Share Values, Inflation, and Escalating Tax Rates

The interaction of inflation with a progressive tax system has been known to cause tax rates, and thus tax liabilities, to escalate with nominal income. Often blamed for having undesirable effects on investment and wealth, this feature of modern tax systems has not received formal treatment in the literature. The partial-equilibrium valuation model presented is used to examine the impact of escalating tax rates on the value of corporate equity. It is shown that the combination of moderate inflation and mildly progressive tax rates may have a substantial adverse effect on share values, an effect sharply increasing with the firm's real growth rate. A by-product of the analysis is a partial equilibrium explanation for the apparent conflict between the Fisherian hypothesis and the commonly observed inverse relationship between the rate of inflation and the deflated value of stock prices. To the extent that occasional adjustments of the tax schedule do not prevent taxpayers from being pushed toward higher tax brackets, these results suggest a sizable potential benefit from full indexation of tax rates in an economy suffering from chronic inflation. These results also confirm the belief that failure to do so is especially harmful to economic growth