The problems associated with the taxation of capital gains in an inflationary situation are somewhat simpler to understand than those connected with the taxation of interest income. Perhaps for this reason they have received far more attention. As recently as 1974, Roger Brinner and Alicia Munnell could write that “it is not just as necessary to adjust wages, interest, and dividends for inflation” as it is to adjust for the effect of inflation on capital gains. As is shown in the following section, contrary to their view, when the price level is changing, the taxation of interest income does create special and serious adjustment problems.

The problems

To set the problem in the proper context, let us first consider a situation in which prices are expected to remain stable and where these expectations are fully realized. Let us assume also that an individual can lend his savings at a rate of interest of 5 percent, which will be called the real rate. To simplify the presentation, we shall avoid the complications that would be introduced by considerations of term structures of the interest rate; we shall, thus, refer to one particular rate of interest. We shall also assume that the marginal income tax rate for this particular individual is 50 percent.

Given these assumptions, if an individual lends $1,000 and after one year receives $50 of interest income – in addition to the return of his principal – this income will be taxed at the marginal tax rate of 50 percent.