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Inflation and the company tax base : methods to minimize inflation - induced distortions

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  • Rajaram, Anand

Abstract

Inflation causes conventionally reported income to differ from real economic income because standard accounting procedures are based on the assumption of price stability. Because of this mismeasurement of economic income, a tax on reported income may distort economic decisions and generate undesirable distributional effects. Marginal effective tax rates, for example may differ across sectors, industries and even firms - making resource allocation less efficient. This paper discusses three alternatives for avoiding these effects: (1) indexing items in the income statement; (2) indexing the balance sheet and deriving the income as a residual; and (3) redefining the tax base in terms of cash flow rather than income. This paper shows that the most accurate method to correct for inflation-induced mismeasurement of income is to use alternative 2 - to index the balance sheet. However, because this method of inflation adjustment is fairly demanding in terms of the general level of bookkeeping and accounting skills in the economy, its use or recommendation for any country should be guided by a realistic appraisal of those skills.

Suggested Citation

  • Rajaram, Anand, 1989. "Inflation and the company tax base : methods to minimize inflation - induced distortions," Policy Research Working Paper Series 278, The World Bank.
    • Handle: RePEc:wbk:wbrwps:278
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