (for example for negative real interest rates) and thus gradually weaken tax compliance.
- Fixed nominal thresholds for paying taxes or “bracket creep”: typically results in higher real taxes, assuming a progressive income tax system.

### Non-neutralities from timing issues
- Collection lags: revenues decline with inflation since they are worth less in real terms by the time they are collected; can encourage payment delays (without necessarily becoming overdue).
- Lags in paying refunds: have the opposite effects to collections.

### Distortions from taxing nominal rather than real incomes and deductions
- Taxation of the nominal return on savings (rather than just the real return): higher inflation leads to higher tax payments and thus a further reduction in the real after-tax rate of return.
- Taxation of nominal rather than real capital gains: higher inflation leads to higher capital taxation and increases lock-in effects (since this higher taxation only occurs on realization).
- Loss in the real value of depreciation allowances that are fixed in nominal terms: higher real revenues but at the cost of discouraging investment.
- Higher inflation increases nominal debt interest payments, allowing greater deductibility from taxable income and increasing the bias towards debt over equity.

- Note: the cutoff between these three groups is at times arbitrary. The impact of depreciation allowances is both a timing issue (depreciation is only allowed over time) and a nominal-terms issue (allowances typically specified in nominal terms). Taxation of nominal capital gains is driven by delay in taxing gains (realization) and by failure to index for inflation.

### Net effects and revenue implications
- Since various effects can act against each other, it is hard to draw general conclusions about the impact of inflation on tax revenues, though it seems likely that for a given tax system inflation increases the extent of tax distortions.
- Revenue gains from bracket creep (larger in countries with progressive income tax systems, typically higher income countries) need to be offset against revenue loss from collection delays (more important for countries with weaker tax administration or higher inflation rates).
- In terms of incentives for savings and investment: higher inflation reduces the after-tax rate of return on saving but could lower the cost of debt finance of investment.
- The impact of the various distortions identified can be quite large, even at relatively modest inflation rates.

### Solutions and policy recommendations
- Narrow, technically straightforward solutions exist for many problems, though they may face political obstacles—for example, adjusting basic tax-system parameters in line with inflation.
- Comprehensive solutions addressing all timing issues and taxation of nominal gains would be complex.
- Simpler measures that would reduce timing-related distortions (though not eliminate them) include:
  - increased use of withholding taxes,
  - increasing advance corporate income tax payments,
  - more frequent asset revaluations (for example, of house values for property tax).
- Broader tax reforms that improve neutrality and efficiency include corporate cash-flow taxes or ACE systems; they tax only economic rents and thereby avoid distorting investment decisions.
- For simplicity and to preserve neutrality, when adjusting tax parameters (thresholds, interest rates on overdue tax payments, specific taxes, measurement of capital income), the same inflation rate should generally be used throughout.
  - Example: if the fuel price increases, the fuel duty would increase but only in line with increases in the general price level.
  - Example: thresholds would not increase with wage increases, but only with some general measure of price increases.
- Because the GDP deflator is only available with a lag and is subject to revision, indexing or adjusting parameters based on CPI inflation is suggested.
- For corporate incomes, avoid using multiple deflators for neutrality with respect to overall inflation; relative real valuation gains or losses from inputs whose prices change at different rates from general inflation need not be removed from the tax base.

### Considerations for deflation
- Effects operate in the opposite direction under deflation:
  - specific taxes, fees, interest rates, thresholds would need to be reduced in line with deflation;
  - collection lags and payment delays would lessen endogenously, with possible incentives for pre-payment if positive balances earn interest;
  - depreciation allowances would be too generous;
  - nominal capital gains and hence capital income taxes would fall as real gains due to deflation would escape tax;
  - the value of the interest rate deduction would fall since nominal interest rates would be lower, and the real value of existing debt would increase as price levels fall.

### Practical approach and caveats
- Given the difficulty of comprehensively addressing all inflation-induced distortions, a practical approach is to focus on distortions where efficiency costs are likely high and solutions are relatively simple, while simultaneously pursuing policies to bring inflation down.
- This approach must guard against second-best problems and consider distributional impacts, which may require compensating measures.
- If the downward path to desired inflation levels takes longer, this strengthens the need for gradually designing a more inflation-proof tax system along the lines considered in the paper.
- Measures on the spending side (including government wages) were not considered in this paper but could also warrant “inflation-proofing” because inflation combined with fixed nominal spending totals may lead to cuts in real government spending.

*Tax Distortions from Inflation: What are they and How to Deal with them? Working Paper No. WP/23/18*

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_Source: https://www.imf.org/-/media/files/publications/wp/2023/english/wpiea2023018-print-pdf.pdf_