EY: Haunted by Phantom Income and at the Mercy of Economic Patterns — Inflation Distorts World Tax Systems

Recent IMF data show developed economies are running at an annual inflation rate of three to 10 percent.

Some eastern European and Asian countries currently sit between 10 and 25 percent — and 10 nations are struggling with higher rates still.

Although the inflation trend is generally declining, there is concern about the tax codes of major economies. The thinktank Taxfoundation.org is calling for the US tax code to be fully indexed. Inflation artificially increases capital gains tax, as it doesn’t adjust the tax basis according to the loss of purchasing power. Capital goods and fixed assets depreciations are also causing concern — the amounts deducted lose value in relation to the original investment.

Inflation benefits highly leveraged businesses, but falls heavily on lenders because, as creditors, they will lose value in real terms. The same approach can be found in governments. Most are heavily leveraged, and inflation allows debt repayment to the private sector, with less valuable currency.

On the other hand, inflation creates a “tax” without representation on the indirect and direct tax fronts. Ultimate beneficiary: the governments. Again.

As recently reported by McBride and Durante, the US nominal GDP increased up to $2.1tn, year on year, in 2022. From that increase, $1.8tn came solely from inflation.

Inflation dynamics affect businesses and the private sector. Let’s say the financial director of a multinational wants to start up a business in a high-inflationary climate economy. Figures from his team’s recent research show a robust business plan and high ROI. The officer tries to do an additional test before giving the green light. He asks one of his managers to create a subsidiary under some basic constraints. The new company will receive $41m on day one, with a fundamental condition: the manager will return the sum at the end of the fiscal year — or lose his position. So, the local manager decides not to take any risks.  The company doesn’t perform any transactions during the fiscal year, and keeps only dollars received in the company bank account. In his reasoning, if he didn’t invest the funds, he couldn’t lose them either. He would be able to repay the debt.

During that fiscal period, the economy of the hypothetical country falls into crisis and the local currency devalues against the greenback. The immediate consequence is a rise of inflation rates.

The local official seems not to notice the economic ups and downs; he keeps the amounts contributed on day one. The surprise comes at the end of the fiscal period, when the local company’s income tax return shows a profit — due to the exchange rate difference — subject to 35 percent tax. Our imaginary official is forced, before clearing out his desk, to sell some of the contributed dollars to pay the tax liability.

This is, in simple terms, how a tax system fails to consider the effect that inflation has on business income. It ends up taxing only the nominal part of the equation that produces devaluation — but not income in real terms.

If the system doesn’t recognise the effect of inflation on business income, or taxing profits that should be exempt, inflation becomes an additional tax without representation. The absence of a tax adjustment leads our manager to sell the dollars to pay the tax when, from the shareholder’s point of view, he lost part of his investment by simply holding on to the cash.

This situation is very difficult to grasp without experience of inflation contexts.

An inflation-adjustment mechanism would allow companies to tax profits in real, rather than nominal, terms. That is, taking into account not only the profit or loss due to devaluation but also the loss of income: inflation caused by the devaluation.

In general, high inflation forces devaluation of local currencies (and vice-versa) with regard to hard currency. Distortions and foreign exchange should be equalised by inflation adjustment. Otherwise, a “phantom income” would be created, subject to tax.

Currency devaluation produces profits in export companies and would have the same effect on companies trading on the domestic market, due to the price increase that inflation would cause.

In either situation, income tax due to devaluation or inflation has an impact that must be factored-into calculations. The effect can be mitigated by a tax adjustment for inflation, which acts as a counterbalance. This even applies if the company generates tax losses.

However, if an inflation adjustment system is not enacted, many companies will feel the impact of corporate income tax on inflationary effects, without considering the protection an adjustment-for-inflation system could provide.

This distortion must also be added to the indirect tax context. In a price-increase scenario, indirect taxes are automatically adjusted for inflation — their tax base is dependent on that. When the price of goods and services increases as the currency erodes, so does the indirect tax base. The effects of inflation / devaluation on phantom income, plus the increase in the tax base on indirect taxes, create a burden for private businesses. This situation needs to be address by policy makers, and soon.

By Sergio Caveggia, Partner at EY Argentina