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Inflation, Tax Rules, and the Long Term-Interest Rate



Inflation, Tax Rules, and the Long-Term Interest Rate MARTIN FELDSTEIN National Bureau of Economic Research and Harvard University LAWRENCE SUMMERS National Bureau of Economic Research and Harvard University Inflation, Tax Rules, and the Long- Term Interest Rate ALTHOUGH the return to capital is a focus of research in both macroeco- nomics and public finance, each specialty has approached this subject with an almost total disregard for the other's contribution. Macroeco- nomic studies of the effect of inflation on the rate of interest have im- plicitly ignored the existence of taxes and the problems of tax deprecia- tion.' Similarly, empirical studies of the incidence of corporate tax changes have not recognized that the effect of the tax depends on the rate of infla- tion and have ignored the information on the rate of return that investors receive in financial markets.2 Our primary purpose in this paper is to begin Note: This study is part of the program of Research on Business Finance and Taxation of the National Bureau of Economic Research. We are grateful to the National Science Foundation for financial support, to several colleagues for useful discussions, and to Dale Jorgenson and Barbara Fraumeani for making unpublished data available. This paper has not been reviewed by the Board of Directors of the National Bureau. 1. For a review of recent empirical studies, see Thomas J. Sargent, "Interest Rates and Expected Inflation: A Selective Summary of Recent Research," Explora- tions in Economic Research, vol. 3 (Summer 1976), pp. 303-25. This criticism ap- plies also to Martin Feldstein and Otto Eckstein, "The Fundamental Determinants of the Interest Rate," Review of Economics and Statistics, vol. 52 (November 1970), pp. 363-75, and Martin Feldstein and Gary Chamberlain, "Multimarket Expectations and the Rate of Interest," Journal of Money, Credit, and Banking, vol. 5 (November 1973), pp. 873-902. 2. The prominent econometric studies include Marian Kr

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