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Inflation tax definition
As a result of inflation (the opposite of deflation), the cost of goods and services rises, but the value of our money decreases. And that inflation is accompanied by inflation tax. To be clear, the inflation tax is not the same as income tax and has nothing to do with the collection of taxes. Inflation tax isn't really visible. That's why preparing and planning for it may be extremely difficult.
Deflation is negative inflation.
Inflation tax is a penalty on the cash you possess.
Fig 1. - Loss of Purchasing Power
As the rate of inflation rises, the inflation tax is the penalty on the cash you possess. Cash loses purchasing power as inflation grows. As Figure 1 above shows, the money you're holding onto is no longer worth the same amount. While you might have $10, you might actually only be able to purchase $9 worth of goods with that $10 bill.
Inflation tax example
Let's go through an example to show you what inflation tax looks like in the real world:
Imagine you have $1000 and you want to buy a new phone. The phone costs exactly $1000. You have two options: buy the phone immediately or put your $1000 in a savings account (that accumulates 5% interest per year) and buy the phone later.
You decide to save your money. After one year, you have $1050 in your savings thanks to the interest rate. You've gained $50 so that's a good thing right? Well, in that same one year the rate of inflation went up. The phone you want to buy now costs $1100.
So, you gained $50 but now have to cough up another $50 if you want to buy the same phone. What happened? You just lost the $50 you gained and had to give an extra $50 on top. If you had just bought the phone immediately before the inflation set in, you would have saved $100. Basically, you paid the extra $100 as a "penalty" for not buying the phone last year.
Inflation tax reasons
Inflation tax is caused by a number of factors, including:
Seigniorage - this occurs when the government prints and distributes additional money into the economy and uses that money to acquire goods and services. Inflation tends to be higher when the money supply is increased. The government may also raise inflation by lowering interest rates, which results in more money entering the economy.
Economic activity - inflation can also be caused by economic activity, especially when there is a greater demand for goods than there is supply. People are generally prepared to pay a higher price for a product when the demand exceeds the supply.
Businesses increasing their prices - inflation may also occur when the cost of raw materials and labor rises, prompting firms to raise their prices. This is what's known as cost-push inflation.
Cost-push inflation is a type of inflation that occurs when prices go up due to the cost of production going up.
To learn more about cost-push inflation, check out our explanation of Costs of Inflation
The revenue gained by the government's authority to issue money is referred to as seigniorage by economists. This is an old word that dates back to medieval Europe. It refers to the authority retained by medieval lords—seigneurs in France - to stamp gold and silver into coins and collect a fee for doing so!
Effects of inflation tax
There are several effects of inflation tax which include:
- Inflation taxes may be harmful to a country's economy if they inflict stress on the country's middle-class and low-income citizens. As a result of the effects of raising the quantity of money, money-holders pay the highest amounts of inflation tax.
- The government can increase the quantity of money accessible in its economy by printing bills and paper notes. As a consequence, revenues are created and raised, which causes a shift in the balance of money within the economy. This, in turn, can cause further inflation in the economy.
- Since they don't want to "lose" any of their money, people are more likely to spend the money that they have on hand before it loses any further value. This results in them keeping less cash on their person or in savings and increases spending.
Who pays inflation tax?
Those that hoard money and can't obtain interest rates higher than the inflation rate will bear the expenses of inflation. What does this look like?
Assume an investor purchased a government bond with a fixed interest rate of 4% and anticipates a 2% inflation rate. If inflation rises to 7%, the bond's value will decline by 3% per year. Because inflation is lowering the value of the bond, it will be cheaper for the government to repay it at the end of the period.
Benefit receivers and public sector workers will be worse off if the government boosts benefits and public sector wages less than inflation. Their income will lose buying power. Savers will also bear the burden of inflation tax.
Assume you have $5,000 in a checking account with no interest. The true worth of these funds will be reduced due to a 5% inflation rate. Consumers will have to spend more money as a result of inflation, and if this additional cash comes from their savings, they will be able to acquire fewer items for the same amount of money.
Those who enter into a higher tax bracket may find themselves paying the inflation tax.
Assume that income exceeding $60,000 is taxed at a higher rate of 40%. As a result of inflation, salaries will grow, and therefore more employees will see their salaries climb over $60,000. Employees who were previously making less than $60,000 are now making over $60,000 and are now going to be subject to a 40% income tax rate, whereas before they were paying less.
Lower and middle classes are more affected by the inflation tax than the rich because the lower/middle classes keep more of their earnings in cash, are far less likely to obtain new money before the market has adapted to inflated prices, and lack the means to evade domestic inflation by transferring resources offshore like the rich do.
Why inflation tax exists?
Tax inflation exists because when governments print money to cause inflation, they typically gain from it due to the fact that they obtain a greater amount of real revenue and can lower the real value of their debt. Inflation can also help the government balance its finances without officially raising tax rates. An inflation tax has the political benefit of being simpler to conceal than raising tax rates. But how?
Well, a traditional tax is something you would immediately notice because you have to pay that tax directly. You're aware of it before-hand and how much it will be. However, an inflation tax does roughly the same thing but right under your nose. Let's do an example to explain:
Imagine you have $100. If the government needed money and wanted to tax you, they could tax you and remove $25 of those dollars from your account. You would be left with $75.
But, if the government wants that money immediately and doesn't want to go through the hassle of actually taxing you, they'll instead print more money. What does this do? This causes a greater supply of money to be in circulation, so the value of the money you have is actually less. The same $100 you have now in a time of increased inflation might buy you $75 worth of goods/services. In effect it does the same thing as taxing you would, but in a more sneaky way.
A severe scenario happens when the government's expenses are so large that the revenue they have cannot cover them. This can happen in impoverished societies when the tax base is small and the collection procedures are flawed. Furthermore, a government may only fund its deficit by borrowing if the general public is prepared to buy government bonds. If a country is in financial distress, or if its spending and tax practices appear to be unmanageable to the public, it will have a tough time convincing the public and overseas investors to purchase government debt. To offset the danger of the government defaulting on its debt, investors will charge a high interest rate.
A government may determine that the only alternative left at this time is to fund its deficit by printing money. Inflation and, if it gets out of hand, hyperinflation are the eventual results. However, from the government's perspective, it at least gives them some extra time. So while deficient monetary policy is to blame for moderate inflation, unrealistic fiscal policies are often always to blame for hyperinflation. In the case of higher inflation, the government might raise taxes in order to discourage spending within the economy and to lower inflation. Essentially, the money supply's growth rate impacts the price level's growth rate in the long run. This is known as the quantity theory of money.
Hyperinflation is inflation that is rising by over 50% per month and is out of control.
The quantity theory of money states that the money supply is proportional to the price level (inflation rate).
To learn more about out of control inflation, check out our explanation of Hyperinflation
Inflation tax calculation and inflation tax formula
To know how high the inflation tax is and how much the value of your money has gone down, you can use a formula to calculate the inflation rate via the Consumer Price Index (CPI). The formula is:
The Consumer Price Index (CPI) is a measure of the change in the prices of goods/services. It measures not only the rate of inflation but also disinflation.
Disinflation is the decrease in the rate of inflation.
To learn more about disinflation and calculating the CPI, check out our explanation - Disinflation
Inflation Tax - Key takeaways
- Inflation tax is a penalty on the cash you possess.
- In the case of higher inflation, the government might raise taxes in order to discourage spending within the economy and to lower inflation.
- Governments print money to cause inflation because they gain from doing so due to the fact that they get a greater amount of real revenue and can lower the real value of their debt.
- Those who hoard money, benefit receivers / public service workers, savers, and those newly in a higher tax bracket are the ones who end up paying the most inflation tax.
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Frequently Asked Questions about Inflation Tax
What is inflation tax?
Inflation tax is a penalty on the cash you possess.
How to calculate the inflation tax?
Find the Consumer Price Index (CPI). CPI = (CPI (given year) - CPI (base year)) / CPI (base year)
How does increasing taxes affect inflation?
It can lower inflation. In the case of higher inflation, the government might raise taxes in order to discourage spending within the economy and to lower inflation.
Why do governments impose inflation tax?
Governments print money to cause inflation because they typically gain from it due to the fact that they obtain a greater amount of real revenue and can lower the real value of their debt.
Who pays the inflation tax?
- Those who hoard money
- Benefit receivers / public service workers
- Savers
- Those newly in a higher tax bracket
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