RDP 9012: Some Calculations on Inflation and Corporate Taxation in Australia 1. Introduction

It is well known that inflation distorts the measurement of income from capital, particularly in the context of corporate taxation. As a result, inflation can introduce distortions in the after-tax cost and returns to capital, either by shifting the relative tax burdens on different types of capital investment or by altering the overall tax burden on capital.

As in many other countries, Australian accounting rules require companies to measure all income and balance sheet items in nominal (or, in some cases, book value) terms. It is often argued that a neutral tax system should exclude from the tax base any income attributable purely to a general rise in the price level.

This paper aims to quantify the distorting effects of inflation on the measurement of corporate income, and on the associated assessment of corporate tax liabilities, over the past two decades. Excluded from consideration are distortions associated with concessional treatment given to particular forms of income, or to income from favoured activities; for example, the favourable treatment given to income from capital gains is not discussed, even though this would have had a sizeable effect on corporate tax liabilities. The aim is not to arrive at comprehensive estimates of the “true” corporate income tax base, but to determine the extent to which corporate tax liabilities are distorted by the unintentional mismeasurement of income due to inflation.[1]

There are three major inflationary distortions to conventionally measured nominal profits.

  • First, inflation reduces the real value of tax depreciation allowances on depreciable assets.
  • Second, the first-in-first-out (FIFO) inventory accounting system commonly used in Australia results in higher taxable profits from holding stocks in inflationary periods.
  • Third, the tax treatment of interest payments results in a better known inflationary distortion. Inflation erodes the real value of financial assets and liabilities, but higher nominal interest rates compensate for these losses. Thus only the real component of interest payments constitutes an expense by a debtor or income to a lender, yet nominal interest payments are fully deductible from taxable corporate income, and interest receipts fully taxable.

In the calculations presented below, these three distortions to corporate income are quantified over the recent historical period, with particular attention paid to the tax treatment of depreciation. A measure of inflation-adjusted income is derived from standard nominal profits data, and the resulting additional corporate tax liability attributable to inflation is assessed.

These figures show that inflation has usually increased the corporate tax burden. Over the past 20 years, the tax treatment of depreciation and inventories has led to greater tax liabilities in inflationary periods, while the deductibility of nominal interest payments has partially offset this effect.

Though this study does not attempt to measure the impact of the inflationary distortions to corporate taxes on investment and financing decisions, the potential incentives from such distortions seem fairly clear. In periods of high inflation, companies will benefit most by avoiding investment in depreciable assets and stocks, and instead, acquiring assets that appreciate in value and which are taxed preferentially. The impact of inflation on these decisions is a more complex question which is examined by Ryan (1990).


For a similar analysis for the United States, see Feldstein and Summers (1979). The Treasury (1987) also calculates real corporate tax rates for Australia. [1]