Deflation and the Income Tax

The extensive literature on inflation and the income tax shows that a tax-system based on nominal costs and revenues may result in considerable distortion even at moderate degrees of inflation. Much of this distortion arises from the use of unindexed historical cost to compute taxes for items such as depreciable assets, inventories, and capital gains. This approach results in over-taxation and consequent increases in the cost of capital. It is tempting, but mistaken, to think that a deflationary environment involves the same phenomena but with the signs reversed. As inflation falls and turns into deflation, the impacts on items subject to historical cost accounting change continuously but only up the point where deflation reaches the "zero bound rate," the rate at which nominal riskless interest rates fall to zero. For perpetual rates of deflation equal or greater than the zero bound rate, any tax system that allows full recovery of nominal costs and provides for full taxation of nominal gains becomes equivalent to a cash flow income tax regardless of the timing for cost recovery specified by the tax system. No distortions arise from historical cost accounting or other timing rules in the tax system. The zero bound rate serves as a discontinuity with respect to the interaction of many features of the tax system with inflation or deflation. Above that rate, the cost of capital for depreciable assets falls as the inflation rate falls. Below that rate, the opposite occurs: The cost of capital increases as deflation intensifies. Similar discontinuities occur at the zero bound rate for the tax treatment of debt and the impact of loss limitations. Above the zero bound rate, certain factors in the tax system tend to make the impact of inflation less than one-to-one on the cost of debt for borrowers. Below the zero bound rate, there is a one-to-one effect. Loss limitation effects for new investments intensify as inflation falls, but this effect stops once the zero bound rate is reached. Given the current stance of central banks, individual and firms are more likely to expect a bout of deflation lasting several quarters or years than perpetual deflation. The impact of expected temporary deflation on the user cost of capital for depreciable assets depends on the expected intensity of the deflation. If individuals and firms expect temporary moderate deflation, the user cost of capital will fall, with the percentage drops being larger for shorter-lived assets. If individuals and firms expect temporary severe deflation, the user cost will rise and more so in percentage terms for long-lived assets. This paper is addressed to a general audience and consequently contains a great deal of basic background material. Results that the author believes are new are concentrated in Parts II and IV. Part I reviews some well-known results on inflation and taxation. Part III provides a macroeconomics orientation that serves as background for the discussion in Part IV. Some readers may wish to focus primarily or solely on Parts II and IV