Optimal Inflation With Corporate Taxation and Financial Constraints

Riksbank Research Paper Series No. 135

Sveriges Riksbank Working Paper Series No. 311

38 Pages Posted: 18 May 2016

See all articles by Daria Finocchiaro

Daria Finocchiaro

Sveriges Riksbank - Research Division

Giovanni Lombardo

Bank for International Settlements (BIS)

Caterina Mendicino

Bank of Portugal; European Central Bank (ECB) - Directorate General Research

Philippe Weil

Université Libre de Bruxelles (ULB) - European Center for Advanced Research in Economics and Statistics (ECARES); Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: September 2015

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 negatively, 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

JEL Classification: E31, E43, E44, E52, G32

Suggested Citation

Finocchiaro, Daria and Lombardo, Giovanni and Mendicino, Caterina and Weil, Philippe, Optimal Inflation With Corporate Taxation and Financial Constraints (September 2015). Riksbank Research Paper Series No. 135. Available at SSRN: https://ssrn.com/abstract=2780362 or http://dx.doi.org/10.2139/ssrn.2780362

Daria Finocchiaro (Contact Author)

Sveriges Riksbank - Research Division ( email )

S-103 37 Stockholm
Sweden

Giovanni Lombardo

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

Caterina Mendicino

Bank of Portugal ( email )

Rua Francisco Ribeiro, 2
Lisbon, 1150-165
Portugal

European Central Bank (ECB) - Directorate General Research ( email )

Kaiserstrasse 29
D-60311 Frankfurt am Main
Germany

Philippe Weil

Université Libre de Bruxelles (ULB) - European Center for Advanced Research in Economics and Statistics (ECARES) ( email )

Ave. Franklin D Roosevelt, 50 - C.P. 114
Brussels, B-1050
Belgium
+32 2 650 4220 (Phone)
+32 2 650 4475 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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