I’m struggling with what I think should be a very simply concept and I was hoping someone can clarify for me.
In the context of corporate finance, why does inflation shift wealth from the taxpayer to government? And how does inflation reduce the value of depreciation tax savings and hence increase a corporations real taxes?
Is it because in a high inflation environment, corporations pay higher taxes due to higher EBIT, and this reduces the “value” of depreciation tax savings as it is not impacted by inflation and hence relatively smaller in proportion to overall taxes paid?
generally inflation springs from printing money. the government is the one printing it…
depreciation is not designed to save tax. it is to improve cashflow matching. inflation causes the cashflows not to match (smaller depreciation expense compared to current value) therefore the “profits” are higher and taxes are higher.
mr.devlilock, YES, the point your Curriculum makes is that higher inflation (than expected) reduces the real value of the depreciation shelter.
The company’s revenues go up, so do most costs, but not the depreciation expense which is fixed in advance and does not adjust with the level of inflation. So, the company ends up paying higher taxes than expected in real, or inflation-adjusted terms.
This is/was often the case in highly inflationary economies, where the value of the depreciation tax shield became negligible when confronted with the rise in overall prices which escalate companies’ revenues as well as most other operating costs. Where I live, this happened in the 90’s, and was partly remedied by an upward revaluation of assets for balance sheet and tax purposes. In this way, the tax savings once again regained real value.
In the context of Corporate Finance, higher than expected inflation would reduce investment probability. It would shift wealth from a taxpayer to Government. As you can see higher than expected inflation would increase corporate’s real taxes as it would reduce Depreciation tax shelter.
Imagine a situation if inflation is higher now…Had inflation been higher when you had actually bought the asset, you could have claimed the higher Depreciation as prices could have been higher as well and because of Higher depreciation, your tax payables could have been reduced as well. So you missed that opportunity to reduce your tax payable.
My way of thinking about it is assuming depreciation is fixed. If you are depreciating an asset on a straighline basis, depreciation will be fixed… when inflation comes around you are still depreciating it the same dollar value you were before inflation, thus losing on the dollars you could have saved from the depreciation being adjusted upward.
