RDP 9012: Some Calculations on Inflation and Corporate Taxation in Australia 4. Debt and Interest

Under tax rules in Australia and most other countries, companies are entitled to deduct the full nominal value of interest payments from income, even though the inflationary component of the interest is compensation to lenders for the loss in real value of the debt. Whether this constitutes a tax bias towards borrowing depends upon the extent to which lenders, who must pay tax on nominal interest receipts, demand a higher pre-tax return on debt. (This is one instance in which consideration of tax treatment of corporations, rather than the ultimate investors, does not provide a complete picture.)

In inflationary periods, the nominal tax treatment of interest results in the understatement of company profits, since the corporate sector is a net debtor in aggregate. The magnitude of this distortion to real income can be calculated as the reduction in the real value of net debt holdings (D):

A similar distortion involves the treatment of non-interest bearing assets and liabilities, particularly trade credit, trade debt, and cash. Company income should also be adjusted for the real loss in value of net non-interest bearing assets.

Quantifying these distortions requires comprehensive national corporate balance-sheet data. New survey data compiled by the ABS are not yet available, and will not cover a significant historical period. Australian Stock Exchange data do not include a complete survey of corporations, and only maintain data for currently operating companies. The Reserve Bank's Company Finance Survey data do not cover a large enough segment of the corporate sector to provide a reliable measure of aggregate corporate debt. The Financial Flows data are more comprehensive, but do not include balance sheet information. However, debt levels can be estimated from the Financial Flows data by assuming some value for the initial stock in the early 1950s and adding the yearly borrowing flows.^[6] The resulting debt measure is admittedly crude, but appears to be roughly consistent with National Accounts corporate interest payments data.

The real gains on net corporate debt and losses on net non-interest bearing assets are shown in column (4) of Table 3.

Footnote

This is the methodology used in EPAC (1990), the main source of the debt data used here, adjusted for net trade debt. Net debt levels for 1986–87 and 1987–88 were estimated by applying market interest rates to the ABS interest payments and receipts data. The implied increase in net debt for these two years is large for any reasonable interest rate assumption. [6]