Stock Prices Under Inflation with Taxation of Nominal Gains

Excess taxation of capital gains is a by-product of inflation in a tax system that uses nominal values as its basis. Studies by Feldstein, Green and Sheshinsky [JPE 1978] and Feldstein and Slemrod [NBER WP 234, 1978] analyze related macroeconomic distortions associated with corporate stock investments by individuals under the U.S. tax system. In a departure from previous works, this study uses a share valuation model [Palmon and Yaari, NYU GSBA, WP No. 78-137, 1978] to examine the interaction between inflation and capital gains tax at the level of the firm, where those distortions are determined. Effects of inflation through this tax are isolated by assuming that other inflation-caused distortions have been removed. (Other inflation-related distortions are treated by Palmon and Yaari [JBF 1981].) Here are the main findings. (a) Under prevailing rates of tax and inflation, and tax deferral practices, the adverse effect of inflation on common equity values is substantial. (b) The contribution of inflation to the overall tax burden is moderate. (c) The adverse effect of inflation on stock prices increases with the real growth rate, while the proportional contribution of this effect to the overall tax burden decreases with the growth rate. (d) The effect of tax deferral on the overall tax burden is likely to be small; its contribution to the (small) impact of capital gains tax and its effect on price may be significant - but smaller than predicted by previous writers. (e) Under prevailing conditions in the U.S., the inflation-produced distortion in capital allocation may be significant