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Adjusting Depreciation in an Inflationary Economy: Indexing versus Acceleration

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  • Martin Feldstein

Abstract

With the existing "historic cost" method of depreciation, higher inflation rates reduce the real value of future depreciation deductions and therefore raise the real net cost of investment. The calculations in this paper show that this rise in the net cost can be quite substantial at recent inflation rates; e.g., the real net cost of an equipment investment with a 13 year tax life is raised 21 percent by an 8 percent expected inflation rate if the firm uses a 4 percent real discount rate. The effects of inflation on the net cost of investment can be completely eliminated by indexing depreciation. A more accelerated depreciation schedule can also lower the net cost of investment and make that net cost less sensitive to the rate of inflation. The current paper examines a particular acceleration proposal and finds that, for moderate rates of inflation and real discount rates, the acceleration proposal and full indexation are quite similar. For low rates of inflation, high discount rates, or very long-lived investments, the acceleration proposal causes greater reductions in net cost than would result from complete indexing. Conversely, for high rates of inflation, low discount rates, or very short-lived investments, the acceleration method fails to offset the adverse effects of inflation. Since the acceleration and indexation methods have quite similar effects under existing economic conditions, the choice between them requires balancing the administrative simplicity and other possible advantages of acceleration against the automatic protection that indexation offers against the risk of significant changes from the recent inflation rates and discount rates.

Suggested Citation

  • Martin Feldstein, 1979. "Adjusting Depreciation in an Inflationary Economy: Indexing versus Acceleration," NBER Working Papers 0395, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:0395
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    References listed on IDEAS

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    1. Aaron, Henry J, 1976. "Inflation and the Income Tax," American Economic Review, American Economic Association, vol. 66(2), pages 193-199, May.
    2. Paul A. Samuelson, 1964. "Tax Deductibility of Economic Depreciation to Insure Invariant Valuations," Journal of Political Economy, University of Chicago Press, vol. 72, pages 604-604.
    3. Gray, Jo Anna, 1976. "Wage indexation: A macroeconomic approach," Journal of Monetary Economics, Elsevier, vol. 2(2), pages 221-235, April.
    4. Martin Feldstein & Lawrence Summers, 1983. "Inflation, Tax Rules, and the Long-term Interest Rate," NBER Chapters,in: Inflation, Tax Rules, and Capital Formation, pages 153-185 National Bureau of Economic Research, Inc.
    5. Auerbach, Alan J, 1979. "Inflation and the Choice of Asset Life," Journal of Political Economy, University of Chicago Press, vol. 87(3), pages 621-638, June.
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    Cited by:

    1. Chang Woon Nam & Doina Maria Radulescu, 2004. "Types of Tax Concessions for Attracting Foreign Direct Investment in Free Economic Zones," ERSA conference papers ersa04p174, European Regional Science Association.
    2. repec:ces:ifodic:v:1:y:2003:i:2:p:14567962 is not listed on IDEAS
    3. Don Fullerton, 1990. "Inputs to Tax Policymaking: The Supply Side, the Deficit, and the Level Playing Field," NBER Working Papers 3507, National Bureau of Economic Research, Inc.
    4. David F. Bradford, 1981. "Issues in the Design of Saving and Investment Incentives," NBER Working Papers 0637, National Bureau of Economic Research, Inc.
    5. Martin Feldstein, 1983. "Inflation, Tax Rules, and the Stock Market," NBER Chapters,in: Inflation, Tax Rules, and Capital Formation, pages 199-220 National Bureau of Economic Research, Inc.
    6. Chang Woon Nam & Doina Radulescu, 2004. "Does Debt Maturity Matter for Investment Decisions?," CESifo Working Paper Series 1124, CESifo Group Munich.
    7. Chang Woon Nam & Doina Maria Radulescu, 2003. "Types of Tax Concessions for Promoting Investment in Free Economic and Trade Areas," ERSA conference papers ersa03p169, European Regional Science Association.
    8. Chang Woon Nam, 2001. "Effects of Tax Depreciation Rules on Firms' Investment Decisions in an Inflationary Phase: Comparison of Net Present Values in Selected OECD Countries," CESifo Working Paper Series 528, CESifo Group Munich.

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