“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily,”
John Maynard Keynes, “The economic consequences of the peace”
Inflation tax is an implicit tax on nominal assets, such as cash, bonds and saving accounts. Inflation reduces the value of money and therefore reduces the real income of households.
When governments create inflation by printing money, they usually benefit from the inflation as they get more nominal revenue and can reduce the real value of the government debt.
Inflation can have the effect of improving government finances without actually increasing tax rates. The political advantage of an inflation tax is that it is easier to disguise than increasing tax rates.
“Inflation is the one form of taxation that can be imposed without legislation.”
In simple terms, suppose investors bought government bonds at 5% interest rate (expecting inflation of 3%). But, then inflation rose to 8%. Bondholders would lose out and governments would gain from fall in real value of debt. In this case, inflation causes a redistribution of wealth from savers (bondholders) to lenders (government)
Seignorage and inflation tax
Seignorage occurs when government print money. Seignorage refers to the difference between the value of money and the cost of producing it. For example, a US $100 bill costs 19.6 cents per note. Therefore from printing a $100 bill, there is seignorage (profit) of $99.804
However, this printing of money can cause inflation. Inflation is like a tax on people who hold money.
Bracket creep – inflation
One way governments can benefit from inflation is allowing income tax thresholds to be frozen so more workers pay higher tax rates.
In March 2022, The UK Office for Budget Responsibility stated that the government’s decision to freeze income tax allowances will raise, by 2026/67, £18.8bn annually because higher inflation reduces the real value of the allowances by a greater amount. (Inflation tax at FT)
Who pays the inflation tax?
The costs of inflation will be paid by those who hold nominal money and are unable to get interest rates greater than the inflation rate. For example, suppose an investor bought a government bond at a fixed 3% interest rate. (Perhaps because they expected inflation of 2%). If inflation then increases to 7%, then the value of the bond will fall by 4% in real terms each year. The government benefits because it will be easier to repay the bond at the end of the term, because inflation is reducing its value.
If the government increase benefits and public sector wages less than the inflation rate, then these benefit recipients and public sector workers will be worse off in real terms. The purchasing power of their income will fall.
Workers who find themselves in a higher tax bracket. Suppose there is a higher tax bracket of 40% on income over £50,000. Inflation will lead to a rise in nominal wages and so more workers will see their nominal wage rise over £50,000. Therefore, workers who used to earn just under £50,000, will now start to pay a marginal tax rate of 40%, whereas before they didn’t.
Savers. Suppose you have $11,000 savings in a checking account, but interest rates on current account are close to 0%. Inflation of 6.2% will lead to a reduction in the real value of these savings. The inflation will mean that consumers have to spend extra money and if this extra money comes from their savings, they will get fewer goods for the same cash.
Bloomberg run this story from March 2022 – U.S. Households Face $5,200 Inflation Tax This Year
They state “Inflation will mean the average U.S. household has to spend an extra $5,200 this year ($433 per month) compared to last year for the same consumption basket”
However, I find this slightly misleading, because the inflation tax of $5,200 assumes nominal wages are unchanged. However, wages in the US are actually growing quite strongly, so workers financing spending from wages will be better off in real terms. However, if they were financing spending from cash savings, it would be correct.
Is there an optimal inflation tax for a government?
Seignorage and the inflationary benefits of increasing the money supply can be tempting for governments in a tight fiscal position. However, there is a great danger that the government will get carried away and cause inflation to increase out of control. When inflation starts to rise, it will cause various costs for the economy – menu costs, uncertainty, and discouraging investment. High rates of inflation can lead to poorer economic performance in the long-term, and this will hurt government finances in the long term. Countries that experience high inflation will put off investors from buying bonds and so it can become more expensive to finance debt in the long-term.