The low inflation that we have seen in this expansion, for example, has been associated with less inflation volatility than in earlier, higher inflation periods. The associated reduction in inflation uncertainty has surely been a positive factor for investment in plant and equipment. Increased investment spending, in turn, has increased the economy s capacity to produce goods and services. As noted earlier, investment as a share of GDP is currently a high 17 percent, and capacity has been growing at very rapid rates. Low inflation also reduces the distortion that arises from the way inflation interacts with the tax code.
Inflation increases the effective tax rate to firms and individuals in many ways.
For example, inflation reduces the value of depreciation allowances, thereby increasing the effective tax rate. For individuals, taxes levied on nominal capital gains and nominal interest income cause the effective tax rate to increase with the rate of inflation. Since inflation increases the effective tax rate on capital income, it discourages capital formation and long-term economic growth. For all these reasons, the low inflation environment we have enjoyed has helped boost investment spending and increased productive capacity, thereby allowing firms to meet increased demand without raising prices. This greater capacity, moreover, should help ensure that the current low inflation environment continues.