The inflation tax isn’t just real, it’s massive

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If you get the impression that the “inflation tax” is just a hint of reducing the impact of inflation on the purchasing power of your income and savings, you should continue. to read.

Inflation is a real tax, just as real and sometimes almost as important as personal income tax. While inflation clearly reduces the purchasing power of your income and the value of your fixed income assets, it also redistributes the purchasing power of businesses and households to the federal government. And in today’s economy, with inflation reaching 5.4 percent, the inflation tax is no small task. The amount the government will collect from the inflation tax in 2021 exceeds $ 1.9 trillion.

Most people understand that inflation can redistribute income and wealth. For example, many are probably aware that unanticipated 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 impact of inflation on the wealth of borrowers and lenders depends on whether inflation is anticipated or not. When inflation is anticipated, creditors include a premium in the interest rate as compensation for purchasing power lost due to inflation. A well-functioning financial market without undue central bank intervention will tend to set nominal interest rates equal to the real interest rate that creditors charge to lend more than the expected rate of inflation (the Fisher effect). Tax rates can also affect the amount of the inflation premium, but to keep things simple I’ll ignore taxes.

Unanticipated inflation transfers wealth between debtors and creditors. If inflation is higher than expected, the rate inflation premium is too low to recoup the purchasing power lost due to higher than expected inflation. When inflation is lower than expected, creditors win at the expense of borrowers because the interest rate compensates for lower purchase losses. The amount of wealth transferred by an unanticipated spike in inflation is approximately equal to the balance of borrowed capital multiplied by the difference between expected and actual inflation rates. If inflation is 3.4% higher than expected, borrowers gain purchasing power equal to 3.4% of the principal balance at the expense of creditors.

With regard to inflation and the federal government, things are a little different. The inflation tax is the amount of corporate and household wealth that is transferred to the federal government due to inflation.

Because the federal government is a massive borrower, unexpected inflation causes a large transfer of wealth to the federal government from households and businesses that extend credit to it. In addition, the federal government also benefits by reducing the purchasing power of cash and public investments that earn interest rates close to zero.

The central bank’s monetary policy can also play a key role in the size of the inflation tax. When central banks pursue aggressive and stimulating monetary policies as they are today, nominal interest rates can be artificially lowered below levels that creditors would normally demand in a market without central bank intervention. In such cases, nominal interest rates may not adequately compensate investors for expected inflation.

How much is the inflation tax?

First, think about what the inflation tax would be like if the Federal Reserve succeeded in meeting its target of 2% annual inflation, and inflation expectations were well anchored at 2%. In this case, the inflation tax is the annual transfer of wealth generated by fully anticipated inflation of 2%.

In a close approximation, current interest rates on cash, checks, savings accounts, and money market accounts are approximately zero. The value of these liquid balances can be approximated by the M2 a measure of money supply, which includes “cash, check deposits and readily convertible near-money”. In July, M2 was valued to $ 20,564 billion. An account included in M2 earns interest paid by the government. Bank reserves held by the Federal Reserve earn 15 basis points of interest per year. Including interest income on the $ 3.944 billion in reserves held by the Fed, at the end of the year M2’s balances would reach $ 20.570 billion. But with inflation at 2%, at the end of the year, these balances will command 2% less purchasing power. By then, $ 411 billion in purchasing power will have been transferred from businesses and households to government.

Now consider the situation today. Inflation expectations were pegged at 2%, but real inflation unexpectedly rose to 5.4%. The inflation tax has a component driven by the loss of purchasing power of the money supply and another component generated by the impact of unforeseen inflation on the debt of the US Treasury. The money supply tax is approximately equal to 5.4% of M2 balances, or about $ 1.1 trillion.

At the end of the second quarter of 2021, I estimated that the public held approximately $ 22.8 trillion in unprotected, interest-bearing, unprotected U.S. government securities. Using 2% as a proxy for the average interest rate on these securities, the wealth transfer generated by an inflation rate of 5.4% when businesses and households expected 2% inflation corresponds to about 3.4% of the value of the outstanding public debt, or about $ 775 billion. With inflation peaking at 5.4% in 2021, the inflation tax will transfer a total of about $ 1.875 trillion of purchasing power from businesses and households to the federal government.

To put the magnitude of this inflationary tax into perspective, consider that in 2021, the federal government expects to collect approximately $ 3,863 billion in explicit taxes, including $ 1,932 billion collected through personal income tax. With inflation currently at 5.4%, inflation will transfer at least $ 1.9 trillion in public wealth to the federal government this year. I say at least because $ 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 costs without adjustment for the impact of l ‘inflation.

In 2021, the inflation tax will be as important, if not more, than the revenues the federal government collects from personal income tax. The inflation tax is not only real, in 2021 it is really important.

No wonder governments love central banks.

Paul H. Kupiec is a resident researcher at the American Enterprise Institute (AEI), where he studies systemic risk and the management and regulation of banking and financial markets.


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