BY PAUL KUPIEC
If you are under the impression that the “inflation tax” is only an allusion to the shrinking impact inflation has on the purchasing power of your income and savings, you should continue reading.
Inflation is a real tax, just as real and at times nearly as important as the individual income tax. While inflation clearly does reduce the purchasing power of your earnings and fixed-income asset values, it also redistributes purchasing power from businesses and households to the federal government. And in today’s economy, with inflation running at 5.4 percent, the inflation tax is no small matter. 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 probably are aware that unanticipated inflation benefits borrowers at the expense of creditors. When inflation is higher than expected, borrowers repay debt with future dollars that have less purchasing power. ADVERTISEMENT
The inflationary impact on the wealth of borrowers and lenders depends on whether inflation is anticipated or unanticipated. When inflation is anticipated, creditors include a premium in the interest rate as compensation for the purchasing power lost 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 creditors require to lend plus the expected inflation rate (the so-called Fisher Effect). Tax rates can also impact the size of the inflation premium, but to keep things simple I will ignore taxes.
Unanticipated inflation transfers wealth between debtors and creditors. If inflation is higher than expected, the inflation premium in rates is too small to recover the purchasing power lost to higher than expected inflation. When inflation is lower than expected, creditors gain at the expense of borrowers because the interest rate overcompensates for lost purchasing lower. The amount of wealth transferred by an unanticipated spike in inflation is approximately equal to the principal balance borrowed times the difference between expected and actual inflation rates. If inflation is 3.4-percent higher than expected, borrowers gain purchasing power equal to 3.4 percent of the principal balance at the expense of creditors.
When it comes to inflation and the federal government, things are a little different. The inflation tax is the amount of business and household wealth that is transferred to the federal government as a result of inflation.
Because the federal government is a massive borrower, unexpected inflation causes a large transfer of wealth to the federal government from the households and businesses that provide it credit. In addition, the federal government also benefits by reducing the purchasing power of the public’s cash and liquid investments that earn near-zero interest rates.
Central bank monetary policy can also play a key role in the magnitude of the inflation tax. When central banks are pursuing aggressively stimulative monetary policies as they are today, nominal interest rates can be artificially depressed below levels that creditors would normally require in a market without central bank interventions. In such instances, nominal interest rates may not adequately compensate investors for expected inflation.
How large is the inflation tax?
First, consider what the inflation tax would be if the Federal Reserve was successful in achieving its target of 2-percent annual inflation, and inflation expectations were well-anchored at 2-percent. In this case, the inflation tax is the annual wealth transfer generated by 2 percent fully-anticipated inflation.
To a close approximation, current interest rates on cash, checking, savings and money-market accounts are approximately zero. The value of these liquid balances can be approximated by the M2 measure of the money supply, which includes “cash, checking deposits and easily convertible near money.” As of July, M2 was estimated to be $20.564 trillion. One account included in M2 earns interest paid by the government. Bank reserves held at the Federal Reserve earn 15 basis points in interest per year. Including the interest earnings on bank’s $3.944 trillion in reserves held at the Fed, by year-end, M2 balances would grow to $20.57 trillion. But with inflation at 2 percent, at year-end, these balances will command 2 percent less purchasing power. By then, $411 billion in purchasing power will have been transferred from businesses and households to the government.
Now consider the situation today. Inflation expectations have been anchored at 2 percent, but actual inflation has unexpectedly spiked to 5.4 percent. The inflation tax has one component driven by the lost purchasing power of the money supply and another component generated by the impact of unanticipated inflation on U.S. Treasury debt. The tax on the money supply is approximately equal to 5.4 percent of M2 balances or about $1.1 trillion.
At the end of the second quarter of 2021, I estimated that the public held about $22.8 trillion in interest-bearing non-inflation-protected U.S. government securities. Using 2 percent as an approximation for the average interest yield on these securities, the wealth transfer generated by an inflation rate of 5.4 percent when businesses and households were expecting inflation of 2 percent is roughly 3.4 percent times the value of outstanding government debt, or about $775 billion. With inflation spiking to 5.4 percent in 2021, the inflation tax will in total transfer roughly $1.875 trillion of purchasing power from businesses and households to the federal government. ADVERTISEMENT
To put the magnitude of this inflation tax into perspective, consider that, in 2021, the federal government expects to collect about $3.863 trillion in explicit taxes including $1.932 trillion collected through individual income taxes. With inflation currently running at 5.4 percent, inflation will transfer at least $1.9 trillion in wealth from the public to the federal government this year. I say at least because $1.9 trillion ignores the extra tax revenues inflation automatically creates in our progressive system that taxes nominal income and historical-cost-based capital gains without adjustments for the impact of inflation.
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In 2021, the inflation tax will be as large if not larger than the revenues the federal government will collect from individual income taxes. The inflation tax is not only real, in 2021 it is really large.
No wonder governments love central banks.
Paul H. Kupiec is a resident scholar at the American Enterprise Institute (AEI), where he studies systemic risk and the management and regulations of banks and financial markets.