Inflation tax
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An inflation tax is a metaphor for the economic disadvantage suffered by holders of cash and cash equivalents in one denomination of currency due to the effects of inflation, which acts as a hidden tax that subtracts value from those assets.
Among the negative effects of inflation tax is that it affects the middle and lower class the most. [1] Some argue that inflation is a regressive consumption tax. [2]
When governments raise revenue by printing notes and bills they increase the amount of money available in the economy. Through a change in real money balances this causes inflation. Financing expenditure in this way is called seignorage and 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 States is 5%, one dollar will buy $1 worth of goods and services this year, but only 95¢ the next year; this has the same effect as a 5% annual tax on cash holdings.
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 value of 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 liquidity and 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).
[edit] "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 rate or nominal gains. For instance, if someone buys a bond with 6% interest and inflation is 4%, their "real" interest is 2%. 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.
