Inflation tax
Encyclopedia
Inflation tax is a term which refers to the financial loss of value suffered by holders of cash
Cash
In common language cash refers to money in the physical form of currency, such as banknotes and coins.In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately...

 and fixed-rate bonds, as well those on fixed income
Fixed income
Fixed income refers to any type of investment that is not equity, which obligates the borrower/issuer to make payments on a fixed schedule, even if the number of the payments may be variable....

 (not indexed to inflation), due to the effects of inflation. This financial loss of value is often expressed as a loss of purchasing power
Purchasing power
Purchasing power is the number of goods/services that can be purchased with a unit of currency. For example, if you had taken one dollar to a store in the 1950s, you would have been able to buy a greater number of items than you would today, indicating that you would have had a greater purchasing...

.
It may be better characterized as a wealth transfer than a tax - since many people
including debtors, holders of hard assets and some equities may simultaneously gain.
Many economists hold that inflation affects the lower and middle classes more than the rich, as they hold a larger fraction of their income in cash, they are much less likely to receive the newly created monies before the market has adjusted with inflated prices, more often have fixed incomes, wages or pensions, and lack the means to avoid domestic inflation by reallocating assets overseas. Some argue that inflation is a regressive
Regressive tax
A regressive tax is a tax imposed in such a manner that the tax rate decreases as the amount subject to taxation increases. "Regressive" describes a distribution effect on income or expenditure, referring to the way the rate progresses from high to low, where the average tax rate exceeds the...

 non-linear consumption tax
Consumption tax
A consumption tax is a tax on spending on goods and services. The tax base of such a tax is the money spent on consumption. Consumption taxes are usually indirect, such as a sales tax or a value added tax...

. Nevertheless, inflation improves the economic position of people with
outstanding fixed interest debt like student loans and mortgages. It can improve the nation's
balance of trade
Balance of trade
The balance of trade is the difference between the monetary value of exports and imports of output in an economy over a certain period. It is the relationship between a nation's imports and exports...

 - stimulating exports with a less expensive currency - and decreasing
imports. A large portion of the "tax" also falls on foreign holders of fixed income debt in the inflated currency. It is important to note that this "tax" on creditors is coupled with a simultaneous transfer to debtors - reducing their debt burden. By transfering wealth to people who
are more likely to spend it, an inflation "tax" can further increase real (inflation adjusted)
economic growth (beyond its beneficial impact on trade). It may also hasten new purchases
since inflation makes it costly to keep cash. Inflation can increase liquidity in depressed
real estate markets since it would increase nominal asset values back above the loan values.
This improved LTV allows for people to sell their homes, and move to pursue better economic
opportunities and as such can improve efficiency of the labor markets. In this way, an
"inflation tax" can improve real (inflation adjusted) economic growth
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...

 and improve employment.
Therefore a very tight monetary policy which seeks to reduce inflation - even at the cost
of real (inflation adjusted) economic growth and jobs can be viewed as a "stagnation tax".

How it occurs

When central banks print notes and issue credit, they increase the amount of money available in the economy. This is sometimes done as a reaction to worsening economic conditions. It is generally held that in the long run, an increase in the money supply causes inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

. Some have argued that, in effect, increasing the money supply and causing the holders of money to pay an inflation tax is a form of taxation.

If the annual inflation rate in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...

 is 5%, one dollar
United States dollar
The United States dollar , also referred to as the American dollar, is the official currency of the United States of America. It is divided into 100 smaller units called cents or pennies....

 will buy $1 worth of goods and services this year, but it would require $1.05 to buy the same goods or services the next year; this has the same effect as a 5% annual tax on cash holdings, ceteris paribus
Ceteris paribus
or is a Latin phrase, literally translated as "with other things the same," or "all other things being equal or held constant." It is an example of an ablative absolute and is commonly rendered in English as "all other things being equal." A prediction, or a statement about causal or logical...

.

Governments are almost always net debtor
Debtor
A debtor is an entity that owes a debt to someone else. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor...

s (that is, most of the time a government owes more money than others owe to it). Inflation reduces the relative value
Relative value
Relative value is the attractiveness measured in terms of risk, liquidity, and return of one instrument relative to another, or for a given instrument, of one maturity relative to another...

 of previous borrowing, and at the same time it increases the amount of revenue from taxes. Thus it follows that a government can improve the debt-to-revenue ratio by employing inflationary measures.

However, if the government continues to sell debt, by borrowing money in exchange of debt papers, these debt papers will be affected by inflation: they will lose their value, and therefore they will become less attractive for creditors, until the government will not find any willing to buy debt.

An inflation tax does not necessarily involve debt emission. By simply emitting currency (cash), a government will induce liquidity and may trigger inflationary pressures. Taxes on consumer spending and income will then collect the extra cash from the citizens. Inflation, however, tends to cause social problems (e. g., when income increases more slowly than prices).

"Tax on the inflation tax"

Although not meant by the term "inflation tax", a related effect is the tax on interest and investment "income" when the tax is levied against the nominal interest rate
Nominal interest rate
In finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation ; or, for interest rates "as stated" without adjustment for the full effect of compounding...

 or nominal gains.


For instance, if someone buys a bond with a nominal interest rate of 6% and the rate of inflation is 4%, their "real" interest is 1.92%.


If, however, they are taxed 25% of the 6% interest "income", or 1.5%, this can be thought of as composed of a tax on real income (0.5%) and a tax on inflation (1.0%). The same principle applies to capital "gains" taxes not adjusted for inflation. In any case, this "tax on the inflation tax" is essentially equivalent to a tax on holdings ("wealth tax") equal to the nominal tax rate times the inflation rate (in example above, 25% of 4% inflation equals 1.0%.) This "property tax" can even apply to non-monetary assets as well as money earning interest. Thus, money itself is subject to both the inflation tax and the tax on the inflation tax, while other assets, on which nominal profit or gains taxes are imposed, are subject only to the tax on inflation.

Another negative effect of this tax is that even inflation-indexed bond
Inflation-indexed bond
Inflation-indexed bonds are bonds where the principal is indexed to inflation. They are thus designed to cut out the inflation risk of an investment. The first known inflation-indexed bond was issued by the Massachusetts Bay Company in 1780...

s carry inflation risk, as the inflation compensation is taxed.

Negative interest rates

If there is a negative real interest rate
Real interest rate
The "real interest rate" is the rate of interest an investor expects to receive after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate...

, it means that inflation is more than the interest. Suppose if the Federal funds rate
Federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...

 is 2% and the inflation rate is 10%, then it means that the borrower would gain 7.27% of every dollar borrowed.


This may lead to malinvestment
Malinvestment
Malinvestment is a concept developed by the Austrian School of economic thought, that refers to investments of firms being badly allocated due to what they assert to be an artificially low cost of credit and an unsustainable increase in money supply, often blamed on a central bank.This concept is...

 and business cycle
Business cycle
The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...

s, as the borrower experiences a net profit by repaying principal with inflated (devalued) dollars.

See also

  • Fisher equation
    Fisher equation
    The Fisher equation in financial mathematics and economics estimates the relationship between nominal and real interest rates under inflation....

  • Financial repression
    Financial repression
    Financial repression is a term used to describe several measures which governments employ to channel funds to themselves which in a deregulated market would go elsewhere. Financial repression can be particularly effective at liquidating debt....

  • Purchasing power
    Purchasing power
    Purchasing power is the number of goods/services that can be purchased with a unit of currency. For example, if you had taken one dollar to a store in the 1950s, you would have been able to buy a greater number of items than you would today, indicating that you would have had a greater purchasing...

  • Inflationism
    Inflationism
    In economics, an inflationist or inflationary economic, fiscal, or monetary policy, is one that is predicted to lead to a substantial level of inflation. Similarly, an inflationist economist is one that advocates an inflationist policy...

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