“If inflation is higher than expected the firm’s real taaxes paid are increased b/c the depreciation tax shelter is less valuable.” Could someone please elaborate on this?
Because depreciation is not adjusted to reflect inflation (even though the value of the asset is undoubtedly increasing due to inflation), the amount of income subject to taxes is higher. For example, if a firm had expected to have dep exp of $50, ebitda of $100 but inflation increased ebitda to $110, tax exp is higher and the value of the depreciation tax shelter is lower.
If inflation is very high, then the depreciation charges could become quite insignificant with respect to earnings. Example, you buy some plant for $5m expecting to get a nice depreciation writeoff of $1m per year over 5 years. Then inflation ramps up to 40% each year and after the first couple of years your depreciation write-off becomes relatively small and your tax bill becomes unexpectedly large in real terms. I would think the effect would be fairly negligible in developed economies (eg. inflation comes in at 3.1% rather than 3.0%. Aaaaargghhh!!!)