This research examines the distortionary effects of inflation on taxes. Following these introductory remarks, an explanation is provided of the rationale underlying the contention that inflation has a distortionary effect on taxes. The remainder of this examination then considers specific examples of the distortionary effects of inflation on taxes. The examples considered are (1) capital gains, (2) debt interest, (3) asset depreciation, (4) inventory valuation, and (5) the effect of the inflationary distortion of taxes on a firm's operating capacity.
THE DISTORTIONARY EFFECTS OF INFLATION
The essence of the rationale underlying the contention that inflation exerts meaningful effects on taxes lies in the differentiation between nominal and real values (Gordon, 1984). An easily understood illustration of the effects of this differentiation in an inflationary environment with respect to taxes involves a capital gain. As an example, if an asset were acquired for $100 in year one, and if that asset were sold in year ten for $900, a nominal capital gain of $800 has been realized. If, over that same 10 year time period, however, a 100 percent price inflation has occurred in the economy, the $900 received in year ten had a purchasing power of only $450 in year one dollars. The real capital gain in year one dollars, therefore, was $350, as opposed to the nominal capital gain of $800 in year ten dollars. An alternative method of determining the amount of the real capital gain in this example involves the revaluation of the acquisition price into year ten dollars. In this instance, the acquisition price would be adjusted to $200, and the real capital gain in year ten dollars would be $700.
In the foregoing example, one has a choice of three capital gains two real and one nominal. The nominal capital gain is the one recognized by the Internal Revenue Service (IRS); therefore, the taxpayer in this example would be required to p...