Inflation Tax

An inflation tax is a tax on cash. Inflation reduces the real purchasing power of cash. After inflation, holders of cash can buy less with that cash. The decrease in what can be purchased with a fixed amount of cash is the tax paid on that cash.

Like all taxes, the inflation tax is a tax imposed by government and the proceeds go to pay for government expenditures. A government initiates an inflation tax by printing money to pay for goods and services instead of raising sufficient revenue through taxation or borrowing. As the money stock grows relative to the production of goods and services, prices rise, leaving households and businesses poorer to the extent that they hold cash balances representing less purchasing power. If the inflation rate is 10 percent, then an individual holding $1000 cash for a year is taxed at a rate of 10 percent on that cash.

Like any property tax, households and businesses can avoid the inflation tax by not holding cash. Economists theorize that there is an optimum inflation rate at which the tax revenue from the inflation tax reaches a maximum. Inflation rates beyond the optimum rate cause cash holdings to shrink to the point that tax revenue from the inflation tax contracts in terms of real purchasing power. At lower inflation rates, households and businesses are more willing to pay the inflation tax, regarding it as a necessary expense to enjoy the convenience of holding cash.

The inflation tax can generate government revenue in other ways. By pushing taxpayers into higher tax brackets, the inflation tax brings in additional tax revenue. In addition, inflation reduces the real, inflationadjusted amount of debt that a government owes. Usually, no additional tax collectors and mechanisms are needed to collect the inflation tax.

Critics observe that the inflation tax is taxation without consent. Without any kind of legislative approval or even public announcement of a tax increase, the government increases the tax burden on citizens. Critics also cite the numerous negative effects of inflation.

Economists seemed to have known about inflation tax for several centuries but paid it little attention until the 20th century, when paper money begin to dominate monetary systems. The famous 20th-century economist John Maynard Keynes credited Rome with discovering the power of taxation through currency depreciation. In 1922, Keynes gave the first full treatment in English of the inflation tax. In his article, “Inflation as a Method of Taxation,” Keynes hinted that the Soviets preceded him in regarding inflation as an instrument of taxation. Evgeni Alexeevitch Preobrazhensky (1886–1937), a Soviet economist, wrote the book Paper Money in the Epoch of Proletarian Dictatorship, published in Russian in 1920, predating Keynes’s article. Preobrazhensky argued that inflation was a highly effective policy for diverting resources from the private to the socialized sector and for expropriating the money capital of the bourgeoisie. One often quoted line from Preobrazhensky’s book on paper money referred to the printing press as “that machine gun which attacked the bourgeois regime in the rear.”

The idea of inflation as a tax on cash balances caught on rapidly in the United States following World War II. It gave a rationale for a government that seemed a bit complacent in combating inflation. The Nobel Prizing economist Milton Friedman broached the subject first in his book Essays in Positive Economics, published in 1953. By the 1980s, the idea had entered into political debate, and “inflation tax” became a household phrase.