Inflation and the Investing Borrower

Abstract

The Mathews Committee report recommends that assets should be depreciable for tax purposes according to replacement cost rather than historic cost, to compensate for inflation. But there is a reverse side to the argument. Under the present taxation system, part of the interest expense allowed on borrowed funds is really a repayment of capital in times of inflation.

This paper examines the two effects quantitatively. It is shown that, for a project financed entirely by borrowings, the extra tax benefit on interest expenses exceeds the extra tax cost on depreciation allowances. If the Mathews Committee recommendations on depreciation are adopted and borrowers are allowed to deduct interest payments in full, then inflationary distortions might be accentuated rather than relieved.