Inflation: A Hidden Tax

Economists may argue on many things. However, they all agree on one thing i.e. the biggest possible economic nemesis that the common man has is inflation. Many economists have called it dangerous. Earlier it was not believed that inflation is a form of taxation. However, in the 20th century based on the discussions amongst the economists, it was more or less agreed upon that inflation is a form of hidden taxation, hidden because we do not see the outflow going from our pockets. However even though the money may not have left our pockets, its soul i.e. the purchasing power has already left. Let’s understand this concept in more detail through this article.

Let’s begin by a quote by an eminent economist. Nobel Prize winner Milton Friedman had once said,“Inflation is the only form of taxation that can be levied without any legislation”

This means that if any other type of tax has to be levied on the general populace, it must be introduced in the parliament and discussions have to take place on the validity of the tax and whether it is being levied correctly. However, this is not the case with inflation. Inflation gives any government the power to take the purchasing power of your money without anyone asking them even a single question. For obvious reasons, this kind of power is not desirable in the hands of a corrupt government. Let’s understand the mechanism with which inflation is used to siphon off money from our pockets.

Most Governments Spend More Than They Earns:

Governments collect money from us in the form of taxation. Governments also control certain businesses such as railways and earn some money from that too. Most governments in the world are accustomed to spending more money than they make. Most governments across the world have been running deficits for decades now. In many countries like Japan and the ones in Europe, this deficit has blown out of proportion.

So, if a government spends more money than it makes, how does it survive. Well, here are the common steps that can be usually taken.

Option #1: Increase Taxation

The first option is relatively straightforward. The government has been spending more than it makes. Now, to cover the deficit, it will have to do the exact opposite i.e. make more than it spends. This can be done by increasing taxation. Common forms of doing so are bringing more goods and services under the purview of taxation as well as increasing the rates of collection for goods and services currently under the purview. This option is not very popular for obvious reasons. The general population does not like to give taxes. Every dollar that they pay in taxes is a dollar that they do not have for personal consumption. Needless to say, that if a government uses this alternative very often, they will not be in power for very long.

Option #2: Austerity

The opposite of this is also true. Instead of making more money, the government could cut down the amount of spending that it is currently doing. This is called austerity measures and this is what IMF is trying to negotiate with the Greek government. With reduced expenditure, governments can save a part of their income and pay the taxes.

Since a lot of government money is spent on populist schemes like social welfare, Medicaid etc, cutting down on these expenses is also an extremely unpopular step and will cause the government to go out of power very soon.

Now, both the common sense measures seem unviable. This is when the government invents a third option i.e. inflation.

Option #3: Hidden Taxation via Inflation

As per the third alternative, the government temporarily borrows the money required to finance the fiscal deficit from the bond market. Later, when the interest and principal repayments are due, the government prints this money and pays it off. This dilutes i.e. increases the money supply decreasing the value of money held by other people. But it pays off the government debt!

What Happens When More Money Is Created?

The new money created derives its value from the old money that was in circulation at that time. Thus every dollar bill that is printed causes the value of other dollar bills worldwide to depreciate. The government therefore in effect has taken the money out from the public’s pockets and has paid off its debt. The effect is similar to that of taxation. But the procedure is hidden. There is no direct payment of tax from the people to the government. Instead, the government has debased the value of currency held by its citizens.

This method is not understood by the masses. Hence there is no major debate on this issue. This gives governments’ world over the authority to continue spending unchecked and then later use inflation to pay it off!

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Managerial Economics