If you have the impression that the “inflation tax” is just a reference to the effect of deflating inflation on the purchasing power of your income and savings, then you should continue reading.
Inflation is a real tax, just as important as the individual income tax at times. While inflation clearly reduces the purchasing power of your earnings and the values of fixed income assets, it also redistributes purchasing power from businesses and households to the federal government. In today’s economy, where the inflation rate is 5.4 percentInflation tax is not an easy matter. The amount the government will collect from the inflation tax in 2021 exceeds $1.9 trillion.
Most people realize that inflation can redistribute income and wealth. For example, many may realize that unexpected inflation benefits borrowers at the expense of creditors. When inflation is higher than expected, borrowers pay off debt with future dollars that have less purchasing power.
The inflationary effect on the wealth of borrowers and lenders depends on whether inflation is expected or not. When inflation is expected, creditors include a premium in the interest rate as compensation for the purchasing power lost due to inflation. A well-functioning financial market without undue central bank intervention tends to set nominal interest rates equal to the real interest rates that creditors would demand to lend plus the expected rate of inflation (the so-called Fisher effect). Tax rates can also affect the size of the inflation premium, but to keep things simple, I’ll ignore taxes.
Unexpected inflation transfers wealth between debtors and creditors. If inflation is higher than expected, the rate inflation premium is too small to regain the purchasing power lost due to higher than expected inflation. When inflation is lower than expected, creditors gain at the expense of borrowers because the interest rate compensates for the purchase loss less. The amount of wealth transferred by an unexpected rise in inflation is approximately equal to the principal balance borrowed multiplied by the difference between projected and actual inflation rates. If inflation is 3.4 percent higher than expected, borrowers gain purchasing power equal to 3.4 percent of the primary balance at the expense of creditors.
When it comes to inflation and the federal government, things are a little different. Inflation tax is the amount of business and family wealth that is transferred to the federal government as a result of inflation.
Since the federal government is a huge borrower, unexpected inflation results in a significant transfer of wealth to the federal government from the families and businesses that provide it with credit. In addition, the federal government also benefits by reducing the purchasing power of public cash and liquid investments that yield near-zero interest rates.
The monetary policy of the central bank can also play a major role in the size of the inflation tax. When central banks pursue aggressive monetary policies as aggressively as they are today, nominal interest rates can be artificially lowered below levels that creditors would normally demand in the market without central bank intervention. In such cases, nominal interest rates may not adequately compensate investors for expected inflation.
What is the size of the inflation tax?
First, consider what the inflation tax will be if the Federal Reserve succeeds in achieving its goal 2% annual inflationInflation expectations were well held at 2 per cent. In this case, the inflation tax is the annual wealth transfer resulting from fully expected inflation of 2%.
To a close approximation, current interest rates on cash, checking accounts, savings and money market accounts are close to zero. The value of these liquid balances can be approximated by m 2 A measure of money supply, which includes “cash, checking deposits and readily convertible near money.” As of July, M2 . is estimated $20.564 trillion. One account included in M2 earns interest paid by the government. Bank reserves held at the Federal Reserve earn 15 basis points in interest annually. Including interest earnings on the bank’s $3.944 trillion in reserves held at the Federal Reserve, by the end of the year, M2’s balances will grow to $20.57 trillion. But with inflation at 2 per cent at the end of the year, these balances will reduce purchasing power by 2 per cent. By then, $411 billion in purchasing power will be transferred from businesses and households to the government.
Now think about the situation today. Inflation expectations were steady at 2 percent, but actual inflation unexpectedly rose to 5.4 percent. An inflation tax has one component driven by the loss of purchasing power of the money supply and another component resulting from the unexpected effect of inflation on US Treasury debt. The tax on the money supply is roughly equal to 5.4% of M2 balances or about $1.1 trillion.
At the end of the second quarter of 2021, it was estimated that the public held approximately $22.8 trillion in unprotected interest-bearing US government securities. Using 2 percent as an approximation to the average interest return on these securities, the wealth transfer resulting from a 5.4 percent inflation rate when businesses and households were expecting 2 percent inflation is roughly 3.4 percent of the value of government debt owed, or About $775 billion. With inflation rising to 5.4 percent in 2021, the inflation tax in aggregate will transfer approximately $1.875 trillion of purchasing power from businesses and households to the federal government.
To put the size of this inflation tax into perspective, keep in mind that in 2021, the federal government expects to collect $3.863 trillion In outright taxes including $1.932 trillion collected through individual income taxes. With inflation currently at 5.4 percent, inflation will transfer at least $1.9 trillion of wealth from the public to the federal government this year. I say at least because the $1.9 trillion ignores the additional tax revenue that inflation automatically creates in our progressive system that taxes nominal income and capital gains based on historical cost without adjustments for the effect of inflation.
In 2021, the inflation tax will be the same size, if not greater, than the revenue the federal government will collect from individual income taxes. The inflation tax is not only real, it is already significant in 2021.
No wonder governments love central banks.
Kubik is a resident scholar at the American Enterprise Institute (AEI), where he studies systemic risk, management, and regulations for banks and financial markets.