The Impact Of Inflation On Corporate Taxes And The Cash Flows Of Business

The purpose of this paper is to identify and measure the effects of inflation on corporation income taxes and on the net cash flows of business. Five ways in which inflation alters corporate taxable income are identified. The paper begins by showing how the use of historical costs rather than the replacement costs of assets in the calculation of depreciation will cause taxable income to be overstated. Taxable income is also overstated because taxation rules require the use of the first-in first-out pricing rule for measuring the cost of goods sold from inventories. They also require the inclusion in taxable income of the full nominal value of interest earned even though during a period of inflation much of the nominal interest earned is simply compensation for the fall in the real value of financial assets. The exclusion of the loss in the real value of cash balances from deductible expenses causes taxable income to be further overstated. Partially offsetting these effects on taxable income is the provision for the full deduction of interest expense, nominal interest rates tend to increase by approximately the same number of percentage points to compensate for the fall in the real value of the principal outstanding. Hence, the amount of the nominal interest paid may increase dramatically even though the real cost of funds might not be appreciably changed.