Monetary Policy, Taxes, and the Business Cycle
FRB of St. Louis Working Paper No. 2004-017B
44 Pages Posted: 29 Jul 2005
Date Written: May 2006
In this paper, we model the interaction of inflation with the tax on nominal capital gains, examining the contribution of this interaction to aggregate fluctuations. Our innovation is to combine monetary policy shocks with non-indexed taxes in a model in which the central bank implements policy using an interest rate rule. Monetary policy shocks enter as persistent shocks to the inflation objective. The use of an interest rate rule makes these shocks highly persistent, leading to persistent changes in the expected marginal tax rate on capital gains. We find that monetary policy had important effects on the behavior of the business cycle before 1980 because the shocks to inflation were large and persistent. Monetary policy reform around 1980 led to a decline in persistence of shocks to inflation. With this lower persistence, the effect of the interaction between monetary policy and the nominal capital gains tax becomes negligible.
Keywords: Inflation, taxation, business cycle
JEL Classification: E31, E32, E42
Suggested Citation: Suggested Citation