Explain how the current U.S. tax system levies taxes on capital gains and earned interest. What does this mean for the costs of inflation?

The U.S. tax system levies taxes on nominal interest earned and on capital gains earned from investment in financial assets. Specifically, the government collects a certain percentage of nominal interest and capital gains earned by households and businesses.

Nominal interest rates are the interest rates stated in a loan contract. Economists explain that the true cost of lending and borrowing is the real interest rate. The real interest rate is the nominal interest rate minus the rate of inflation. This correction for inflation makes the real interest rate a more accurate measure of the transfer of purchasing power between the borrower and the lender. If the government collects a certain percentage of nominal interest earned, then, during periods of high inflation, nominal interest earned may increase, even if real interest earned does not.

Similarly, when the inflation rate is high, prices of financial assets rise to keep pace with the rising prices of goods and services. While an investor may earn a capital gain in nominal terms, he or she may earn no gain in real terms. Since the government collects a percentage of the nominal capital gain, the investor is made worse off by high inflation.

The tax system limits the amount of funds savers are willing to lend and invest in financial assets during periods of high inflation, limiting the funds available for investment in physical capital. This reduction in funds available for investment would slow down production of capital goods and could hinder technical progress that is often made possible by new investment.