What is Indexation?
Indexation is way to adjust the purchase price of an of the investment (bonds, debentures or any other asset class) in such a manner that it takes into consideration the effect of inflation over the investment term and therefore, capital gain on investment is brought down and taxable income is reduced.
Indexation can be derived as the price of a good in a given year divided by the price of the same good taking a year as a base which is as follows:
Indexation = (Value of Good in Given Year/Value of Good in Base Year) * 100
How does it work?
- The first and most important step is to decide upon the base year as that sets our benchmark or comparison period. Generally, the base year is set by specifically authorized agencies who consider different factors like economic or social based. Now when this has been done, the aim of the task should be to determine the cost of the good or asset under consideration during the phase of the set base year.
- The second step is to take any other time frame for the same good and calculating its value. We do arrive at a number which can be further compared with the base year.
- The final and most important step is the application of the indexation formulaIndexation FormulaIndexation is a technique to adjust the amount byways of a price index to maintain the purchasing power after excluding the effect of inflation. Indexation = Original cost of acquisition x CII of the given year / CII of the base year using the two values under consideration, i.e., the value of the good during the base year time frame and the value of the same good during another period apart from the base year. This formula can be derived as, the price of a good in a given year, divided by the price of the same good taking a year as a base which is as follows:
Indexation = (Value of good in given year/Value of good in the base year) * 100
The resultant obtained is the price index for the particular good and can vary year to year. Thus a comparison among various time frames is essential to predict a price index for a future time frame or a long term perspective. Generally, index calculation is prepared by registered authorities who have expertise in this field and have knowledge about the economic and social scenarios prevalent in the country.
Practical Example of Indexation
Graphical representation: Please use the excel file attached. We are assuming here the price of gold using 2015 as the base year and including 5 years prices.
Price of Gold for a period of 5 years:
If the base year is 2015, then the price index for other years are as follows:
- Indexation2016 = ($450.00/$500.00) * 100
Similarly, calculate indexation for the years 2017,2018, and 2019.
Now, If the base year is 2016, then the price index for other years is as follows:
- Indexation2017 = ($650.00/$450.00) * 100
Similarly, calculate indexation for the years 2018,2019, and 2020.
Thus we see with a change of base years, the price index also varies. It plays a major role in considering the inflation factor while computing the price of goods.
Why Is It Important?
- It is a very important method that every government or firms use for calculation of the value of assets or goods using inflation as a factor.
- It is also used as a wage monitoring benchmark at times when the economy is passing through high inflation.
- Indexation can not only play its role in determining just the price index of an asset or good but also as what the consumer price index is and what is the confidence level index among both business and consumer.
- It helps investors to save tax during long term capital gains.
- It comes into use to adjust inflation or living cost or prices among various geographical regions as a whole.
- It can be used by businesses to remove wage disputes among employees as it comes into play for benchmarking wages too.
- It can be seen as a way to reduce the tax burden for investors were rising the price of commodity results in lesser profit and thus lower taxable income.
- It comes into use to adjust the prices among two substitute goods available.
- Apart from price indexation is also used to calculate the confidence level among the business and the consumers.
- It is a key measure used by government and business firms to adjust prices, considering the very important factor known as inflation. It is also widely popular among investors who prefer to stay in a win-win situation rather than shelling huge tax to the tax authority.
- Indexation can come into play into various fields like price index and confidence index. The only thing which it requires is an accurate calculation of the price or value of assets and choice of a proper base year. It is not every person’s job; it is only conducted by authorities who are registered to do so. It can also be done to adjust the level of inflation, cost of goods, and discrepancy among wages.
This article has been a guide to What is Indexation & its Definition. Here we discuss how indexation works and why it is important along with examples and benefits. You can learn more about from the following articles –