Inflation and the Tax System in Canada: An Exploratory Partial-Equilibrium Analysis

This paper reports on an exploratory application to Canadian data of an approach pioneered by Martin Feldstein (1997, 1999). Feldstein finds that even at low inflation rates there are costs arising from the distortions introduced by the interaction of inflation with the taxation of income from capital (capital gains, dividends, and interest) in a less-than-perfectly-indexed tax system. Given the exploratory nature of our work, only the main aspects of the conceptual basis of this approach are sketched, and very rough-and-ready estimates for inputs and outputs reported. The economically significant welfare costs of inflation obtained when this approach is applied to Canada arise mainly from distortions in the timing of consumption and saving. However, our reservations about the approach have not led us to refine the estimates or to indicate a preferred estimate.