the U.S. tax code works to the detriment of shareholders during infla-
tionary times: corporate profits and capital gains.
Earnings are distorted by standard and accepted accounting prac-
tices that do not properly take into account the effects of inflation on cor-
porate profits. This distortion shows up primarily in the treatment of
depreciation, inventory valuation, and interest costs.
Depreciation of plant, equipment, and other capital investments is
based on historicalcosts. These depreciation schedules are not adjusted
for any change in the price of capital that might occur during the life of
the asset. During inflation, the cost of replacing capital rises, but re-
ported depreciation does not make any adjustment for this. Therefore,
depreciation allowances are understated since adequate allowances for
the rising cost of replacing capital are not reported. As a result, reported
depreciation is understated, and reported and taxable earnings are
overstated.
But depreciation is not the only source of bias in reported earnings.
In calculating the cost of goods sold, firms must use the historical cost,
with either “first-in-first-out” or “last-in-first-out” methods of inventory
accounting. In an inflationary environment, the gap between historical
costs and selling prices widens, producing inflationary profits for the
firm. These “profits” do not represent an increase in the real earning
power of the firm; instead, they represent just that part of the firm’s cap-
ital—namely, the inventory—that turns over and is realized as a mone-
tary profit. The accounting for inventories differs from the firm’s other
capital, such as plant and equipment, which are not revalued on an on-
going basis for the purpose of calculating earnings.
The Department of Commerce, the government agency responsi-
ble for gathering economic statistics, is well aware of these distortions
and has computed both a depreciation adjustment and an inventory
valuation adjustment in the National Income and Product Accounts
going back to 1929. But the Internal Revenue Service does not recognize
any of these adjustments for tax purposes. Firms are required to pay
taxes on reported profits, even when these profits are biased upward by
inflation. These biases reduce the quality of the earnings that firms re-
port to stockholders.Inflationary Biases in Interest Costs
There is another inflationary distortion to corporate profits that is not re-
ported in government statistics. This distortion is based on the inflation-
ary component of interest costs, and, in contrast to depreciation andCHAPTER 11 Gold, Monetary Policy, and Inflation 203