Taxation and Real Cost of Capital

Abstract

The effects of inflation, via taxes, on the firm's cost of capital are analyzed. The taxes are the corporate income tax and household taxes on dividends and capital gains. The costs of equity and debt are taken at their nominal values as observed by the firm on the capital market. The net real cost of capital, where market rates of return are adjusted for inflation, are analyzed. The net effects of inflation on capital cost can thus be determined, while recognizing several counteracting tendencies which operate through the tax system. It turns out that for most reasonable assumptions, real capital cost will fall as a result of inflation when both profit tax and taxes on dividends and capital gains are taken into account. Different ways of indexing the system of taxation to insulate it from inflationary distortions are also presented. I. The Problem This study deals with profit taxation of the business sector and income taxation of the household sector. The central concept is the cost of capital and our intention is to analyze in detail the effects of taxation on capital cost in times of inflation. When there is inflation, the tax system produces distortions because not all real costs are deductible for taxation and not all real income is included in taxable profits. Costs of debt and equity also become distorted. Under the tax regimes which exist in most countries, four different distorting factors operate in times of inflation. Two of them are due to the way the system of corporate profit taxation is constructed (points 1 and 2 below) and two to income taxation of households (points 3 and 4 below). 1. When depreciation allowances are based on historical costs under corporate tax laws, inflation undermines their real significance. As a result, part of capital consumption may be included in the tax base (or accelerated