Nominal interest rates, expected inflation and varying marginal income tax rates

Sadhana Alangar and Scott Hein

Applied Financial Economics, 1999, vol. 9, issue 2, 209-214

Abstract: This paper reconsiders the empirical work of Tanzi which examines the link between nominal interest rates and expected inflation. Tanzi did not undertake a direct test of the Darby relationship, as a result of a specification flaw. This paper provides evidence correcting for this flaw. It still remains the case, however, that evidence of fiscal illusion persists. The paper further provides evidence that there is important information in the empirical specification of the Fisher relationship, the Darby relationship, and the Tanzi relationship which is not included in either of the other two models. This evidence suggests a general model incorporating aspects of all three specifications. Most interestingly, the evidence from the general model suggests a fiscal perversion, in which interest rates are less responsive to changes in expected inflation, the higher the marginal tax rate.

Date: 1999
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DOI: 10.1080/096031099332474

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