Tax, Credit Constraints, and the Big Costs of Small Inflation

This paper develops an overlapping generations model incorporating credit constraints, owner-occupier and rental sectors, and detailed tax regulations to examine how the interaction of inflation and the tax system affect the housing market.

It shows that even modest rates of inflation can have very large effects on the home-ownership rates of young households, particularly at low real interest rates. This occurs even if there is a large supply response in the quantity of housing. The model suggests that the welfare costs of inflation could be ameliorated by exempting the inflation component of interest payments from income tax.

This version (published August 2009) refers to additional results from an extended model developed for Motu Working Paper 09-13 (see below).