Inflation As a Hidden Tax Increase

With all of the current government spending, future promised spending, and the huge trillion-dollar budget deficit, there is a lot of talk about impending inflation. Many people are convinced that there is going to be a tax increase as a result, regardless of your political affiliation. However, this reminded me that we shouldn’t forget that the government can increase taxes without ever passing a bill, making you a new line on your IRS 1040 form, or even telling you about it. It simply has to keep pumping more money into the system.

The Wikipedia entry on “inflation tax” focuses on the idea of increasing prices and devalued currency as a increasing burden on people. But rising inflation itself is a hidden tax increase.

Let’s take a simple investment like a savings account or a bond earning an interest rate of 2% a year, but there is no inflation. Income tax is 25%. So you grumble about your low interest rates, pay your 2 x 0.25 = 0.5% in taxes, and keep the other 1.5% as your after-tax “real” return.

What if inflation is 3%, but you are slightly happier because you’re earning 2% above that for a total of 5%. Income tax stays the same, 25%. But now you’re paying 5% x 0.25% = 1.25% a year in taxes, and after 3% inflation you are left with 0.75% as your after-tax real return. Even worse.

Finally let’s say that inflation is now 6%, and you are still earning 2% above inflation. Income tax again is based on your nominal income, so you’re stuck paying 25% of that 8% interest. This leaves you earning 2% above inflation pre-tax, and then going and paying 8 x 0.25 = 2% in taxes. Your after-tax real return is now zero. You’re not making any money, it all went towards taxes.

All this could happen without ever raising the official income tax rate. This fact is sometimes brought up when talking about inflation-indexed bonds, but applies the same to all investment returns.

Comments

  1. You also have to account that income tax brackets move along with inflation.

  2. Good point here. The government has a big incentive to allow inflation to creep upwards because they can pay down their debt in less valuable dollars. Certainly more politically palatable than keeping prices stable and having to overtly raise taxes to pay off the debt. If policy goes down this road, and I’m talking about several years at controlled 3-4% inflation not a hyperinflation scenario, it is really going to just erode the savings of those of us who have lived within our means and piled up big savings account balances. Inflation can be a way to transfer wealth from savers to debtors, and we are in aggregate a nation of debtors. I’ve been worried about this for some time now.

  3. THANK YOU THANK YOU THANK YOU for writing on this subject. Every American needs to know about the dangers of inflation and thus Keynesian economics. Only an Austrian economic system is indefinitely sustainable, and deflation is NOT a bad thing, despite what the mainstream media will tell you!
    The ONLY way we’ll ever get rid of inflation in this country is to get rid of the private, secretive organization with no oversight known as the federal reserve (about as federal as FedEX) because THEY have the power to create money, rather than our congress, which is laid out in the constitution.
    Check out mises.org and inflation.us.

  4. One thing worth nothing is that we’re not a fiat currency based economy as many believe but rather a credit based economy. The amount of base money (the fiat currency) is dwarfed when compared to the amount of credit money. So even while the Fed has been attempting to pump money into the system, the supply of credit money has decreased much more significantly. And even so, the demand for money has decreased further (to wit, the extremely low interest rates).

    Using the definition of inflation as “too much money chasing too few goods”… we have much unused capacity (human and otherwise) and the supply of money (credit money) has decreased. It’s, therefore, hard to imagine a short-term scenario whereby there’s any general inflation.

  5. @ jeff well said I couldn’t agree more, the federal reserve is what got us into this recession anyway

  6. So many people get all cranky over the Federal Reserve. The Fed has the power create money, rather than Congress, *because Congress delegated it to them*. How can that be unconstitutional??

    Frankly I’m much more comfortable with monetary policy not being up for votes all the time – Congresspeople just have too much incentive to juice the short run at long-term expense. Jonathan’s example shows exactly why this agency needs to be shielded from the budget makers.

  7. Spend some time reading http://www.shadowstats.com/, find out what real inflation (not the ‘let them eat cake’ manipulated CPI-U).

    Even the Congressional Budget Office is open about our problems but most American’s are more focused on their 401Ks and Ikea catalogs than real, difficult reforms. The former Comptroller of the U.S., David Walker, had some pretty powerful things to say in I.O.U.S.A.

    @Lewis
    If they were open about it maybe it is obvious by the gutted ‘Audit the Fed’ bill and other jokes such as the banking reform bills we, the taxpayers, are getting stiffed.

  8. The table initially confused me. Looked like you were figuring nominal return based on adding a real return + inflation, but thats backwards. You figure real return by subtracting inflation from nominal return. Inflation doesn’t determine your nominal return unless you’ve got an inflation indexed investment like TIPS.

  9. StLPastor says:

    I think your math is right, but inflation is much more than a hidden tax increase. More so, it is a tax on the past economy by the future economy. Inflation tends to wipe out previous economic results-inflating away both debts and savings, thus erasing old binges, and encouraging new investment. We need more inflation in our economy right now, not less (here’s a nice primer http://web.mit.edu/krugman/www/deflator.html). A few years of 4% inflation would do good things for our economy and great things for our national debt.

    Also, obviously the Fed has oversight-Congress can take away their power whenever they want.

  10. I’m confused. If I were investing at a 2% return and inflation was 3%, I would not see this as a 5% return at all. I don’t get additional dollars for inflation, I just get reduced buying power of the dollars I have. I would see this as a -1% real return pre-tax, and a -1.5% real return post-tax (using the 25% rate in the hypothetical). I guess I agree with the premise that inflation affects investment return, but the approach is a little confusing. Am I missing something?

  11. Yes you are missing it. Basically the example is of an asset with a given real return under different inflation scenarios. Like suppose you expect equities will have a 5% real return over the long term regardless of inflation. If inflation is 3% per year for 10 years you would expect to get an 8% nominal return on equities. If inflation were 5% you’d expect to get a 10% nominal return on equities.

    His point is that you pay taxes on the entire gain (real return and inflation component) so under a higher inflation regime you end up paying higher taxes for a given level of real return, and therefore your real after-tax return is lower than under a low/no inflation scenario.

  12. Scott, you’re just missing the nominal return. The nominal return is what you will mathematically calculate before you adjust for inflation. So, a $100,000 investment becoming $105,000 after one year has a nominal return of 5%. If the inflation rate was 3% in that year, the real return is only 2%, but you are still taxed on your nominal “gain” of 5%.

    The 2% return in the example accounts for inflation already, as it is a real return.

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