Distortionary Effects of Inflation on Taxes

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 determinin

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ing/valuation is a process whereby the replacement costs for existing assets are used in lieu of the historical costs of such assets in financial reporting. Market value, or current value, accounting/valuation restates the values of assets and liabilities from an historical cost basis to a current cost basis. Market value accounting/valuation differs from general pricelevel accounting/valuation, in that the current values of specific assets and liabilities are determined, as opposed to the adjusting of all valuations according to a pricelevel index. Discounted cashflow accounting/valuation, or present value accounting/valuation, converts historical cost asset valuations to net present values. Historical cost accounting/valuation assumes that the value of the monetary unit of measure is stable over time. General pricelevel accounting/valuation recognizes the fact that such stability rarely exists. In theory, valuations in financial performance and financial position statements may be adjusted either up or down, as a result of the application of a pricelevel index. Since the end of the Second World War, however, downward adjustments in the United States would have been a rarity. When assets and liabilities (assets

Category: Economics - D