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This paper analyzes the interaction of inflation with the tax code and its contribution to aggregate fluctuations. We find significant effects operating through the tax on realized nominal capital gains. A tax on nominal bond income magnifies these effects. Our innovation is to combine monetary policy shocks with non-indexed taxes in a model where the central bank implements policy using an interest rate rule. Monetary policy had important effects on the behavior of the business cycle before 1980 because policymakers did not exert effective control over inflation. Monetary policy reform around 1980 led to better control, and with more stable inflation, the effect of the interaction between monetary policy and the nominal capital gains tax has become negligible.

Does the interaction of inflation and the tax code contribute considerably to aggregate fluctuations? There is a large body of work showing that the steady-state welfare effects of moderate inflation are large when nominal capital gains are taxed. These include the partial equilibrium analyses of Fischer (1981), Feldstein (1997), and Cohen et al. (1999).1 The literature also includes the steady-state analysis of general equilibrium models in Abel (1997), Leung and Zhang (2000), and Bullard and Russell (2004). In general equilibrium, the welfare costs arise because, for any given capital income tax rate, an increase in the inflation rate raises the real pre-tax rate of return to capital and lowers the after-tax return. The lower after-tax return causes a decline in the capital stock and a reduction in labor productivity. These analyses are about steady states and only suggestive about the cyclical impacts. This paper examines the dynamic implications for the interaction between inflation and the capital gains tax. We specify a dynamic, stochastic, general equilibrium model that combines monetary policy shocks with taxes on nominal capital gains in a setting where the central bank implements policy using an interest rate rule. The use of an interest rate rule makes inflation highly persistent, leading to persistent changes in the expected marginal tax rate on real capital gains. We find that monetary policy had important effects on the behavior of the business cycle before 1980 because the Fed did not respond aggressively to inflation shocks that were highly persistent. Monetary policy reform around 1980 led to lower and more stable inflation. A more credible commitment to price stability and a more aggressive response to inflation shocks has led to less persistent inflation dynamics and effectively eliminated the cyclical effects of the interaction between monetary policy and the nominal capital gains tax. Inflation persistence induces changes in expected tax rates. Dittmar et al. (2005) show that inflation persistence is common in models where the central bank uses an interest rate rule. When the central bank is using an interest rate rule, a persistent shock to the inflation trend appears as a shock to the inflation target. It leads to a persistent deviation of inflation from the steady state and, in the presence of a nominal tax on capital gains, causes a persistent change in the effective marginal tax rate on capital. Thus, a positive shock to the inflation objective distorts the consumption/saving decision and may have a long-lasting effect on capital accumulation.2 The next section describes the model with taxes on realized nominal capital gains as well as on income from labor, capital, and bonds. We then consider the model dynamics, showing how inflation affects the business cycle through the tax on nominal capital gains. As it turns out, only the taxes on capital gains and bond income are important for business cycle dynamics. The bond tax only matters if there is also a tax on capital gains. Note that the current U.S. tax code continues to tax nominal income from bonds and realized capital gains. Finally, the model is used with the history of inflation shocks and estimates of inflation persistence to show how the interaction of monetary policy with the tax code has affected capital, hours, and productivity in the U.S. economy.

When the central bank operates with an interest rate, persistent shocks to the inflation target can have large real effects on the business cycle if the tax system is not indexed for inflation. In our model, there is a tax on realized nominal capital gains. The business cycle effects of inflation interacting with the tax code were large before 1980 both because the shocks to the inflation target were highly persistent and because the Fed responded weakly to deviations of inflation from target. Monetary policy reform around 1980 led to better control of inflation, and with more stable inflation, the effect of the interaction between monetary policy and the nominal capital gains tax has become negligible. We present a model of the capital gains realization problem in a representative agent setting. Using a common calibration for all parameters except for those in the monetary policy function, we find that bad monetary policy may partially explain the slowdown in productivity growth before 1980. The upward trend in the average inflation rate interacted with the tax on nominal capital gains to reduce productivity growth in the 1960s and 1970s. Better policy after 1980 may partially explain the revival of productivity and the lower variability of real variables since then. We find that accrual equivalent capital gains tax rate of 4 percent results in the same welfare costs of a 10 percent inflation as we get with the realization based tax and a 20 percent tax rate. This estimate of an accrual-equivalent rate is in line with earlier estimates by Bailey (1969) and Protopapadakis (1983). We also find that the business cycle effects of the 4 percent accrual-equivalent tax are about the same as the effects using a 20 percent tax on realized gains. Our study is aimed at understanding business cycle effects, not welfare effects. The welfare effects of these taxes may be quite large even if the cyclical effects are negligible. The results in this paper suggest that taking account of them would be important for understanding the nature of the U.S. economy, especially before 1980. One explanation given for the relative stability of the post-1980 economy is that monetary policy was much improved. This article demonstrates one channel for real effects of monetary policy that is consistent with that explanation.