# RDP 9012: Some Calculations on Inflation and Corporate Taxation in Australia 3. Inventories

Inflation also distorts conventionally measured company income by creating capital gains on stocks. The FIFO accounting method commonly used in Australia measures the cost of goods sold from inventory at book value (cost) rather than current market prices. In inflationary periods, current prices exceed book values, raising the value of company sales relative to costs. Taxable company income consequently includes a holding gain component. In fact, the increased replacement cost of the goods sold means that there is no real gain to the company. This practice of effectively taxing the capital gains on stocks constitutes a substantial tax bias against investment in stocks relative to other assets that are free of (nominal) capital gains taxation.

In recognition of this problem, a trading stock valuation adjustment (SVA) was allowed on company tax returns in Australia between 1976 and 1979. This deduction was calculated as half the general inflation rate applied to the initial value of inventories. Total deductions claimed on company tax returns totalled about \$1 billion in each year of the SVA's existence, more than 10% of company income. Since 1979, however, stock holding gains have again been fully assessable as income.

In contrast to existing tax rules, a SVA is included in the National Accounts to ensure that the operating surplus and change in stocks components of national income and expenditure do not include stock holding gains associated with inflation. The SVA is calculated approximately as:

where Si is the book value of stocks for each type of good (i) and πi is the specific inflation rate. The additional income tax paid is equal to: τ.SVA where τ is the company income tax rate; thus the after-tax return on stock investment is reduced by τ.πi percentage points as a result of book valuation of stocks.

The official SVA measure is used in this analysis to quantify the inflationary distortion to company income from book valuation of stocks. Annual data are shown below in column (3) of Table 3. As would be expected, the SVA fluctuates widely with stock levels and inflation rates, reaching a level of more than \$3 billion in 1987–88. It is not uncommon for the SVA to far exceed the estimated change in stocks.

Table 3: Corporate Income and Inflation
(\$ million)
Total Nominal Income
(1)
minus Depreciation less Allowances
(2)
minus Stock Holding Gains
(3)
plus Real Gain on Debt
(4)
(5)
Difference (1–5)
(6)
1966–67 2,246 119 110 148 2,165 81
1967–68 2,564 134 125 103 2,408 157
1968–69 2,840 149 67 211 2,835 6
1969–70 3,430 156 183 228 3,319 111
1970–71 3,516 274 235 364 3,371 145
1971–72 3,854 367 364 600 3,723 131
1972–73 4,683 497 533 692 4,345 338
1973–74 5,511 666 1,225 1,229 4,850 661
1974–75 5,891 1,133 1,753 2,017 5,022 869
1975–76 6,694 1,421 1,722 1,950 5,501 1,193
1976–77 7,475 1,650 1,369 1,582 6,038 1,437
1977–78 7,649 2,171 1,179 1,284 5,583 2,067
1978–79 9,835 2,618 1,803 1,464 6,878 2,957
1979–80 12,635 3,210 2,686 1,878 8,617 4,018
1980–81 13,659 3,598 2,070 2,070 10,061 3,598
1981–82 12,796 4,139 2,298 2,602 8,961 3,835
1982–83 12,597 5,238 2,233 3,255 8,381 4,216
1983–84 15,347 4,272 1,374 2,330 12,031 3,316
1984–85 18,871 3,872 2,108 2,108 14,999 3,872
1985–86 19,753 4,487 1,628 2,795 16,433 3,320
1986–87 20,786 4,648 3,140 3,845 16,843 3,943
1987–88 23,833 4,874 3,159 6,020 21,820 2,013

(1) Gross operating surplus of pete's (ANA, Table 19) – depreciation allowances (as in Table 2) + SVA (see below) – net interest paid by pete's (ANA, Table 29)
(2) Replacement cost less depreciation allowances (both as in Table 2)
(3) Unpublished ANA data for the SVA of pete's (ANA, Table 61 includes unincorporates)
(4) See Footnote 6 for debt data. Deflator is that for gross domestic product (ANA, Table 3)