Taxation of capital gains on foreign exchange transactions and the non- neutrality of changes in anticipated inflation

In a two-country world with perfect capital markets and no taxes, the existence of purchasing power parity is fully consistent with interest party and the equalization of real interest rates across countries. In such a world, changes in anticipated inflation in either country will not alter the world equilibrium real interest rate. If asset returns are taxed, the existence of taxes may drive a wedge between real after-tax interest rates, and changes in anticipated inflation may create arbitrage opportunities, thereby creating capital flows between countries and thereby altering equilibrium interest-rate differentials. ; The purpose of this paper is twofold. First, the paper demonstrates that the source of the wedge between real rates is not the existence of a tax on interest income (as argued in the literature on this subject) but instead the implicit assumption that capital gains are taxed as if they were interest income. Second, the paper attempts to clarify the conditions under which the basic proposition first argued by Howard and Johnson (1982) holds "exactly" (rather than as an approximation)--the proposition that in a world in which interest income is taxed, both purchasing power parity and equalization of real after-tax interest-rates (or constancy of the real after-tax interest-rate differential) cannot hold simultaneously. Furthermore, cases in which real returns are taxed are also considered.