The effects of rising inflation on capital budgeting are many, but the most important one is that it has to be properly considered. Inflation is the result of an association between the real and financial activities of a firm. As the rate of inflation increases, so does the tax burden on the firm. If you want to know more about the impact of rising inflation on capital budgeting, read on.
Price stability is a measure of price stability
It is important for the economy to have stable prices because the absence of fluctuation in prices can lead to anxiety and uncertainty. Prices that fluctuate wildly can result in inflation. The aim of price stability is to keep prices low for a year or more, which is typically the case when countries are experiencing high levels of price stability. But even in a stable economy, some fluctuations can still occur due to the law of supply and demand.
Core consumer inflation is a measure of price stability
What is core inflation? The term “core” refers to the price stability of a consumer’s monthly expenditures, which excludes items that tend to rise and fall dramatically in price. Energy and food prices tend to fluctuate much more than the overall CPI and, therefore, policymakers use core inflation as a good indicator of price stability. However, the use of core inflation as the only indicator of price stability is problematic because it tends to underestimate the impact of volatile prices on overall prices.
Tax burden increases with inflation
Inflation affects the tax treatment of interest income. Investors demand higher nominal rates in order to offset rising inflation, which increases the tax burden on interest income. The lower the inflation rate, the greater the tax benefit from allowable interest deductions. However, previous research shows that these effects cancel each other out, and the real burden from inflation rises despite lower interest rates. Inflation affects the tax burden on capital income in a variety of ways.
Liquid assets are affected by inflation
Rising inflation has several consequences for businesses and individuals. As prices increase, so do the assets in which those moneys are invested. Rising inflation depreciates the purchasing power of dollars and makes it harder to maintain a certain standard of living. Businesses and individuals must work to ensure that their investments are earning enough returns to match the inflation rate. Rising inflation impacts many different types of assets and makes them subject to different capital budgeting strategies.
Forecasting inflation is difficult
There are many reasons why forecasting inflation is difficult. One reason is that demographic developments can have a decisive impact on the rate of inflation. As the number of retirees and young people increases relative to the working population, fewer active persons will be needed to take care of a larger section of the population. As a result, the labour factor will become scarcer and thus drive up prices and inflation. The question is, how can economists make accurate predictions?