Inflation Tax

Inflation tax example

Let's go through an example to show you what inflation tax looks like in the real world:

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.

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?

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.

Those who enter into a higher tax bracket may find themselves paying the inflation tax.

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:

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.

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:

$ConsumerPriceIndex=\frac{ConsumerPriceInde{x}_{Givenyear}-ConsumerPriceInde{x}_{Baseyear}}{ConsumerPriceInde{x}_{Baseyear}}\times 100$