In times of inflation, the price of everything should go up proportionally, but stock returns often drop in the presence of inflation. Why is that?
Several theories attempt to explain this phenomenon. One argues that investors don’t know how to make financial models based on inflation. Another says that inflation announcements come with bad news that is reflected in stock returns. A third explanation, known as the tax hypothesis, suggests that firms with tax deductions related to inventory and property, plant, and equipment (PP&E) experience a higher tax burden in the presence of inflation relative to firms that do not use these historical cost-based tax deductions.
In a direct test of the tax hypothesis, my colleagues Dan S. Dhaliwal of the University of Arizona, Hye Seung “Grace” Lee of Lehigh University, Robert Trezevant of the University of Southern California, and I found that, indeed, firms that take historical cost-based tax deductions are harmed by inflation more than firms that do not.
In the case of depreciation of PP&E, tax deductions are based on the price of that capital at the time of purchase. As selling prices increase with inflation the tax deduction for depreciation will remain flat, increasing firms’ taxable income and therefore the corporate tax burden. Section 179 of the United States Internal Revenue Code enables firms to deduct some PP&E expenses early to compensate for inflation, but our study shows that this measure fails to fully offset the effects of inflation.
Similarly, with inventory, since tax deductions for the cost of producing goods are based on historical accounting rather than on inflation-indexed or current asset value, nominal taxable income increases at a rate higher than inflation, which increases the real tax burden for these firms.
“Last in, first out” (LIFO) accounting, which allows firms to assume tax deductions on the most recently produced products, reflecting the highest cost of production, mitigates this effect somewhat; however, there have been recent policy proposals to eliminate LIFO accounting.
Our research shows that capital- and inventory-intensive firms are being hurt by inflation even when they use inflation-mitigating tax law provisions. We conducted this research because of the mixed results of previous research, which used indirect measures such as stock returns to test the tax hypothesis. The problem with using stock returns as means of measuring the effects of inflation is that stock prices are affected by so many different factors. Our approach of looking at how much firms pay in tax is a direct measure of how inflation affects the corporate tax burden.
Our results provide strong evidence that capital- and inventory-intensive firms face a higher tax burden than other firms even when inflation is low. Policymakers should consider these results as they debate measures to mitigate the effects of inflation on taxes.