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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.
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
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