Optimal inflation with corporate taxation and financial constraints

•The value of interest deductions from corporate taxation rises with inflation.•To benefit from this tax shield, firms need to borrow more.•To borrow more, they need extra capital when it serves as collateral.•This counteracts the under-investment distortion stemming for corporate taxation.•Inflation thus mitigates, not exacerbates, distortions from corporate taxation. How does inflation affect the investment decisions of financially constrained firms in the presence of corporate taxation? Inflation interacts with corporate taxation via the deductibility of i) capital expenditures and ii) interest payments on debt. Through the first channel, inflation increases firms’ taxable profits and further distorts their investment decisions. Through the second, expected inflation affects the effective real interest rate and stimulates investment. When debt is collateralized, the second effect dominates. Therefore, present a tax-advantage to debt financing, positive long-run inflation enhances welfare by mitigating or even eliminating the investment distortion.