Taxation and Real Cost of Capital

The effects of inflation, via taxes, on the firm's cost of capital are analyzed. The taxes are the corporate income tax and household taxes on dividends and capital gains. The costs of equity and debt are taken at their nominal values as observed by the firm on the capital market. The net real cost of capital,where marketrates of returnare adjustedfor inflation,are analyzed. The net effects of inflationon capitalcost can thus be determined,while recognizingseveral counteractingtendencies which operate throughthe tax system. It turns out that for most reasonableassumptions,real capitalcost will fall as a resultof inflationwhen both profittax andtaxes on dividendsandcapitalgainsaretakenintoaccount.Differentways of indexingthe system of taxationto insulateit frominflationarydistortionsare also presented.