Monetary Policy, Taxes, and the Business Cycle

In this paper, we model the interaction of inflation with the tax on nominal capital gains, examining the contribution of this interaction to aggregate fluctuations. Our innovation is to combine monetary policy shocks with non-indexed taxes in a model in which the central bank implements policy using an interest rate rule. Monetary policy shocks enter as persistent shocks to the inflation objective. The use of an interest rate rule makes these shocks highly persistent, leading to persistent changes in the expected marginal tax rate on capital gains. We find that monetary policy had important effects on the behavior of the business cycle before 1980 because the shocks to inflation were large and persistent. Monetary policy reform around 1980 led to a decline in persistence of shocks to inflation. With this lower persistence, the effect of the interaction between monetary policy and the nominal capital gains tax becomes negligible