inventory profits, it leads to a downward biasin reported corporate earn-
ings during periods of inflation.
Most firms raise some of their capital by issuing fixed-income as-
sets such as bonds and bank loans. This borrowing leverages the firm’s
assets since any profits above and beyond the debt service go to the
stockholders. In an inflationary environment, nominal interest costs rise,
even if real interest costs remain unchanged. But corporate profits are
calculated by deducting nominalinterest costs, which overstates the real
interest costs to the firm. Hence, reported corporate profits are de-
pressed compared to true economic profits.
In fact, the firm is paying back debt with depreciated dollars, so the
higher nominal interest expense is exactly offset by the reduction in the
real value of the bonds and loans owed by the firm. But this reduction in
the real indebtedness is not reported in any of the earnings reports re-
leased by the firm. Unfortunately, it is not easy to quantify this earnings
bias because it is not easy to separate the share of interest cost due to in-
flation from that due to real interest rates.
Capital Gains Taxes
In the United States, capital gains taxes are paid on the difference be-
tween the cost of an asset and the sale price, with no adjustment made
for the impact of inflation on the amount of the real gain. Thus, if asset
values rise with inflation, the investor accrues a tax liability that must be
paid when the asset is sold, whether or not the investor has realized a
real gain. This means that an asset that appreciates by less than the rate
of inflation—meaning the investor is worse off in real terms—will still
be taxed upon sale.
Chapter 5 showed that the tax code has a dramatic impact on in-
vestors’ realized after-tax real returns. For even a moderate inflation rate
of 3 percent, an investor with a five-year average holding period suffers a
31-basis-point (hundredths of a percentage point) reduction in average
after-tax real returns compared with the after-tax returns that he or she
would have realized if the rate of inflation had been zero. If the rate of in-
flation rises to 6 percent, the loss of returns is more than 65 basis points.
The inflation tax has a far more severe effect on realized after-tax
real returns when the holding period is short than when it is long. This
is because the more frequently an investor buys and sells assets, the
more the government can capture the tax on nominal capital gains. Nev-
ertheless, even for long-term investors, the capital gains tax reduces real
returns in inflationary times.
204 PART 3 How the Economic Environment Impacts Stocks