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

Expected inflation has few real effects in purely private economies, but this is not the case when the tax system is not neutral with respect to inflation. In practice, tax systems are not neutral—though some have attempted to be so in the past—and this paper provides a comprehensive overview of the most relevant non-neutralities drawing both on existing literature and showing new illustrations and evidence of the effects. The paper shows, for example, how taxing inflationary gains can have tremendous impact on effective tax rates—even at relatively low rates of inflation. It also shows how partial adjustment—for only some types of incomes—can create additional distortions. A new empirical analysis reveals how the erosion of the value of depreciation allowances through inflation affects investment. Finally the paper discusses policy options to address such non-neutralities.