A NOTE ON INFLATION AND COMMON STOCK VALUES

Abstract

INFLATION AFFECTS the real value of the claims on the return to capital. Previous literature documents its effect on the relative value of equity and fixedincome claims [1], [2], [4]. This literature leaves an impression of having isolated all the major effects of inflation on real equity values. But an unmentioned effect of equal importance is the effect on the real value of the claims of the tax authorities. Tax liabilities may increase under inflation to such an extent that the real value of the equity claims diminish even though the equity claims profit from the decreased value of the debtholders' claims. This is due to the manner in which the tax laws treat depreciation charges. Depreciation charges represent the recovery of investment. They are part of the gross returns to equity and are free of tax liability. Since they are fixed in monetary terms, an inflation diminishes their real value.' The effect of the inflation is cet. par. to decrease the real non-taxable portion of the return to equity and to increase the real taxable portion by the same amount. From a given real gross return to equity, the result is an increase in the real value of tax liabilities and a decrease in the real net return to equity. It should be noted that it is not my purpose to re-examine the question of the adequacy of depreciation charges to replace worn-out capital. I intend merely an analysis of the redistributional effects of inflation. The argument is as follows: Assume the inflation is such that it does not affect the real return on capital, i.e. the prices of the goods sold by the firm increase in the same proportion as the prices of the goods and services bought. Profits before taxes equal total returns to capital (C) minus interest charges (rM) minus depreciation charges (D). Profits after tax (a) equal one minus the tax rate (1 T) times pre-tax profits.