The Tax Effects of Inflation: Depreciation, Debt, and Miller's Equilibrium Tax Rates — A Reexamination

Abstract

According to conventional wisdom, the use of debt financing offsets the negative effect of historical cost depreciation on the firm's real cash flows. This effect derives from the following: According to tax law, the debtor firm can claim the entire nominal interest payment as a tax deduction notwithstanding the fact that the nominal interest payment includes a component which represents the return of real capital to the firm's bondholders.Maher and Nantell (Journal of Accounting Research, Spring 1983, pp. 329-340) claim to show that, given Miller's equilibrium tax rates, the use of debt financing does not ameliorate but rather aggravates the deleterious effect of historical cost depreciation. The aim of this paper is to criticize their conclusion. It is shown that their result derives, not from Miller's equilibrium tax rates, but rather from their implicit assumption regarding the behaviour of bond interest rates in the presence of inflation. They assume that bondholders are fully compensated on a postpersonal tax basis for the effect of inflation. We argue that it is implausible to assume that bondholders are completely insulated from the effects of inflation while shareholders suffer wealth losses due to inflation. A more plausible assumption is that both groups of investors are affected by inflation. Consistent with the theoretical result of Nielsen (Journal of Monetary Economics, 1981, pp. 261-2701, we assume that the real post-personal tax rate of return on the firm's bonds declines in the presence of inflation. Given this stipulation. we show that traditional wisdom is upheld, e. debt financing ameliorates the negative effect of historical cost depreciation.