This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: The Costs and Benefits of Price Stability Volume Author/Editor: Martin Feldstein, editor Volume Publisher: University of Chicago Press Volume ISBN: 0-226-24099-1 Volume URL: http://www.nber.org/books/feld99-1 Publication Date: January 1999 Chapter Title: Excess Capital Flows and the Burden of Inflation in Open Economies Chapter Author: Mihir A. Desai, James R. Hines, Jr. Chapter URL: http://www.nber.org/chapters/c7775 Chapter pages in book: (p. 235 - 272) 6 Excess Capital Flows and the Burden of Inflation in Open Economies Mihir A. Desai and James R. Hines Jr. 6.1 Introduction Access to the world capital market provides economies with valuable bor- rowing and lending opportunities that are unavailable to closed economies. At the same time, openness to the rest of the world has the potential to exacerbate, or to attenuate, domestic economic distortions such as those introduced by taxation and inflation. This paper analyzes the efficiency costs of inflation-tax interactions in open economies. The results indicate that inflation’s contribu- tion to deadweight loss is typically far greater in open economies than it is in otherwise similar closed economies. This much higher deadweight burden of inflation is caused by the international capital flows that accompany inflation in open economies. Small percentage changes in international capital flows now represent large resource reallocations given two decades of rapid growth of net and gross capi- tal flows in both developed and developing economies. For example, the net capital inflow into the United States grew from an average of 0.1 percent of GNP in 1970-72 to 3.0 percent of GNP in 1985-88. Gross capital flows have also expanded rapidly, as indicated by the growth of international loans from a stock of 5 percent of GNP in industrial countries in 1973 to 17 percent of GNP in 1989 (International Monetary Fund [IMF] 1991). Similarly, the ratio of the stock of foreign direct investment in the United States to U.S. GNP grew from 1.2 percent in 1972 to 7.4 percent in 1990 (Graham and Krugman 1991). Mihir A. Desai is assistant professor of business administration at Harvard Business School. James R. Hines Jr. is professor of business economics at the University of Michigan Business School and a research associate of the National Bureau of Economic Research. The authors thank Kathryn Dominguez, Martin Feldstein, Jeffrey Frankel, Erzo Luttmer, James Poterba, and Shang-Jin Wei for helpful comments on an earlier draft. 235 236 Mihir A. Desai and James R. Hines Jr. Inflation rate differences have the potential to reroute much of this interna- tional capital because prices inflate at widely different rates around the world. For example, average inflation rates from 1973 to 1989 among OECD coun- tries range from 3.8 percent for Germany to 10.6 percent for the United King- dom. Variation in inflation experiences is even greater in the developing world, with Malaysia averaging 4.6 percent and Bolivia 206.7 percent during the same period.' The analysis in this paper starts by considering the effects of inflation on saving and investment when governments provide nominal depreciation ac- counting for tax purposes, firms are able to deduct nominal interest payments, and individual savers are taxed on their nominal interest receipts and capital gains. The model then incorporates open economy considerations, including the taxation of foreign exchange gains and losses, international portfolio capi- tal mobility, and foreign direct investment. The welfare effects of inflation in open domestic and foreign economies are then compared to those in closed economies. The main finding of this analysis is that inflation in an open economy can generate worldwide reallocations of capital with large associated efficiency consequences. As such, the international dimensions of the effects of inflation are properly considered together with effects that are well known from con- ventional closed economy analyses. Furthermore, the international effects of inflation-tax interactions suggest that there may be possibilities for efficiency gains through international coordination of monetary and fiscal policies. Section 6.2 of the paper reviews the effects of inflation in closed and open economies with nominal-based tax systems. Section 6.3 develops an open economy model incorporating inflation-tax interactions and uses the model to analyze the effect of domestic inflation on domestic and foreign interest rates, saving, and investment. Section 6.4 translates the real effects of inflation into efficiency terms in order to contrast its welfare consequences in open and closed economies. Sections 6.5 and 6.6 generalize the model to include consid- eration of imperfect international capital mobility and foreign direct invest- ment, respectively. Section 6.7 is the conclusion. 6.2 Inflation and Taxation in Closed and Open Economies Irving Fisher's (1930) hypothesis that nominal interest rates rise by exactly the rate of inflation (dr/d~= 1, in which r is the nominal rate of interest and T the inflation rate) was once thought to carry the strong implication that infla- tion does not influence the size of the capital stock because real interest rates and therefore real borrowing costs would not change with inflation. Mundell 1. Data drawn from Romer (1993). These figures represent average annual changes in log GDP, or GNP deflators, from 1973 to 1989. 237 Excess Capital Flows and Inflation in Open Economies (1963) and Tobin (1965) dispute this conclusion, noting that inflation could raise the capital intensity of an economy through its effect on the demand for liquidity. As nominal interest rates increase, the cost of holding nominal money balances rises, thereby shifting portfolio demand from money to real capital and putting downward pressure on interest rates (dr/dn < 1). Subsequent work by Darby (1975) and Feldstein (1976) argues that inflation is likely to have the opposite effect on interest rates (dr/dn> 1) in realistic settings in which savers pay taxes on interest receipts and borrowers deduct interest payments. Darby and Feldstein observe that the tax structure is based on nominal val- ues. In particular, nominal interest payments are deductible and nominal inter- est receipts are taxed. As a consequence, inflation has two countervailing ef- fects. Since lenders are taxed on the pure inflation component of interest rates, higher rates of inflation reduce their after-tax returns. At the same time, bor- rowers deduct their nominal interest payments, and therefore, higher rates of inflation reduce their after-tax borrowing costs. The net effect of inflation on the real rate of interest depends on the difference between tax rates applicable to savers and borrowers. Darby and Feldstein conclude that nominal rates rise by more than the rate of inflation (the modified Fisher hypothesis, or dr/dT > 1) and that inflation may influence the size of the capital stock in a closed economy. Even after incorporating liquidity effects, Feldstein concludes that, for plausible parameter values, inflation is likely to depress the capital stock of a closed economy through its interaction with the tax structure. While these initial models are limited by their exclusive consideration of investments that are fully debt financed and tax systems that permit assets to be depreciated at economic rates, the results have been extended to consider alternative means of financing and historic cost depreciation (see Feldstein, Green, and Sheshin- ski 1978; Feldstein 1983). Hartman (1979) extends this analysis to open economy settings. In particu- lar, he reconsiders the implication that nominal interest rates rise by more than the rate of inflation. In an open economy with flexible exchange rates and pur- chasing power parity, Hartman concludes that capital flows will remove any real interest rate differentials caused by interactions between tax systems and inflation. In Hartman’s model, inflating countries receive capital inflows that prevent interest rates from rising more than one-for-one with inflation. Howard and Johnson (1982) extend this logic to suggest that the interaction of inflation and taxation could result in either a worldwide reallocation of capital as sug- gested by Hartman or a violation of purchasing power parity. More recent in- vestigations focus on ways in which details of tax structure may imply some- thing other than the Hartman result. Sorenson (1986) notes that the differential taxation of exchange gains and losses can generate an outcome in which the inflating country does not receive capital inflows, while Sinn (1991) shows that inflation in countries with tax systems that use historic cost depreciation may also have effects other than those Hartman posits. Bayoumi and Gagnon (1996) 238 Mihir A. Desai and James R. Hines Jr. suggest that inflation-taxation interactions can explain observed patterns in capital flows between developed countries. International evidence of the relationship between nominal interest rates and inflation provides tests of these theories. Hansson and Stuart (1986) survey empirical work suggesting that dr/dr is close to or less than unity, thereby rejecting the modified Fisher hypothesis. More recent empirical work closely examines certain aspects of this evidence. In particular, Mishkin (1992) ana- lyzes the stochastic trends underlying inflation and interest rates to distinguish between the absence of a short-run Fisher effect and the presence of a long- run Fisher effect. 6.3 A Model of a Small Open Economy with Taxation In order to assess the effect of interactions between inflation and taxation in open economies, it is helpful to review the reasoning that underlies Hartman's (1979) analysis. This framework is then applied to a more general model of saving and investment in a small open economy. 6.3.1 The Fisher Effect in a Small Open Economy with Taxation Consider the case of a small open (home) economy.