Share values, inflation, and escalating tax rates

Dan Palmon, Uzi Yaari

Research output: Contribution to journalArticlepeer-review

1 Scopus citations

Abstract

The interaction of inflation with a progressive tax system has been known to cause tax rates, and thus tax liabilities, to escalate with nominal income. Often blamed for having undesirable effects on investment and wealth, this feature of modern tax systems has not received formal treatment in the literature. The present study examines the impact of this inflation-related phenomenon upon the value of corporate equity within the framework of partial equilibrium. It is shown that the combination of moderate inflation and a mildly progressive rate structure may have a substantial adverse effect on share values, an effect sharply increasing with the firm's real growth rate. These results provide a partial explanation for the apparent conflict between the Fisherian hypothesis and the commonly observed inverse relationship between the rate of inflation and the deflated value of stock price indices. To the extent that occasional adjustment of tax schedules does not prevent taxpayers from being pushed toward higher tax brackets, these results suggest a sizable potential benefit from full indexation of tax rates in an economy suffering from chronic inflation. They also confirm the belief that failure to do so is expecially harmful to economic growth.

Original languageEnglish (US)
Pages (from-to)395-403
Number of pages9
JournalJournal of Banking and Finance
Volume5
Issue number3
DOIs
StatePublished - Sep 1981

All Science Journal Classification (ASJC) codes

  • Finance
  • Economics and Econometrics

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