Discussion Paper Details

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Title: Optimal Inflation with Corporate Taxation and Financial Constraints

Author(s): Daria Finocchiaro, Giovanni Lombardo, Caterina Mendicino and Philippe Weil

Publication Date: September 2015

Keyword(s): credit frictions, Friedman rule, optimal monetary policy and tax benefits of debt

Programme Area(s): Macroeconomics and Growth and Monetary Economics and Fluctuations

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 firmsí taxable profits and further distorts their investment decisions. Through the second, expected inflation affects the effective real interest rate negatively, relaxes firmsí 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.

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Bibliographic Reference

Finocchiaro, D, Lombardo, G, Mendicino, C and Weil, P. 2015. 'Optimal Inflation with Corporate Taxation and Financial Constraints'. London, Centre for Economic Policy Research.