"Price stability would produce permanent annual dividends equal to about 1 percent of GDP."
In the popular press, the glowing reviews of America's so-called "Goldilocks" economy -- not too hot, not too cold -- focus on what is often viewed as a battle won: the conquering of inflation. In Capital Income Taxes and the Benefits of Price Stability (NBER Working Paper No. 6200), NBER President Martin Feldstein argues that, given the way inflation interacts with American tax law, even the current relatively low inflation rate does significant damage to the economy. And he asserts that the gains from bringing inflation closer to zero or "price stability" would easily offset the pain of getting there.
In his analysis of the U.S. economy, Feldstein cites evidence that reducing inflation from 2 percent to zero would inflict a "one-time" loss (because of a temporarily higher level of unemployment) equal to about 6 percent of GDP. But the resulting price stability would produce permanent annual dividends equal to about 1 percent of GDP, he argues. And, unlike the "one-time" loss, those annual dividends would continue forever. Furthermore, Feldstein calculates that the present value of those annual gains would be equal to 30 to 40 percent of current GDP.
Feldstein notes that taxes reduce the return to saving more at modest inflation rates than they would with pure stability because the tax is levied on nomianl interest rates and nominal capital gains. Taxes also distort the uses of saving, causing more investment in housing and less in productivity-increasing plant and equipment.
Feldstein suggests that the benefits of inflation reduction could "in principle also be achieved by eliminating all capital income taxes or by indexing capital income taxes so that taxes are based only on real income and real expenses." But he notes that "technical and administrative difficulties" make it unlikely such changes will ever be adopted, and that "no industrial country has fully (or even substantially) indexed its taxation of investment income." "Moreover, the annual gains from shifting to price stability that are identified in this paper exceed the costs of transition within a very few years," Feldstein adds. "Even if one could be sure that the tax-inflation distortions would be eliminated by changes in the tax system ten years from now, the present value gain from price stability until then would probably exceed the cost of inflation reduction."
Feldstein's argument that zero inflation is a worthy economic goal for the United States appears to be true for Germany as well, another country where inflation would not, at first glance, seem to be much of an issue. In Price Stability vs. Low Inflation in Germany: An Analysis of Costs and Benefits (NBER Working Paper No. 6170), Karl-Heinz Tödter and Gerhard Ziebarth conclude that their analysis "has confirmed for Germany what Feldstein discovered for the United States: inflation is anything but an attractive option."
"The interaction of even moderate rates of inflation with the existing system of taxation (in Germany) results in a significant loss of welfare," the authors conclude. Changing from an equilibrium "true" inflation rate of 2 percent to a rate of zero would bring permanent welfare gains, they find, equivalent to 1.4 percent of GDP per year.
The authors acknowledge that their argument is charged with political implications, given the fact that deflationary policies could be an irritant, in the short-term, to Germany's current unemployment problems, and to the economic difficulties in the formerly communist east.