THE EFFECTS OF INFLATION AND BUSINESS INCOME TAXES ON INVESTMENT AND NATURAL RESOURCE UTILIZATION

Abstract

The combination of price inflation and historical cost-based depreciation for tax purposes has been shown in the finance literature to reduce the present value of depreciation deductions. Since tax depreciation deductions are limited to a nominal dollar amount, when inflation occurs a future tax deduction has less real value. This effect is pedagogically presented in a capital budgeting context. In the economic literature Hotelling and Herfindahl have contributed models describing natural resource production changes in response to changes in demand, production cost, and cost of capital. Parts of the inflation-explicit capital budgeting model and the Hotelling and Herfindahl models are combined. The result is a partial equilibrium model which yields the conclusion that production from a natural resource is reduced if inflation is increased. Copper industry data from 1947-1978 are examined for empirical confirmation of the theoretical model. A copper industry production function, which contained demand, real price and labor strike variables, gained in descriptive capability by inclusion of inflation as an additional multiple regression variable. The dissertation reviews literature on the relationship between capital investment and inflation. The cases of hyper-inflation in Germany and medium inflation in Latin America are considered. Other literature review topics include the inflation effects in the securities markets, inflation-caused wealth transfers and inflation adjustments in accounting statements.