Inflation Tax

Published Jan 4, 2023

Definition of Inflation Tax

The inflation tax is an implicit tax imposed on holders of money due to the effects of inflation. That means it is a tax on the real value of their money because inflation erodes the purchasing power of money over time.

Example

To illustrate this, let’s say you have USD 1,000 in your bank account. Now, imagine that the inflation rate is 10% per year. That means the purchasing power of your money decreases by about 9% each year. Note that the purchasing power doesn’t decrease as much as the price increases in percent. That’s simply because of how percentages are calculated (I.e., a 100% in price results in a 50% decrease in purchasing power and not a 100% decrease). Therefore, after one year, your USD 1,000 will only be worth USD 909 in real terms. In other words, the effects are the same as if you had paid a USD 91 tax (USD 1,000 / 1.1) due to the effects of inflation.

Another way to look at this is to think about what you can buy with your money. Since you’ll still have USD 1,000 in your bank account after a year, this might be easier to understand. So let’s say at the beginning of last year, you could have bought 1,000 cups of coffee (at 1.00 USD each) with your savings. Now, because of inflation, the price of a cup of coffee has increased to USD 1.25 this year. As a result, you can only buy 800 cups of coffee for the same money. That’s the same effect a 20% tax would have had at constant prices.

Why Inflation Tax Matters

Inflation taxes are an important source of revenue for governments. That is because they are relatively easy to collect and do not require any additional paperwork or bureaucracy. In addition, inflation taxes are also considered to be regressive, as they disproportionately affect lower-income households. That means they are often used by governments to finance their spending without having to raise taxes on the wealthy. However, inflation taxes can also have a negative effect on the economy, as they reduce the purchasing power of money and can lead to higher prices for goods and services.