Reading 33 - Equities as an Inflation Hedge into, understand, corporate, investor

Otabek

From CFA curriculum:
“Because corporate income and capital gains taxes are not indexed to inflation, inflation can reduce the stockholder’s after-tax return, unless this affect was priced into the investor’s return (through lower share prices) when the stock was purchased.”
I don’t quite understand this concept.
Let’s say in Year One Company A earns $100 in nominal profits which are taxed at a marginal tax rate of 10 percent. In Year Two lets assume that inflation is 20 percent and Company A reports nominal profits of $120.
Now in real terms the $100 and $120 of profits should be equivalent (if the $120 were discounted back to year one). But assuming that the extra profits kicks Company A into a higher marginal tax bracket the real value of the profits in Year Two will actually be less than $100.
Am I interpreting this correctly?

Wendy01

I have the same question as the post above. could anyone help clarify?

LPoulin133

I think you are missing the part of the sentence that says that corporate income is not indexed to inflation.

DoubleDip

your scenario assumes it is indexed to inflation.
Likewise, if cap gains were indexed to inflation you would only pay tax on the real return and the inflation would be tax free (although you wouldn’t really be gaining anything).

LPoulin133

so the reduced real returns basically assumes you would be in a higher marginal tax bracket due to inflation?
and if you stay in the same tax bracket, inflation would not have an an effect, kuz tax is in %.

wake2000

Since we are just trying to see the effect of taxes, lets assume that both the principal invested and the return (we can assume a bond coupon payment) are inflation protected. (i.e. the only thing not indexed to inflation are the tax rates)
2 scenarios. 100 investment. coupon =10%, taxes 20%,
1. no inflation.
100*1.1=110/100-1=10% pre tax real return
100+(10*.8)=108/100-1=8% after tax
2. 20 % inflation
100*1.2=120
10*1.2=12
132/1.2=110/100-1=10% pre tax real return
100+(32*.8)=125.6/1.2-1=4.67% after tax
In scenario 2, we are taxed on the inflation impact of the investment (even though there was no real “gain” to us in terms of purchasing power)
I would never go as far as to assume changing marginal tax rates or anything like that. I can see how that makes sense, but reaching…
Just a guess

PalacioHill

got it. thanks a lot!