To understand the effect of inflation on corporations, it is necessary to understand the impact on the firm's income of traditional accounting practices together with the tax code. Inflation changes the prices of the items an enterprise buys and sells, thereby affecting costs and revenues, income, and the effective tax base. In addition, the use of the convention of historical cost accounting has a very important impact on business tax liabilities.

Introduction

There is almost universal agreement that the historical cost method of accounting significantly increases nominal profits during periods of inflation. Profits are higher than what they would be if all of a firm's costs and receipts were expressed in similar and constant prices (Mathews 1975:338).

Martin Feldstein (1979b:57) has discovered that the effective tax rates on capital income of various kinds increased substantially during the inflationary decade of the seventies. The reason was not due to increases in the statutory rates of taxation but to the mismeasurement of capital income. Mismeasurement occurs during inflation because of two main features in the present U.S. tax code: depreciation allowances on structures and equipment permitted by the government are based on the original or historical costs of the capital rather than the current replacement costs; and inventories are valued at current prices, and nominal or paper profits that accrue because of this practice are subject to the corporate income tax.