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

IMF Working Papers, January 27, 2023

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Expected inflation has few real effects in purely private economies, but tax systems that are not neutral with respect to inflation produce real distortions.
The paper provides a comprehensive overview of the most relevant non-neutralities, drawing on existing literature and presenting new illustrations and evidence of the effects.
The analysis highlights how taxing inflationary gains and partial adjustment across income types generate substantial distortions, and it includes a new empirical analysis on depreciation allowances and investment.

Taxing inflationary gains can have tremendous impact on effective tax rates — even at relatively low rates of inflation.
Partial adjustment of tax parameters for inflation — applying to only some types of incomes — can create additional distortions.
Erosion of the value of depreciation allowances through inflation negatively affects investment (documented in a new empirical analysis).

Presents new empirical evidence on how inflation erodes the NPV of depreciation allowances and the implications for the cost of capital and investment decisions.
Highlights interactions between expected inflation, depreciation treatment, and the effective tax burden on savings and investment.

Discusses policy options to address non-neutralities in tax systems induced by inflation.
Reviews approaches to reduce taxation of inflationary gains and to improve neutrality across income types.
Emphasizes the importance of addressing the erosion of depreciation allowances to avoid adverse effects on investment.

Subjects: Depreciation, Income, Income tax systems, Inflation, Labor, National accounts, Non-wage benefits, Prices, Taxes
Keywords: Africa, bracket creep., cost of capital, Depreciation, expected inflation, Global, impact of inflation, Income, Income tax systems, inflation, Non-wage benefits, NPV of depreciation, rate of return, savings income, tax distortions from inflation, Tax policy