7 Tax Administration and Inflation

Richard Bird, and Milka Casanegra de Jantscher
Published Date:
September 1992
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Milka Casanegra de Jantscher, Isaias Coelho and Arturo Fernandez 

This paper discusses the impact of inflation on tax systems and analyzes the revenue and administrative effects of measures designed to adjust tax systems for inflation.

In a monetary economy most transactions, including the payment of taxes, are carried out by means of money. Because inflation erodes the purchasing power of money, it ends up affecting all aspects of economic activity. Money has several important functions in the economy: it serves as a means of exchange, an accounting unit, a wealth reserve, and as a standard for deferred payment. As a unit of exchange, money is involved in almost all transactions; as cash, it serves as a measure of the value of goods; as a wealth reserve, money grants a right to acquire goods that can be exercised at any time; and as a standard for deferred payment, money acts as a credit or liability account.

The effects of inflation on the functions of money apply directly to the tax system:

  • The unit of measurement employed by tax statutes to determine tax bases is the same monetary unit which devalues with the passage of time.

  • Taxes are paid with lags and they are measured in monetary units, the value of which decreases over time.

This paper assesses the impact of inflation on the tax system’s ability to produce revenues, giving special emphasis to administrative aspects such as the frequency of payments, payment periods and advance payments, and calculation of the tax base, mainly with respect to income taxes paid by businesses (corporations, partnerships, and sole proprietorships). It also analyzes the problems created by inflation with respect to late payments, and, in general, those relating to penalties and surcharges.

I. Collection Lags

Collection lags reduce the tax system’s ability to generate a certain level of real revenue during inflationary periods. These lags arise from the way the assessment and the payment periods are defined.

Income, profits, and other taxable items are generated over time, with a particular purchasing power. In order to impose taxes, tax statutes define assessment periods, that is, periods during which an obligation to pay a particular tax arises, that generally coincide with specific calendar periods. This is why income taxes are generally applied on income earned in the calendar year, whereas taxes on consumption are levied with respect to shorter periods (monthly, bimonthly, or quarterly).

Most tax statutes establish a time interval from the end of the assessment period (when taxes are generated) to the time when payment must be made, in order to allow taxpayers to calculate correctly their tax liability. Several countries’ tax statutes also provide taxpayers the opportunity of requesting deferral of tax payments.

Inflation, combined with the above-mentioned collection lags, weakens the tax system’s revenue-generating ability. The cost of collection lags is reflected in the ability of the tax system to produce a particular real amount of revenues.

The lower the inflation rate, the greater the frequency of provisional payments, and the shorter the assessment period, the lower will be the revenue loss resulting from collection lags. The relationship between collection levels, frequency of payment, and inflation rates can be illustrated with the following example. Assuming a country has an inflation rate of 20 percent and one yearly tax payment, if inflation increases to 200 percent, 20 tax payments will be required during the year to collect the same real amount. If inflation increased to 2,000 percent, there would have to be 200 payments a year (one every 1.82 days!).

There are several methods for reducing the impact of collection lags on revenue during periods of inflation. These include the following: shortening assessment and payment periods; establishing a system of payments on account (provisional payments) or increasing the frequency of such payments; and lastly, indexation of tax payments.

Provisional Payments

If a system of advance payments or provisional payments does not exist, it seems logical to introduce one. Payments on account are relatively common with respect to the business income tax. The choice of a suitable formula, however, is not an easy one. If the provisional payments are to be equal to a fraction of the previous year’s final tax, it is important to establish a mechanism for adjusting this amount to the new price levels. Another way of calculating the provisional payment is to establish it as a percentage of gross income. This percentage is equal to the ratio of taxable profits to gross income for the previous year. However, this formula is inequitable for economic sectors in which gross income and expenditure do not take place in the same time period. It also creates complications when dealing with income from interest.

In periods of high inflation some countries have established biweekly provisional payments of monthly taxes. In Chile, for example, in the mid-1970s large enterprises had to make advance fortnightly value-added tax (VAT) payments. This measure was very effective from a revenue point of view, given that in Chile, as in other countries that apply a VAT, a small number of taxpayers account for a considerable percentage of the total VAT yield. From an administrative point of view, the system did not cause any great problems as it affected a relatively limited number of taxpayers.

Shortening Payment Periods

One option that is frequently exercised in highly inflationary circumstances is to shorten payment periods. In Uruguay, for example, between 1987 and 1988 the VAT payment period was reduced by approximately 60 days. In other countries the period for payment of monthly taxes has been reduced from 20 to 15 or even to only 7 days from the last day of the month in which the tax is generated.

In the case of annual taxes, such as income taxes, the period for filing annual tax returns and making final payments can be shortened from three months to one. It is not advisable to shorten it further since the data needed to calculate the tax due may not be available to the taxpayer (for example, profit statements, bank statements, or the settling of accounts with clients or suppliers).

Indexing of Payments

The third measure aimed at decreasing the negative revenue impact of collection lags is to index tax payments. This involves, in practice, abandoning the legal tender as a unit of account for tax liabilities and replacing it with a fiscal or tax unit adjustable according to a selected index (consumer price index (CPI) or other). This measure is indispensable when the inflation rate exceeds 100 percent per annum, in which case even with monthly payments the loss in tax revenues exceeds 4 percent. In order to implement this measure, it is essential to take into account the frequency with which the CPI is calculated and published. These elements are fundamental in establishing the payment periods and the time lag that necessarily has to exist between the period to be indexed and the index that is applied in practice (for example, payments to be indexed month 2 to month 5, index variation month 1 to month 4).

The Mexican Experience

Several Latin American countries, particularly those in the southern cone, have a great deal of experience in using different combinations of the methods described above to decrease the revenue impact of collection lags.

Mexico’s experience is worth analyzing since it is the most recent and therefore is little known. At the beginning of the inflationary spiral of 1979, politicians refused to recognize explicitly the effects of inflation in the hope that anti-inflationary measures would eliminate or at least substantially reduce them. This position forced the administration to introduce isolated and not always consistent changes; first, the provisional payments of company taxes were changed from four-monthly to quarterly, later to bimonthly, and finally to monthly. At the same time, payment periods were reduced from three to two and finally to one month, and even to ten days. This process caused discontent among taxpayers, who saw their compliance costs increase, until some elements of indexation were finally introduced starting in 1987. The administrative changes prior to 1987 gave rise to constant modifications in the regulations and forms of payment, causing uncertainty and confusion not only among taxpayers but also within the tax administration.

Perhaps the most important lesson from this experience is that, in countries unaccustomed to high levels of inflation, the introduction of tax adjustments aimed at maintaining revenue levels can be quite traumatic, both for taxpayers and for the tax administration. Adjustments that in Argentina, Brazil, and Chile are part of the tax culture may cause political and administrative problems of great magnitude in countries where previous levels of inflation have not been so high as to justify the introduction of such adjustments.

Administrative Cost of Measures to Decrease the Revenue Impact of Collection Lags

Reducing the periods of assessment and payment of taxes or increasing the number of provisional payments may give rise to substantial costs for the tax administration as well as for taxpayers. These costs constitute a “deadweight loss” for the economy as a whole, since in order to make a payment it is necessary to employ resources that benefit nobody.

As far as the tax administration authorities are concerned, introducing or increasing the number of provisional payments requires a significant increase in the administration’s ability to monitor liabilities, check tax returns, and account for revenues. If collection is done through the banking system, the cost of this service rises in proportion to the number of tax returns and payments made. A greater number of periodic payments implies higher compliance costs for taxpayers.

If taxes normally paid quarterly become due monthly, the tasks associated with controlling collection are multiplied by three. There might, however, be surplus processing capacity if the personnel and material resources of the administration are employed intensively for only four months a year. In Mexico, when inflation rose above 100 percent, provisional payments for business income taxes were required monthly instead of the previous arrangement of one payment every four months. This change disrupted tax administration, and the control of provisional payments totally broke down. Data entry personnel and existing computer facilities were insufficient to handle four times the previous work load.

Some of the costs associated with increasing the number of provisional payments can be reduced considerably by consolidating in one return form the main monthly taxes paid by enterprises: VAT, withholding taxes, provisional business income taxes, and excises. Further savings can be obtained by eliminating the payment form, and making the tax return function as a payment form. These measures are beneficial even without inflation. However, when inflation accelerates, these measures markedly reduce the administrative costs associated with increasing the number of provisional payments.

A consolidated tax form of this nature allowed Chile successfully to implement and control a system of monthly provisional payments for business income taxes. However, the option of a unified or consolidated form faces great difficulties in countries in which the VAT is administered by state authorities while income taxes are administered federally (as it is in Brazil and was in Mexico until 1990).

As mentioned earlier, an alternative to increasing the frequency of payments or shortening payment periods is to index such payments. Depending on the type of tax, one solution may be more appropriate than the other. For example, the annual income tax return and final payment of business taxpayers cannot be advanced like the monthly VAT, because, as previously explained, it requires time for the necessary data to be available. In this case, indexation of the final payment is appropriate. Usually, increasing the number of advance payments or shortening payment periods can be done directly by the tax administration while indexation requires the enactment of legislation.

II. Delinquent Taxes, Additional Assessments, and Penalties

The previous section discussed various methods of reducing the negative revenue impact of legal collection lags. This section analyzes payments made after the legal payment period, including delinquent taxes, additional assessments, and penalties.

Taxes Paid After the Legal Payment Period (Delinquent Taxes)

Whatever the mechanism chosen to adjust delinquent taxes, it must protect the real value of the tax due (principal obligation). In addition, it must ensure that delinquent taxpayers incur a real financial cost so that there is no incentive to default. In principle, there are two options for indexing delinquent taxes. The first is to adopt a variable interest rate based on a market rate, or to apply an interest rate that includes an estimate of inflation. The second option consists of indexing the value of the tax liability and fixing a real interest rate.

The use of a market interest rate as a reference (for example, the banking system’s borrowing rate, the prime rate, or the rate of government bonds) poses certain difficulties that should be taken into account. In a high-inflation economy, financial markets tend to contract, reduce the time span of operations, and be extremely volatile. These features intensify when financial operations are not indexed. The resulting interest rates can be excessively low in some cases, thus encouraging delays in tax payments. Generally, after an abrupt devaluation, real interest rates become negative and if interest on delinquent taxes is fixed according to market rates, taxpayers will prefer to finance their operations by incurring late payment of taxes. On the other hand, an interest rate that includes an estimate of inflation must be reviewed periodically so that the real cost proves to be greater than that of the market.

The second option—to index taxes owed—protects the real value of the tax liability. In principle, a periodic review of the (real) interest rate applicable to the indexed tax liability is required to prevent such interest from being equal to or less than the real cost of credit in financial markets. However, periodic reviews of nominal or real interest rates are not always possible; in most countries these charges require legislative approval and it is not always feasible or advisable to initiate tax legislation on this matter.

Decisions concerning indexation of the tax liability and the interest rate to be applied will generally depend on the institutional structure of each country and the level of inflation. The mechanism that is adopted should, however, comply with three conditions:

(1) The real value of the tax liability must be preserved.

(2) The real cost to the taxpayer of incurring tax delinquency must always be higher than the real cost of bank finance.

(3) The elements for calculating the cost of tax delinquency must be known before the payment is calculated and their evolution must be foreseeable.


The previous section discusses options for preserving the real value of delinquent taxes and fixing an appropriate real interest rate. Besides interest for the delay in tax payments, tax statutes generally establish penalties for noncompliance with tax obligations. In some countries, most penalties consist of a percentage of the tax due, whereas in others penalties are expressed in fixed amounts of local currency even in the case of unreported taxes.

Where high inflation prevails, fines expressed in fixed amounts lose their effectiveness if they are not indexed. This of course has a negative impact on tax compliance levels. Solutions generally adopted are the following: (1) expressing penalties as a percentage of the indexed unpaid tax; (2) if that is not possible because the penalty is for nonfulfillment of a formal requirement, expressing the penalty in an automatically adjustable unit (as is the case of the tax unit in Chile)1; and (3) periodically modifying the tax statutes to adjust (index) penalties expressed in local currency.

The most practical solutions are those indicated in (1) and (2), as they do not require continuous legal modifications. In some countries solution (3) is also automatic, in the sense that the tax statute authorizes the administration to undertake this adjustment periodically. In this case, the problem of having to depend upon periodic legislation in order to make adjustments is eliminated.

Finally, we should point out that in periods of high inflation there is a tendency to confuse the concepts discussed in this section: (1) the indexation of delinquent tax payments in order to maintain their real value; (2) the interest rate charged by the government for the use of the money; and (3) the penalties for noncompliance. In countries that are familiar (unfortunately) with the problem of inflation, such as those in the southern cone of Latin America, these concepts are relatively clear. In others, where experience with this problem is limited, there is a tendency to believe that indexation of tax payments is a kind of penalty, thereby making it unnecessary to apply additional penalties. As previously indicated, the indexation of tax due and the charging of interest are not intended to penalize the taxpayer. In order to maintain an adequate level of tax compliance it is also necessary to apply effective penalties for noncompliance.

III. Credits Against the Treasury

The above sections referred to the indexation of claims that the treasury has against taxpayers. For reasons of equity, and in order to increase the level of voluntary compliance, equal treatment should be given to claims that taxpayers have against the treasury. In practice, countries that have indexed late tax payments also permit an adjustment of the refunds owed to taxpayers. A number of countries have recognized, however, that the problem of equal treatment is not limited to the question of refunds. This is why, for example, excess VAT credits can generally be indexed by the taxpayer when VAT statutes require them to be carried forward. In Brazil and Chile, taxpayers are allowed adjustments for inflation in a variety of situations, including refunds, carryforward of losses, payments on account, and so forth.

These measures, similar to those used to index late tax payments, give rise to administrative costs because they complicate the calculation of claims against the treasury. But their cost is low compared with the equity that they introduce in the system.

IV. Calculation of Business Income

Generally accepted accounting principles adopt legal tender as the unit for measuring transactions. This allows adequate calculation of business income in noninflationary economies. In an inflationary economy, however, the lack of stability of the currency creates serious problems that prevent the correct calculation of real business income.

Distortions generated by inflation in the calculation of business income are caused by two elements: first, the lack of stability of the accounting unit adopted, and, second, the fact that many financial instruments are not indexed.

The loss in purchasing power of the currency gives rise to the following distortions:

  • Transactions are registered in a currency that has a different purchasing power at the beginning, middle, and end of the financial year.

  • Deductions for depreciation of fixed assets and the cost of goods sold are based on historic costs, and therefore do not represent the true cost of their contribution to the production process.

In the case of financial transactions, inflation forces interest rates up in order to reflect the loss in the principal’s real value, so that a portion of the interest rate represents anticipated retirement of outstanding debt. Deductibility of nominal interest payments and taxation of nominal interest received lead to an incorrect calculation of income, underestimating it when nominal interest is deducted and overestimating it when it is taxed.

In developing countries with high inflation rates, the absence of inflation adjustments for business profits tends to reduce tax revenues considerably. Such countries are usually net capital importers and the financial liabilities of companies exceed the financial assets of the savers. This leads to higher deductions for nominal interest by companies than the nominal interest earned by national savers, which causes a negative impact on tax revenues that is not offset by the increased collections arising from underestimated depreciation deductions. Where the interest income of savers in the national financial system is exempt from tax, or is taxed at reduced rates, as is the case in Mexico, Guatemala, Honduras, Venezuela, and Paraguay, the negative revenue impact of nominal interest deductibility is even greater.

The absence of indexation, aside from the above-mentioned revenue effects, increases or decreases the tax burden of companies according to the nature of their assets and liabilities and their degree of indebtedness. Small and medium-sized companies that do not have access to financial markets suffer disproportionate increases in their tax burdens, whereas large companies can take action to reduce them considerably. The frequent use of “back-to-back” operations has been detected in several Latin American countries. Shareholders of large companies place their funds in national or foreign banks in order to guarantee credit for their companies, instead of financing them with equity capital, thereby managing to reduce company profits to a minimum.

To summarize, the absence of indexation causes serious problems with respect to the economic decisions of enterprises. It encourages indebtedness instead of equity financing and favors short-term assets as opposed to those with longer useful lives. This implies discrimination against economic activities with high stock levels and low turnover, sectors with longer-lived fixed assets, and enterprises with high equity ratios.

Given this situation, experts currently tend to agree on the advisability of introducing inflation adjustments for business profits. The main question is at what level of inflation are such adjustments justified, bearing in mind the greater complexity they introduce in the tax system. It is likely that with an inflation rate exceeding 20 percent or 30 percent per annum, these adjustments are justifiable.

Most countries that have introduced such adjustments have initially done so partially, generally permitting revaluation of fixed assets with the aim of adjusting depreciation. These partial adjustment mechanisms, besides reducing tax revenues, generate imbalances that favor financial strategies aimed at tax avoidance. An army of tax consultants emerges to provide advice on how to take advantage of these regulations. The complexities of partial adjustment systems, and the possibilities of tax evasion and avoidance that they create, make control practically impossible. These difficulties are caused principally by the lack of symmetry in these partial adjustment schemes. For example, in a system of partial adjustment, the taxpayer has an incentive to “inflate” his revaluation of assets to the maximum, since it will be reflected only in greater depreciation allowances (unless there is a separate tax on assets or net wealth). In an integrated or comprehensive adjustment system, such as that of Chile, asset revaluation also gives rise to an entry in the enterprise’s profit account, which curbs such taxpayer maneuvers and facilitates the task of control.

The distortions, complexities, and revenue losses created by partial adjustment systems have led several countries, among them Argentina, Brazil, Chile, Colombia, Israel, Mexico, and Uruguay, to introduce more or less integrated or comprehensive systems of profit adjustment.

The Chilean method is considered one of the more technically appropriate. This method consists of the following:

(1) The revaluation of fixed assets according to CPI variations. Inventories are adjusted to the value of the last purchase while nonmonetary assets (indexed credits or credits in foreign currency) are adjusted in accordance with the variation of the agreed index or the value of the foreign currency. These revaluations are considered taxable income. Assets acquired during the assessment period are only adjusted for the fraction of the period since their purchase.

(2) The revaluation of the firm’s net worth according to the CPI variation and of nonmonetary liabilities (indexed debts or debts in foreign currency) in the way indicated in (1) for similar assets. The sum of these adjustments is deducted as a loss.

(3) Depreciation is calculated using the adjusted asset figures for the beginning of the assessment period.

(4) The cost of sales is calculated using the adjusted value of the initial inventory of the reference period.

(5) When nonmonetary assets or liabilities are sold, the revalued figure is considered as cost for the purpose of determining capital gains.

The index used is generally the CPI, except when dealing with non-monetary assets or liabilities expressed in foreign currencies or those subject to indexing. Such assets and liabilities are adjusted according to the variation in the value of the foreign currency or the index agreed upon. Inventories are adjusted, in general, to the value of the last purchase.2

The method described above shows the loss or gain that the firm has derived from inflation. In practice, this system has proved to be less complex to administer than previous partial systems. This is mainly because it is a comprehensive system, whose symmetry hinders tax evasion. It is interesting to note that in Chile the system, introduced in a year when inflation exceeded 300 percent (1975), is still in force, in spite of inflation having declined since 1975 to figures that fluctuate between 10 percent and 25 percent. This shows that both taxpayers and the administration have become accustomed to the system, which does not cause any real problems in application. One “technological” reason for the preservation of the system is that large and mediumsized companies have incorporated the monetary adjustment program in their computerized accounting systems and complications would arise were it to be eliminated.

Although large and medium-sized companies have adapted to the comprehensive adjustment system, this has not been easy for small companies. A senior civil servant of a country in which a comprehensive adjustment system is applied stated that he “prefers not to know what small companies do with the monetary adjustment system and especially with inventory valuation.” For small businesses, an appropriate solution might be the cash flow system recently introduced in Mexico.

V. Personal Income Tax

Most countries tax the income of private individuals at progressive rates, exempting those whose income is below a certain level. When the tax brackets are measured in monetary units, inflation distorts these parameters. People who were previously exempt begin to be liable and taxpayers move up into higher tax brackets simply because of a nominal increase in their income. This “bracket creep” has led many countries to take corrective measures.

The decision of whether or not to introduce an automatic indexing system depends, among other factors, on the desired income policy. As regards tax administration, it is necessary to bear in mind the following:

  • Automatic indexation of exemptions and tax brackets in accordance with a pre-established index is very easy to administer. If exemptions and brackets are expressed in an indexed unit, as is the tax unit of Chile (which is adjusted according to CPI variations), it is not necessary to modify tax forms or instructions to take account of the periodic adjustment. All that is required is the regular periodic announcement of the monetary value of the new tax unit.

  • Adjustment of the exempt minimum is necessary to avoid an excessive increase in the number of taxpayers and consequently in the tax administration’s work load. If wage earners without other sources of income are not required to file a tax return, the adjustment of the exempt minimum is not as important from an administrative point of view.

  • Discretionary adjustments of tax brackets and exemptions are the least advisable because their predictability obliges the administration to make changes in tax forms, instructions, and programs, which increase administrative costs.

Another feature of income taxation that is distorted by inflation is the calculation of capital gains and losses. Many countries tax these gains while others exempt them. In the case of capital gains, distortions arise when comparing historic costs with current sale prices. Countries with high inflation levels that tax these gains generally permit indexation of historic costs according to a general index. In Chile, for example, in the period when occasional capital gains from the sale of real estate were taxed,3 the CPI was used to index the original cost. Chile’s experience was interesting because the indexation of capital gains was not difficult to apply; one of the reasons for eliminating this tax, however, was that most of the transactions, once indexed, resulted in capital losses.

VI. Taxes on Interest and Dividends

Capital markets are very sensitive to taxes on dividends and interest. When inflation accelerates, this is one of the areas in which tax treatment needs to be redesigned.

In addition to ensuring better compliance, withholding taxes on interest and dividends decreases the impact of inflationary erosion on revenue from these sources. The tax withheld may be an advance payment on account of the income tax or a final (definitive) payment. From an administrative point of view, a final tax is obviously preferable because it makes it easier to eliminate filing requirements for wage earners, including those who, in addition to a salary, receive interest income or dividends. Moreover, making the withholding tax a final tax eliminates the need to index the withheld amounts for purposes of crediting them against the final payment.

Although withholding makes it easier to tax interest, it does not solve the problem of how to establish a “real” tax base with respect to interest received. When an indexation clause has been included in the loan agreement, the tax law may exempt the indexation (monetary adjustment in Brazil) and tax only the real interest. If the loan is not indexed, nominal interest includes a portion that is an adjustment of the principal and another that is the “real” interest. Some countries have chosen to reduce the tax rate applicable to interest payments during periods of inflation in order to indirectly avoid taxing debt repayment. Chile applies a more technical solution: for tax purposes, loans are expressed in development units4 and only amounts received by creditors that exceed the adjusted value of the loan are taxed as interest. Chile’s experience has shown that such adjustments are workable.

VII. Types of Rates

One obvious result of inflation is the loss of revenue from taxes levied with specific rates. The classic recommendation in this case is to replace specific rates with ad valorem rates. From an administrative point of view, this measure makes control of such taxes more complicated, since it requires controlling sales prices, financial accounts, and so forth. An alternative is to keep the specific rates and legislate to establish their periodic adjustment in accordance with a specified index. The index chosen should relate to general price level changes (for example, the CPI) and not to changes in the prices of the goods taxed.

VIII. Fiscal Assessments

As regards property taxes, and especially taxes on real property, inflation reduces tax revenues because property values become outdated. In countries with high inflation rates it is impossible for periodic reassessments to keep values up to date. One practical solution, such as that applied in Chile for example, is to index assessments. At present, fiscal assessments are adjusted biannually in accordance with the CPI variation during the previous six months. This solution, although administratively simple, does not eliminate the distortions among assessments caused by changes in relative property values; on the contrary, it aggravates them. To reduce these distortions, periodic assessments are needed; however, given the chronic lack of resources in the tax administrations of developing countries, they are not usually possible.5

IX. Lessons from Experience with Inflation Adjustment Systems

It is generally accepted that when inflation exceeds certain limits, it is necessary to adjust the tax system to protect tax revenues and reduce inequities and distortions produced by inflation. Experience shows that such adjustments are also necessary for reasons related to tax administration. Indeed, if obvious inequities are not corrected, compliance levels will fall because of the perceived unfairness of the system. An example of unequal treatment is the advantage enjoyed by taxpayers who pay with a lag vis-a-vis wage earners whose taxes are withheld. Equally, if delinquent taxes and penalties for noncompliance are not indexed, the administration will be faced with a wave of delinquent taxpayers and tax evaders.

Experience has shown that ad hoc measures designed to maintain collection levels during inflationary periods—such as increases in rates—increase economic distortions and reduce tax compliance. For this reason, they are not a suitable substitute for a rational system of adjustments for inflation. The question is not, therefore, whether adjustments for inflation are advisable or not, but rather how they should be designed in order to meet their objective effectively.

From a tax administration point of view, certain methods of adjustment for inflation are less cumbersome to manage than others. However, most of them imply an additional cost for the taxpayer as well as for the administration.

Some of the lessons learned from experience with adjustments for inflation follow:

  • Positive effects on revenues can be produced by shortening payment periods, increasing the number of provisional payments, and indexing payments. In order to achieve this, it is necessary to have a well-designed system of return filing and tax payment that permits adequate control. Collection through banks and the use of a single form for filing and paying the main business taxes have eased the implementation of measures to decrease collection lags.

  • Comprehensive profits adjustments seem to cause fewer problems for tax administration than partial adjustments. The mechanics of comprehensive adjustments frustrate attempts to increase deductions by artificially inflating certain items (for example, indexation of assets and “back-to-back operations”), since they will show up as a profit in the profit and loss accounts.

  • Automatic indexation of individual income tax brackets and exemptions gives rise to lower administrative costs than discretionary adjustments.

  • Indexation of interest earned is feasible and does not cause major administrative problems, as long as there is a well-publicized daily index.

To conclude, we must emphasize that, despite the administrative costs involved in adjustments for inflation, once inflation exceeds certain limits these costs must be faced, as the alternative is the collapse of the tax system. The most that tax officials (and taxpayers) can demand is that the design of adjustment methods take into consideration the difficulties involved in applying them and that mechanisms that cause the fewest complications are chosen.


Botaro Renato

In the little more than twenty years since a major tax reform was implemented in Brazil at the three levels of government (municipal, state, and federal), many changes have occurred in the tax system without adequate harmonization among them. In the last twenty years, the inflation rate in Brazil has always been high. Five economic plans, or shock treatments, were adopted from 1986 to 1991.

The profound changes that the new federal constitution introduced in the fiscal area in 1988 resulted more from political than from technical considerations. Consequently, a new tax reform is necessary despite the relatively short time that has elapsed since the last one, and the Brazilian Government has begun work on this task.

Methods for Diminishing the Effects of Inflation—The Brazilian Experience

Some aspects of the Brazilian experience are important when considering methods for diminishing the negative impact on revenue of high inflation. It must be remembered that the Brazilian tax system has been subjected to adjustments for inflation for more than twenty years. They can be summarized as follows:

Provisional Payments

For large legal entities, an advance monthly payment of one twelfth of the income tax is required, based on the updated value of the previous year’s tax.

The following are used for individuals: (1) withholding at source for employees; (2) mandatory monthly payments for professionals, rents from house leasing, and so on; and (3) monthly adjustment option for employees with more than one job. All prepayments are adjusted in the annual return, which can show a positive or negative balance (refund or amount owed).

Reduction of Payment Periods

The reduction of payment periods is a practice much used by the Brazilian tax authorities, notwithstanding the opposition from business and political circles.

Indexation of Payments

For many years, the value of adjustable obligations of the national treasury (ORTN) was adopted as an index to adjust tax payments. In 1986 these were replaced by national treasury obligations (OTN). In 1989 the index was changed again, this time to the value of the national treasury bonus (BTN), set monthly for general use and updated daily for tax purposes.

In February 1991 the total deindexation of the economy was decided on as a means of combating inflation, and a charge named the daily reference rate (TRD) was imposed on overdue tax payments. Although this charge is not an index, people insist on calling it one.

Thus, the last five years have seen five economic stabilization plans and three new indexes (ORTN, OTN, and BTN), before the whole approach was jettisoned in February 1991. At present, with inflation at some 9 percent a month, a new index is already felt to be necessary.

Brazilian reality thus confirms what was said in the paper: after a time, the adjustments caused by inflation become part and parcel of the tax culture and society can no longer get along without them.

Nevertheless, although in the Brazilian case the tax culture has already absorbed adjustments for inflation through the use of the appropriate indexes, it is difficult to count on the full understanding of the taxpayers. During the 1991 filing period, for example, the fact that the individual income tax return was filed at a time when inflation was slowed by a new economic plan made it difficult for people to understand that a correction of only 270 percent was being made on taxes withheld or paid provisionally in the previous year, when inflation had been over 300 percent. Subsequently, the Federal Supreme Court ordered application of that correction index suspended. We now face the problem of having to extend for the second time the deadline for submitting 1991 returns based on incomes of 1990.

Reasons for Adopting an Inflation Adjustment System

The rationale that may lead lawmakers to introduce an inflation adjustment system into tax legislation generally springs from the urge to reduce the effects of inflation on society. In that context the function of tax indexation is to avert the loss of real value from the moment the clock starts running until the tax payment is legally due.

In countries where inflation remains at a high level for many years, the adoption of tax indexation is primarily a means of fiscal justice, inasmuch as those who benefit most from its absence are those best able to pay higher taxes.

As for the mechanism of adjusting business profits for inflation, it has the advantage of presenting a picture that is closer to reality. In financial terms, the analysis of the assets of corporations reveals the existence of some assets whose value shrinks as inflation erodes the currency’s purchasing power, and others that maintain their intrinsic value in spite of inflation. The former are monetary assets and the latter are nonmonetary assets. Only the nonmonetary assets should be subject to a monetary correction, because a new monetary expression is necessary for assets that keep their value unaltered despite changes in the currency’s purchasing power.

Other Considerations

Inflation adjustments are necessary in a country experiencing chronic inflation or inflation above a reasonable degree. Without adjustments such a society’s wealth can be virtually wiped out in a few years or reduced to merely symbolic worth. With respect to tax indexation, the inflation adjustment mechanism is also justified because it prevents the loss of tax revenue.

Meanwhile, it must be recalled that a tax indexing system can lead to general indexation of the economy through the adoption by businesses of the correction indexes used in the system. In such cases, indexation can represent a perverse form of inflation feedback.

In line with this thinking we must bear in mind that the monetary discounting indexes used by the adjustment system can turn into a psychological component of the inflationary process, interfering in price formation.

A problem that arises when the adjustments are made by using price indices is the lag due to the time needed for collection and processing of those indices. The price index used in a month thus usually measures the mean variation in the previous month’s prices. In cases where the monetary correction index is announced at the beginning of the month, this will probably cause a lag of more than a month. That is how the inflationary feedback occurs.

Sometimes correcting for expected inflation is preferable to indexing on the basis of past inflation. In one way or another, indexing keeps inflation at levels where it is difficult to overcome.

The introduction of a system of inflation adjustment into tax legislation is complex and entails profound changes in the way businesses keep their accounts. Tax administration also suffers the effects of having to regulate procedures and guide businesses in applying the legislation correctly.

To prevent problems stemming from incorrect interpretations and inadequate tax planning, it is important that the system adopted should be perfectly understood in its structure, function, and effects, not only by the tax authorities but also by businesses and tax consultants.

Charles E. McLure, Jr.

Inflation creates problems in essentially three areas: measurement of income from business and capital, reduction in the real value of amounts stated in nominal (monetary) terms, and evaporation of real tax revenues because of collection lags. Inflation adjustment, or some ad hoc surrogate for it, is required for three reasons: to preserve the real value of tax revenues, to prevent economic distortions, and to prevent inequities. Administrative goals and compliance problems constrain what can be done to achieve these goals. It should be recognized, however, as the authors do, that inflation adjustment may reduce administrative problems, as well as cause them.

The authors devote about half of the paper to collection lags and similar issues—matters that affect primarily the preservation of real revenues—and the rest to other issues: the calculation of the taxable business income, indexing in the personal income tax, taxation of interest income, inflation and excise taxes, and fiscal valuation, issues where income measurement, equity, and neutrality figure more heavily. Reflecting my background as an economist, I would have preferred more emphasis on the second half of the paper; I will emphasize it in my comments. I have little to say about indexation of nominal amounts, which is simple and straightforward.

Collection Lags and Related Problems

Inflation, combined with lags in collections, can cause tax revenues to fall in real terms. The conceptually correct way to deal with this problem is to index payments. There may be problems in knowing the change in the relevant price index on a timely basis, but subsequent adjustments could be made in a final setting of accounts.

Such techniques as increasing the frequency of payments and consolidating tax return and payment forms are poor substitutes for indexing payments. If payments are made too frequently, administration and compliance problems inevitably arise. I am surprised that Mexico chose to rely so heavily on increasing the frequency of payments, which could have been seen in advance to swamp the tax administration system.

Income Measurement

The Haig-Simons definition of income—consumption plus the change in net wealth—is a useful point to begin in discussing the need for inflation adjustment in the measurement of income. Once inflation exceeds a relatively low threshold, it is meaningless to speak of implementing Haig-Simons, unless there is a comprehensive adjustment for inflation.1 Inflation that is not anticipated undermines the fairness of an unindexed tax system. Anticipated inflation causes such a system to distort the allocation of resources. More commonly, both distortions and inequities occur. In addition, the opportunities for tax avoidance created by an unindexed system are likely to increase compliance and administrative burdens.

The authors’ statement that “experts currently tend to agree on the advisability of introducing inflation adjustments for business profits” stands in sharp contrast to the conventional wisdom of a quarter century ago. The Taylor Mission to Colombia (see Joint Tax Program of the Organization of American States and the Inter-American Development Bank (1965, p. 84)) wrote:

If inflationary pressure is to be contained, certainly it is not desirable economic policy, in general, to remove its penalties through automatic adjustments. A more therapeutic method is to permit the painful effects of inflation to be manifested for whatever beneficial effects these will have as a restraint on inflationary pressures. (emphasis added)

The Musgrave Commission (Musgrave (1971, p. 82)) reached the following similar conclusion:

The Commission…believes that the proper solution for Colombia lies in a well-designed stabilization policy …, rather than a general and automatic adjustment for inflation provided through the tax system. Such an adjustment would tend to encourage inflation and have detrimental effects on economic development.

Inflation causes mismeasurement of income in four areas: depreciation (and similar) allowances, cost of goods sold from inventories, capital gains, and indebtedness (divergence between nominal and real interest income and expense).2 It is common for business people to propose inflation adjustment (or ad hoc surrogates for it) for the first three of these; they hardly ever want adjustment for interest expense. Such partial steps to compensate for inflation, the authors rightfully note, “generate imbalances that favor financial strategies aimed at tax avoidance.” I wish those responsible for tax policy in the United States—and even some of my academic colleagues—realized the problems caused by asymmetric or inconsistent treatment of similar or related transactions.

Despite this discussion of partial steps and asymmetrical treatment, the paper does not indicate clearly how the various forms of inflation adjustment in the measurement of income are related. In particular, how are the integrated systems of income measurement for companies in Chile and Colombia tied in with the taxation of interest received by individuals? Also, in countries that have inflation adjustment of the measurement of income from business and capital and deductions for interest on home mortgages, how is the latter treated?

Similarly, I was somewhat surprised to see the endorsement of a cashflow tax for small business. It would seem that there are possibilities for game-playing in a system in which part of the economy is taxed under a cash-flow tax and other parts are not. My own proposal for avoiding the problems of income measurement addressed in the second half of the paper is what I call the simplified alternative tax or SAT3. Under the SAT, interest and dividends are neither deductible nor taxable and all business expenditures are deducted in the year in which they are incurred. This system avoids all the problems of inflation adjustment (as well as timing issues). In addition, it automatically takes care of another problem the authors address—the need to impose a final withholding tax on interest and dividends; these are taxed by disallowing a deduction for them.

Inflation has impacts on tax liabilities and incentives that depend in complicated ways on debt-equity ratios, types of investment, and provisions of the tax law. The marginal effective tax rate (METR) usefully summarizes the effects of these factors.4

The Case for Specific Excises

Part of the conventional wisdom of public finance has been the superiority of ad valorem taxes, including excises, over specific excises, because the latter are vulnerable to inflation. I believe this view is fundamentally wrong. There are good reasons to prefer specific excises to ad valorem ones in many cases.

I would guess that in almost no case are the social costs connected with private consumption related directly to the value of the consumption; it is far more likely to be related to the quantity of consumption. For example, are the social costs (alcoholism, family dysfunction, traffic accidents) greater from drinking expensive Scotch whiskey than from drinking cheap rum? How about the costs of caring for those with lung disease caused by smoking cheap or expensive cigarettes? Do expensive pesticides necessarily cause more damage than cheap ones? What sense does it make to speak of using ad valorem effluent charges to combat pollution? Specific excises are clearly better in all these cases.

The point about vulnerability to inflation is at best a red herring. Specific excises can be indexed for inflation. They can be reviewed periodically and adjusted on the basis of the best and most recent knowledge about social costs—something that seems less likely to occur under an ad valorem tax system.


    Casanegra de JantscherMilka “Taxing Business Profits During Inflation: The Latin American Experience,”International Tax Journal (Winter1976) pp. 12846.

    Casanegra de JantscherMilka “Inflation Adjustment in Chile,” in Taxation in Developing Countriesed. by Richard M. Bird and OliverOldman (Baltimore: Johns Hopkins University Press4th ed. 1990).

    Centro de Perfeccionamiento y Extensión Tributaria “Corrección Monetaria 1984,” Cartilla TécnicaNo. 29 (SantiagoJanuary1984).

    Hoerner J.Andrew “Indexing the Tax System for Inflation: Lessons from the British and Chilean Experiences,”Tax Notes International (June1990) pp. 55256.

    International Fiscal Association “Inflation and Taxation,” Proceedings of the Thirty-First International Congress of Financial and Fiscal LawCahiers de Droit Fiscal InternationalVol. 62-a (Vienna1977).

    International Fiscal Association “Adjustments for Tax Purposes in Highly Inflationary Economies,”Proceedings of a Seminar held in Buenos Aires in 1984 During the Thirty-Eighth Congress of the International Fiscal Association (Antwerp: Kluwer1985).

    International Fiscal Association “Administration and Compliance Costs of Taxation,”Proceedings of the Forty-Third International Congress of Financial and Fiscal Law held in Rio de Janeiro in 1988Cahiers de Droit Fiscal InternationalVol. 74-b1989.

    McLureCharles E. Jr. John MuttiVictor Thuronyi and George R. ZodrowThe Taxation of Income from Business and Capital in Colombia (Durham: North Carolina: Duke University Press1990).

    Organization of American StatesInflatión y tributación Documentos Ocasionales, Programa del Sector Público (Washington1978).

    SadkaEfraim “An Inflation-Proof Tax System? Some Lessons from Israel,”IMF Working Paper No. 90/46 (Washington: International Monetary FundMay1990).

    TanziVitoInflation and the Personal Income Tax: An International Perspective (Cambridge, England: Cambridge University Press1980).

    TanziVito “Inflation, Real Tax Revenue, and the Case for Inflationary Finance: Theory with an Application to Argentina,”Staff Papers International Monetary FundVol. 25 (September1978) pp. 41751.

    WeaverR.KentAutomatic Government: The Politics of Indexation (Washington: Brookings Institution1988).

The tax unit is an amount determined by law which is continuously updated according to CPI variations. There are annual and monthly tax units.

The main conceptual defect of the Chilean system is that it bases adjustments for inventories on replacement costs and adjustments for assets and liabilities denominated in foreign currencies on individual exchange rates. For a full discussion of the criteria for valuation of inventories and assets and liabilities in foreign currency, see McLure and others (1990).

This levy was introduced in 1964 and abolished in 1974.

The development unit is an amount fixed by law that is adjusted daily from the tenth of each month until the ninth of the following month, according to the geometric average rate corresponding to the variation of the CPI in the calendar month immediately prior to the month being adjusted. The value of the development unit is published daily.

In Chile, for example, a process of reassessment of all real estate has ended and will take effect in the second half of 1991. Current assessments derive from assessments performed in 1977 with respect to nonagricultural property and in 1980 with respect to agricultural property, indexed periodically in accordance with the property tax statute.


    Joint Tax Program of the Organization of American States and the Inter-American Development BankFiscal Survey of Colombia (Baltimore: Johns Hopkins Press1965).

    McLureCharles E. Jr. John MuttiVictor Thuronyi and George R. ZodrowThe Taxation of Business and Capital in Colombia (Durham, North Carolina: Duke University Press1990).

    MusgraveRichard A.Fiscal Reform for Colombia: Final Report and Staff Papers of the Colombian Commission on Tax Reformed. by Malcolm Gillis (Cambridge, Massachusetts: Law School of Harvard University, International Tax Program1971).

    SimonsHenry C.Federal Tax Reform (Chicago: University of Chicago Press1950).

    ZodrowGeorge R. and Charles E. McLure Jr. “Implementing Direct Consumption Taxes in Developing Countries,”Tax Law ReviewVol. 46No. 4 (1991). pp. 40587.

It is interesting to note, however, that Henry Simons, in his Federal Tax Reform (1950, p. 136), wrote derisively about the possibility of inflation adjustment in the measurement of income, “Does anyone really propose that we correct all tax bases for price-level changes?”

For further discussion, see McLure and others (1990, Chapter 71. Some might add exchange rate gains and losses to this list. I do not, because debts denominated in foreign currencies are just a special case of indebtedness.

See McLure and others (1990, Chapter 9), or Zodrow and McLure (1991).

See, for example, McLure and others (1990) for calculations of METRs under the Colombian tax system.

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