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Taxing with Inflation

Deficit financing and inflation are other ways to hide taxes. Variations on these methods have a very ancient history. In the days before paper money, money was usually in the form of coins, generally gold or silver. Sometimes, the government would collect as much of the previous issue of coins as possible, melt them down, add a generous portion of copper, and reissue them. The advantage to the ruler is obvious. If he could issue three coins for every two he collected, he could sizably increase his expenditures without seeming to increase the level of taxation. But because he was diverting resources from the private sector to his use, someone had to suffer reduced consumption. The new money would be more plentiful than the old had been in the past, and hence less valuable. If money becomes less valuable, then other things must be more valuable relative to it--that is, prices rise. The debasement of coinage is well illustrated in the Roman empire in the first 300 years after Christ. The denarius evolved from a silver coin about the size of a dime into a copper coin the size of a nickel, and lost almost all value in the process.

Modern governments have more options than did their predecessors. Financial markets and banks allow them to borrow without debasing their money. Because resources are shifted to the public sector, someone bears the burden of the action. If the government borrows more, higher interest rates will "crowd out" someone who will not be able to pay the higher rates. Because the government borrowing is only one of a great many factors that influence the level of interest rates, and because interest rates affect other variables such as people's wealth, the price of bonds varies inversely with the level of interest rates), it is impossible to identify the precise individuals whose spending is curtailed by the government deficit.

There is, however, a temptation by modern governments to finance some spending by printing money and thus causing inflation. Most countries have a progressive income tax--that is, as income goes up, so does the tax rate. Thus if income doubles, taxes will more than double. With this system, inflation will push people into higher tax brackets. Suppose a person starts at an income of $10,000 and a tax rate of 10% or taxes of $1000. If prices and wages all rise by 20%, he will have an income of $12,000. If his tax bill were $1200, he would pay the same real purchasing power to the government. But if the tax rate at $12,000 is 11%, he will pay $1320 to the government. This means that the government can raise taxes by causing inflation, without ever formally acting to raise tax rates.

Inflation can also produce a tax bonus for the government because of the way it affects wealth. If there is no inflation and a person has $10,000 in a savings account earning $300 a year in interest, the $300 is income because real wealth is increasing. But if the rate of price increase is 6%, then the real purchasing power of the $10,000 is decreasing and the $300 interest does not fully compensate for this. When inflation is taken into account, there should be a negative entry of $566 because the purchasing power of the original $10,000 has shrunk to $9434 in the second year. Thus the owner of this savings account has suffered an actual loss of about $266. However, the tax laws can and often do ignore the effects of changing real values, and the owner of the account may find that he pays taxes, even though in real terms (that is, in terms of purchasing power) he has no income at all.1

Governments, given the right mix of taxing and spending laws, can have an incentive to inflate. But once they do, there is an opportunity for political entrepreneurs to inform the public of the damage that inflation does and promise policies that will end inflation. Thus, the self-interest hypothesis of government is consistent with either inflation or stable prices. This inability of the hypothesis to give a clear prediction is a weakness.

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1One of the consequences of the rising inflation during the 1960s and 1970s was the failure of a great many savings and loan associations. Because they had lent long term at fixed rates, the increases in interest rates caused by higher inflation drained away their net worth, and this drainage was the root cause of the large-scale failures in the 1980s. Because these institutions were insured by the federal government, the government ended up paying many billions of dollars as a result of these failures. So, in the long run some of the increased revenues that the government obtained from inflation during the 1960s and 1970s was illusionary--it was lost by the inflation-induced failures of insured financial institutions.

Copyright Robert Schenk