Indexation: what is it and how to calculate it

Indexation helps adjust gain or loss. When applied, it can reduce your business's tax liability or keep your employees' salaries steady by accounting for inflation. Here's an indexation definition, along with some examples of how this method works in real life.

Indexation meaning: what is indexation?

Indexation is a method used by companies or investors to prevent tax loss on investments. It applies to long-term investments like debt funds or other assets, adjusting their purchase price to lower tax liability. As the market experiences fluctuations over time, returns may not be what the investor expects. To compensate, indexation regulates the balance between investment and changes to the cost of living.

Whether used by governments or organizations, indexation connects asset value with price. Payments are adjusted using a price or composite index to keep the taxation value in check. The first step is identifying the price index before linking it to the item or investment value.

Indexation and inflation

The primary reason why indexation is beneficial is to offset inflation. By using indexation, you can adjust an investment's purchase price to reflect the impact of inflation more accurately. This carries over into tax liability because a higher purchase price leads to lower profits and lower taxes. Adjusting for inflation using indexation allows an investor to reduce long-term capital gains, bringing down taxable income.

When it comes to indexation for companies or governments, it's often used to adjust wages. These adjustments reflect a high inflation environment. Without regular wage increases, employees would experience significant wage cuts due to inflation. In addition to inflation, indexation may be applied to account for differences in price across geographic regions or the cost of living.

Life insurance terms offer another real-world indexation example. Insurance companies often include clauses for clients with terms for indexation, promising pay-outs adjusted for inflation.

Indexation benefit on debt funds

Another typical indexation example is debt mutual funds. Capital gain is the return incurred by selling an asset, whether it's tangible or intangible. However, inflation could change the value of this asset over time. To regulate capital gains (and the accompanying income tax), the Cost Inflation Index (CII) is taken into account in some countries. For example, the CII of the sale year is divided by the CII of the purchase year and applied to the purchase cost to determine the actual value of a profit after indexation.

To get maximum indexation benefit on debt funds, extend the holding period. Investors will experience a higher reduction in long-term capital gains tax.

How is indexation applied?

There are a few different ways to apply indexation, depending on the intended purpose.

If the indexation goal is to maintain a stable relative price between at least two goods or services, the process is simple. A business would specify the intended ratio between two prices. If one changes, the other would be adjusted to fall in line with this ratio. Take the example of a bakery. When the wholesale price of flour goes up, it might increase its sales price for loaves of bread to achieve the same profit margin. Therefore, the input and output prices are adjusted to keep the same profit margin.

The second goal of indexation would be to maintain a stable price of a good or service in relation to a currency unit's purchasing power. In this case, the price or asset value is linked to a price level. These price indexes might be published by a government agency or used within a business. When used by a corporation to match employee salaries to inflation, this is called a cost of living increase (COLA). Governments might use indexation in the same way to mitigate the impact of inflation on the recipients of tax benefits or other entitlements.

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