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Costs of Inflation in Japan: Tax and Resource Allocation

November 2001
Kozo Ueda

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This paper tries to shed light on the optimal inflation rate by investigating the effects of changes in inflation on resource allocation via changes in the effective tax rates. Given that some taxes are not lump-sum but subject to the proportional/progressive tax schedule, and that taxes are levied on nominal income instead of real income, an increase in the inflation rate has a distortional effect because it raises the effective tax rates. This paper tries to estimate that effect by taking Japan's institutional background fully into account and by applying the general equilibrium framework of Abel [1997]. The current costs of the higher inflation are found to be larger in Japan compared with those in other industrial countries, because of the lower rate of corporate capital return.