Indexation

Definition

Indexation is a dual-focused term encompassing:

Accounting Context: The practice of adjusting the chargeable gain from the sale of an asset to account for inflation over the asset’s period of ownership. In the UK corporation tax system, an indexation factor based on the rise in the Retail Price Index (RPI) during ownership is applied to the cost or 31 March 1982 value of an asset. This indexed cost (or value) is deducted from the sale proceeds to establish the chargeable gain. Until April 1998, indexation was also applied to capital gains tax. For assets acquired before this date and sold before April 2008, the indexation allowance was calculated to 5 April 1998 and used to determine the chargeable gain.
Economic Policy: Connecting economic variables such as wages, taxes, social security payments, annuities, or pensions to rises in the general price level. This policy is often suggested to mitigate the effects of inflation. However, complete indexation is rarely implemented, leading to inflation affecting different economic agents (e.g., borrowers vs. lenders) differently.

Examples

Sale of an Asset: A company purchased a property for £100,000 in 1985 and sold it in 2005 for £500,000. If the RPI saw a considerable rise over these 20 years, the indexed cost might push the effective gain needed to include inflation, potentially lowering taxable income from the gain.
Social Security Payments: Suppose a government increases social security payments annually based on the inflation rate. If inflation rises by 2%, social security payments are indexed to increase by the same percentage, maintaining the beneficiaries’ purchasing power.

Frequently Asked Questions (FAQs)

What is the primary purpose of indexation?

Indexation aims to adjust economic indicators to account for the effects of inflation, ensuring that valuations remain current and relevant over time.

Is indexation applicable globally?

Indexation policies are common but vary significantly across different jurisdictions, accounting practices, and economic policies specific to each region or country.

How does indexation affect investors or savers?

Indexation helps protect investors’ and savers’ gains from being eroded by inflation by adjusting purchase prices and gains for inflationary measures.

How is the Retail Price Index (RPI) used in indexation?

RPI indexes the change in the cost of a basket of retail goods and services over time. This index showcases the inflation rate and by extension, adjust the initial value of an asset when calculating gains.

Are there limitations to indexation?

Yes, one key limitation is that complete indexation is often impractical due to administrative complexity and variances in inflation impact across different economic sectors.

Chargeable Gain: The profit realized from the sale or disposal of an asset, subject to taxation after considering relevant deductions, such as indexed cost.
Corporation Tax: A tax imposed on the net income of corporations.
Retail Price Index (RPI): An index measuring the change in the cost of a representative basket of retail goods and services, used as an inflation indicator.
Capital Gains Tax: A tax on the profit from the sale of property or an investment.
Inflation: The rate at which the general level of prices for goods and services rises, eroding purchasing power.

Online References

Suggested Books for Further Studies

Taxation of Capital Gains by D. J. Carter & N. Milford, a comprehensive guide on the taxation implications for capital gains.
Understanding Inflation and the Implications for Monetary Policy by Jeff Fuhrer & Geoffrey M.B. Tootell, providing deeper insights into inflation and economic policies.
Economics by Paul Samuelson & William Nordhaus, which covers various aspects including inflation and economic indices.

Accounting Basics: “Indexation” Fundamentals Quiz

### What is the primary purpose of the accounting term "indexation"? - [ ] To reduce the cost of an asset. - [x] To adjust the chargeable gain from the sale of an asset for inflation. - [ ] To increase the taxation rate on disposed assets. - [ ] To set the price of new assets in the market. > **Explanation:** The primary purpose of "indexation" in accounting is to adjust the chargeable gain from the sale of an asset to account for inflation over the period of ownership. ### Which index is commonly used in the UK to calculate the indexation allowance? - [x] Retail Price Index (RPI) - [ ] Consumer Price Index (CPI) - [ ] Producer Price Index (PPI) - [ ] Employment Cost Index (ECI) > **Explanation:** In the UK, the Retail Price Index (RPI) is commonly used to calculate the indexation allowance for adjusting the chargeable gain of an asset sale. ### Until what year was indexation applied to capital gains tax in the UK? - [ ] 1995 - [x] 1998 - [ ] 2005 - [ ] 2008 > **Explanation:** In the UK, indexation was applied to capital gains tax until April 1998. After that, it was phased out for new calculations. ### What economic policy does indexation support in mitigating? - [x] Inflation - [ ] Deflation - [ ] Recession - [ ] Stagflation > **Explanation:** Indexation supports policies aimed at mitigating the effects of inflation by adjusting economic indicators to reflect changes in price levels. ### Who generally benefits more from complete indexation policy? - [ ] Borrowers - [ ] Lenders - [x] None of the above, as complete indexation is rarely possible - [ ] Both equally > **Explanation:** Complete indexation is rarely possible in practice, thus typically leaving one side (borrowers or lenders) better off than the other depending on inflation impact. ### What does the indexed cost of an asset refer to? - [ ] The initial purchase price of the asset. - [x] The inflation-adjusted cost of the asset during the period of ownership. - [ ] The selling price of the asset. - [ ] The overhead maintenance cost of the asset. > **Explanation:** The indexed cost of an asset refers to the inflation-adjusted cost during the ownership period, calculated using inflation indices like the RPI. ### Does indexation affect the total sale proceeds of an asset? - [ ] Yes, it increases the sale proceeds. - [x] No, it adjusts the purchase cost rather than sale proceeds. - [ ] Yes, it decreases the sale proceeds. - [ ] No, it only impacts historical market data. > **Explanation:** Indexation adjusts the purchase cost of an asset to account for inflation but does not directly impact the sale proceeds. ### How did indexation in the UK impact assets acquired before April 1998? - [ ] Complete elimination of capital gains tax. - [x] The indexation allowance was calculated up to 5 April 1998 and used in chargeable gain calculations. - [ ] Increased the tax rate. - [ ] Immediate asset valuation increase. > **Explanation:** For assets acquired before April 1998, the indexation allowance was calculated up to 5 April 1998, which was then used to determine the chargeable gain on disposal. ### When was indexation phased out for new calculations in the UK? - [ ] January 2000 - [x] April 1998 - [ ] December 1999 - [ ] March 1997 > **Explanation:** In the UK, indexation was phased out for new calculations starting April 1998. ### Why is indexation rarely fully implemented in economic policies? - [x] Due to administrative complexity and varied inflation impact. - [ ] Because it does not require government approval. - [ ] It is a reserved approach for capital countries only. - [ ] It provides no real financial benefit. > **Explanation:** Indexation is rarely fully implemented in economic policies due to administrative complexities and the varied impact of inflation on different economic sectors.

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