Taxation and inflation: a new explanation for current account imbalances

In a world of mobile capital, the current system of nominal interest taxation implies that the cost of capital and the return to saving in each country are strongly and negatively correlated with the rate of inflation. It follows that a country's net foreign asset position (and its current account balance) ought to be negatively correlated with its inflation rate. The magnitude of these effects is shown to be large, both theoretically and empirically. For OECD countries, cross-sectional regressions confirm that inflation rates are good predictors of current accounts, even after controlling for business cycles and government budget deficits. These results imply that existing current account imbalances largely reflect tax distortions rather than an optimal allocation of world savings.