An inflation tax is an analogous
pejorativefor the economic disadvantage suffered by holders of cashand cash equivalents in one denomination of currencydue to the effects of inflation, which acts as a hidden taxthat subtracts value from those assets.
Austrian Schoolviews that inflation tax affects the middle and lower class the most. [http://video.google.com/videoplay?docid=- Money, Banking and the Federal Reserve ] ] Some argue that inflation is a regressive consumption tax. http://www.ssc.uwo.ca/economics/econref/workingpapers/researchreports/wp2000/wp2000_1.pdf]
When central banks print notes and issue credit, they increase the amount of money available in the economy, usually as a reaction to worsening economic conditions. Through a change in real money balances, this causes inflation. Financing expenditure in this way is called
seignorageand the effect of increasing the money supply and causing the holders of money to pay an inflation tax is the most obvious cost of inflation.
If the annual inflation rate in the
United Statesis 5%, one dollar 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, provided there is 0% economic growth, or other price-reducing factors, such as efficiency-enhancing technology. With price reducing factors at play, a 5% inflation rate indicates a tax rate of higher than 5%.
Governments are almost always net
debtors (that is, most of the time a government owes more money than others owe to it). Inflation reduces the relative valueof 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
liquidityand 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 rateor 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 1.89%.
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 bonds carry inflation risk, as the inflation compensation is taxed.
Negative interest rates
If there is a negative
real interest rate, it means that inflation is more than the interest. Suppose if the Federal funds rateis 2% and the inflation rate is 10%, then it means that the borrower would gain 7.84% of every dollar borrowed.
Obviously, this would lead to commodity
speculationand business cycles, as the borrower can profit from the interest.
Besides the negative side effects such as devaluation of the currency, inflation has a business cycle effect. According to the
Austrian Business Cycle Theory, inflation creates malinvestment from malallocation of resources of debitors. It creates wasteful investment where inefficient businesses succeed by inflation.
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