A proposal for the indexation of debt for inflation.

• Author: Mick, Joel

INTRODUCTION

This Comment is concerned with the effects of inflation on the taxation of debt. The current approach to the taxation of debt creates several inflation-induced inequities and economic distortions. Some of these inequities and distortions result directly from the taxation of nominal interest which leads to the overstatement of real interest income and expense. Others derive from the advantageous tax treatment accorded other forms of capital income relative to the treatment of interest income. Although the latter inequities and distortions exist even under inflation-free conditions, they are magnified by the existence of inflation. This Comment considers the feasibility of eliminating these inequities and distortions by altering the taxation of debt to account properly for the effects of inflation.

As a theoretical matter, the merit of indexing debt for inflation has been widely recognized.(1) Yet significant disagreement remains over the administrability of any actual indexation scheme.(2) Therefore, rather than recapitulate the detailed theoretical arguments in favor of indexation, this Comment focuses on the administrative and transitional issues that would arise in the implementation of debt indexation, topics that have not been addressed as thoroughly in the existing academic literature.

The magnitude of the inequities and economic distortions that result from the taxation of nominal interest increases dramatically with higher maximum tax rates and elevated levels of anticipated inflation.(3) This suggests that debt indexation is less important now than it was in the late 1970s and early 1980s, when both tax rates and inflation were significantly higher. Yet, lower tax rates and reduced inflation also mean that the transitional effects of adopting debt indexation would be much smaller now than were reform to await renewed inflation and increased tax rates.(4) Thus, debt indexation remains a reform worthy of serious consideration even in the present economic climate.

This Comment is divided into five sections. Part I begins with a brief discussion of the normative assumptions that underlie many of the arguments made later. The economic effects of our present method of taxing debt are then presented through a series of numerical examples. Part II summarizes the inequities and economic distortions that result from the failure to index debt for inflation. Part II also discusses the revenue effects of debt indexation and provides an overview of the relevant administrability issues. Part III considers several general topics in the implementation of debt indexation. These topics include the choice between partial and comprehensive tax base indexation, the timing of the indexation adjustment, the proper measurement of inflation, and problems of distinguishing debt from other assets. Part IV considers the issue of transition rules. After rejecting a number of familiar rules, a novel transition scheme for debt indexation is proposed and defended. Finally, Part V suggests specific methods of administering debt indexation for various classes of debt.

1. ECONOMIC EFFECTS OF INFLATION ON DEBT

   This Comment assumes that the correct tax base under the federal income tax system is income rather than consumption.(5) This assumption is necessary to establish a normative framework in which to discuss the taxation of debt, a framework that our present hybrid of income and consumption taxation cannot offer.(6) This Comment also adopts the classic Haig-Simons definition of income.(7) According to the Haig-Simons definition, income is the value of a person's rights that can be consumed without altering the value of his pre-existing store of rights.(8) This value is properly measured by the potential quantity of real goods and services that an individual could consume, rather than in nominal monetary terms.(9) Because an administrable tax system must assess income in monetary terms, a tax based on Haig-Simon income requires some form of adjustment to compensate for the decreasing real value of money due to inflation.

   Inflation affects the taxation of income under the Internal Revenue Code ("the Code") in two ways. First, inflation affects the tax rate structure by reducing the real value of all nominal dollar amounts in the Code.(10) This effect is easily eliminated by automatically increasing these dollar figures based on the rate of inflation.(11) Second, inflation distorts the tax base by increasing taxpayers' nominal income, causing them to pay tax on a greater income than they would in the absence of inflation.(12) With respect to debt, inflation increases interest rates, and higher interest rates result in higher nominal interest income.(13) The inflation-induced component of interest is, in an economic sense, a partial repayment of debt principal. Like other recoveries of capital, it should not be treated as income or expense under the Haig-Simons definition. Taxation of nominal interest under the present Code incorrectly measures creditors' real income and debtors' real expense on indebtedness by treating this inflation-induced component of interest as taxable.(14) The following series of examples illustrates the proper tax treatment of debt under inflationary conditions and the economic effects of our present departure from this ideal.

   Example 1: C agrees to lend D the sum of $100 for a period of one year. Both C and D anticipate an inflation rate of 5% and both agree that C should receive an anticipated real rate of return of 2%. There is no credit risk(15) and there are no taxes.

   Absent taxes and credit risk, the nominal interest rate should theoretically follow the formula: [r.sub.money]= (1 + [r.sub.real]) X (1 + [i.sub.a]) - 1 where [r.sub.money] is the nominal interest rate, [r.sub.real] is the real interest rate, and [i.sub.a] is the anticipated rate of inflation.(16) Based on this formula, the interest rate in Example 1 would be 7.10%.(17) Assuming that the parties did agree on an interest rate of 7.10%, at the end of the year, C would receive $107.10 from D. Of this amount, $100.00 would constitute a return of nominal principal and $7.10 would constitute nominal interest. Yet, of this $107.10, $105.00 actually constitutes anticipated return of real principal, because $105.00 one year in the future has the same anticipated real value as $100.00 has at present.(18) The remaining $2.10 constitutes anticipated real interest at a rate of 2%, also in deflated dollars.(19)

   The previous interest rate formula can be rewritten as: [r.sub.money] = [r.sub.real] + [i.sub.a] + ([r.sub.real] x [i.sub.a]) where the real interest rate and the anticipated rate of inflation are small, the cross-product, [r.sub.real] x [i.sub.a], is much smaller than the sum, [r.sub.real] + [i.sub.a], and can be ignored with little loss of accuracy.(20) This results in the approximate interest rate formula: [r.sub.money] = [r.sub.real] + [i.sub.a]. Using this approximate formula, the interest rate in Example 1 would be 7%.(21) For the sake of simplicity, this approximate interest rate formula is used for the remainder of this Comment.

   Example 2: The facts are identical to those in Example 1, except that C and D both face a 50% marginal tax rate.(22) Debt is indexed for inflation, meaning that the portion of nominal interest that is necessary to maintain the real value of the debt principal is excluded from taxation. The parties agree that C should receive an anticipated, real pre-tax rate of return of 2%(23) and that D should pay an anticipated, real pre-tax interest rate of 2%.

   Where debt is indexed for inflation, the interest rate should still follow the formula given in Example 1.(24) In Example 2, this means that C will receive interest at a rate of 7%.(25) At the end of one year, C will receive $107, of which $7 will be nominal interest. The parties anticipate an inflation rate of 5%, so they anticipate that $5 of this nominal interest will be excluded from taxation.(26) Expected, real pre-tax interest is therefore $2,(27) for an anticipated, real pre-tax interest rate of 2%.(28)

   Example 2A: The facts are identical to those in Example 2, except that debt is not indexed for inflation. Any interest paid is fully includable in income to C and fully deductible for D.

   The general interest rate formula under proportional taxation of full nominal interest income is: [r.sub.money] = [r.sub.real] + [i.sub.a] + [[i.sub.a] x t / (1 - t)] where t is the taxpayer's marginal tax rate.(29) For C to receive an after-tax inflationary component, [i.sub.a], of 5%, the interest rate must contain an additional tax-on-anticipated-inflation component, [i.sub.a] x t / (1 - t), of 5%,(30) resulting in a nominal interest rate of 12%.(31) At the end of one year, C would receive $112, of which $12 would be nominal interest. C would pay a tax of $6 on this $12 of nominal interest income, and D would receive a $6 tax savings from his $12 interest deduction.(32) Of the remaining $6 of after-tax interest, $5 represents anticipated return of principal(33) and $1 represents anticipated, real after-tax interest.(34) At a 50% tax rate, this is equivalent to $2 of anticipated, real pre-tax interest,(35) for an anticipated, real pre-tax interest rate of 2%.(36)

   In Example 2, where debt was indexed for inflation, the parties agreed to a nominal interest rate of 7% that resulted in an expected, real pre-tax interest rate of 2% for both the creditor and the debtor. In Example 2A, where debt was not indexed, the parties agreed to a nominal interest rate of 12% that also yielded an anticipated, real pre-tax interest rate of 2% for both parties. Examples 2 and 2A thus demonstrate that where creditors and debtors face the same marginal tax rate, they are able to compensate exactly for the taxation of nominal interest by increasing the agreed upon interest rate.(37) This ability does not exist, however, where creditors and debtors face different tax rates, as the...