Optimal inflation with corporate taxation and financial constraints

Daria Finocchiaro, Giovanni Lombardo, Caterina Mendicino and Philippe Weil

No 520, BIS Working Papers from Bank for International Settlements

Abstract: This paper revisits the equilibrium and welfare effects of long-run inflation in the presence of distortionary taxes and financial constraints. Expected inflation interacts with corporate taxation through the deductibility of i) capital expenditures at historical value and ii) interest payments on debt. Through the first channel, inflation increases firms' taxable profits and further distorts their investment decisions. Through the second, expected inflation affects the effective real interest rate, relaxes firms' financial constraints and stimulates investment. We show that, in the presence of collateralized debt, the second effect dominates. Therefore, in contrast to earlier literature, we find that when the tax code creates an advantage of debt financing, a positive rate of long-run inflation is beneficial in terms of welfare as it mitigates the financial distortion and spurs capital accumulation.

Keywords: optimal monetary policy; Friedman rule; credit frictions; tax benefits of debt (search for similar items in EconPapers)
Pages: 39 pages
Date: 2015-10
New Economics Papers: this item is included in nep-acc, nep-cba, nep-dge and nep-pbe
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Related works:
Journal Article: Optimal inflation with corporate taxation and financial constraints (2018)
Working Paper: Optimal Inflation with Corporate Taxation and Financial Constraints (2018)
Working Paper: Optimal Inflation with Corporate Taxation and Financial Constraints (2018)
Working Paper: Optimal Inflation with Corporate Taxation and Financial Constraints (2017)
Working Paper: Optimal Inflation with Corporate Taxation and Financial Constraints (2015)
Working Paper: Optimal Inflation with Corporate Taxation and Financial Constraints (2015)
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