How Inflation is Like a Tax
1. Erosion of Purchasing Power
Inflation reduces the real value of money — that is, what your dollars can buy.
- When prices rise, the same amount of cash buys fewer goods and services.
- This loss of purchasing power acts like a hidden tax on cash holdings and fixed incomes.
- For example, if inflation is 5%, and your savings earn only 2%, your real wealth effectively shrinks by 3% — similar to being taxed at that rate.
2. Redistribution from Savers to Borrowers (Including Government)
Inflation benefits borrowers at the expense of lenders.
- Debts are repaid in money that is worth less than when it was borrowed.
- Because the government is one of the largest debtors, inflation reduces the real value of its outstanding debt — effectively transferring wealth from private citizens (bondholders, savers) to the state.
- This transfer resembles a tax that funds government obligations without explicit legislation.
3. Bracket Creep and Nominal Taxation
In a nominal (non-inflation-adjusted) tax system, inflation can push people into higher tax brackets or inflate nominal income and capital gains without increasing real income.
- This increases tax revenue even though people are not wealthier in real terms.
- Thus, inflation can raise effective tax burdens invisibly — a phenomenon called bracket creep.
4. Hidden and Regressive Effects
Like many indirect taxes, inflation tends to hurt those with fixed or lower incomes more than wealthier individuals.
- Those with few assets or no access to inflation-protected investments suffer the most.
- It is “hidden” because it does not appear as a line item on a paycheck or bill, yet erodes living standards.
5. Inflation as a Form of Seigniorage
When governments or central banks create new money to finance spending, they gain purchasing power before prices adjust — known as seigniorage.
- The public bears the cost later as prices rise.
- This is functionally equivalent to the government collecting a tax through money creation.
Example: Inflation as a 5% “Tax” on Savings
You have $10,000 in a savings account earning 2% annual interest.
During the same year, inflation is 5%.
Step 1. Nominal Return (What You See)
- Bank interest: 2% × $10,000 = +$200
- End of year balance: $10,200
At first glance, it seems you’ve earned $200 — a gain.
Step 2. Real Value After Inflation (What You Get)
Since prices rose 5%, your $10,200 now buys what $9,714 would have bought a year ago.
(Calculated as $10,200 ÷ 1.05 = $9,714)
That means in real purchasing power, you’ve lost $286.
Step 3. The “Hidden Tax”
Even though you paid no explicit tax, inflation effectively reduced your wealth by:
$286 ÷ $10,000 = 2.86%
So the “real return” on your savings is:
2% nominal interest – 5% inflation = –3% real return
That 3% loss functions exactly like a 3% wealth tax on your savings — imposed silently through inflation.
Inflation as Seigniorage (Government View)
Suppose the government prints new money equal to 5% of the money supply to fund spending.
- The government gains new purchasing power immediately.
- The public later pays through higher prices.
- The real value of all existing money falls by about 5%.
From the government’s perspective, that’s revenue — just as if it had collected a 5% tax on everyone’s cash holdings.
Summary Table
| Measure | Before Inflation | After 5% Inflation | Real Change | Like a Tax Rate |
|---|---|---|---|---|
| Savings Value | $10,000 | $10,200 | $9,714 (in real terms) | 2.9% loss |
| Government Debt | $1 trillion | $1 trillion nominal | Real value = $952 billion | 4.8% gain (public loss) |
European History 