Inflation, Taxation, and Interest Rates



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    • Vice President, Citibank New York and NBER. I would like to thank Henry Korytkowski for his help in preparing this paper. I would also like to thank Michael Darby for his helpful comments on an early draft and express my appreciation to the editor and James Pesando who made many helpful suggestions.


This paper demonstrates that the response of nominal interest rates to changes in inflationary expectations should lie between that predicted by the “Fisher” and “Darby” effects. The exact nature of the response will depend on the relative size of the income and capital gains tax rates, and the relative size of the derivatives of investment and savings to their respective after-tax real rates. The other major conclusion of this paper is that capital gains taxation offsets the negative effect on investment produced by treating depreciation on a historic rather than a replacement cost basis.