Thursday, January 11, 2018

The GOP's Tax Reform Offers No Relief from the Inflation Tax

By Brendan Brown

The Tax Cuts and Jobs Act (TCJA) signed into law on December 22, 2017 promises no relief from one big tax on income — the
inflation tax. Quite the contrary, there are strong grounds to expect this burden to increase as new and unannounced methods of collection evolve further.

In recent years, the Fed’s commitment to the two-percent inflation standard, buttressed by radical experimentation in interest rate manipulation, has created a famine of interest income from which Uncle Sam has been a main gainer. Just look at the dwindling interest bill on government debt. As the Federal deficit to GDP ratio now climbs to a new peacetime record for the US economy in a late boom phase of its business cycle, this partly hidden and widely underestimated form of inflation tax alongside its older forms loom large as potential expedients to tackle crumbling public finances.

The omission of the inflation tax from the whole discussion about the Republican tax cuts may be due partly to the failure of the economic profession to update its analysis of this subject. Yes, it was a popular topic for study during episodes of high inflation in the past including the great hyperinflations of historical folklore. It has suffered some neglect since, even though monetary inflation remains prevalent. Official inflation rates reported over many years of “only or below” two-percent have proved to be a tonic to academic inquiry.

The monetary officials who administer today’s two-percent inflation regime deny that they are tax collection agents. They claim that the interest income famine stems from natural misfortune (dwindling investment opportunity, excess savings) and that two-percent inflation really isn’t that bad given the difficulties of measuring quality improvements. A powerful downward rhythm of prices attributable to globalization and digitalization has allowed them to pursue monetary inflation and levy inflation tax in the new form of interest rate manipulation — all while complaining that “inflation is too low” and winning friends enriched by asset price inflation.

A stellar effort by economists to unmask central bank tax collectors would be a real contribution to capitalism and freedom. They should start with a history of past collections and progress to the identification of new forms. When they arrive at the Republican tax cut, serious economists should reject any notion in the sales propaganda that the architects have succeeded in bringing manna from heaven.

Asset Inflation Leads to Higher Tax Collections
In so far as the immediate beneficiaries of the cuts increase their claim on resources, they generate forces (both public and private) which restrain competing demand. A rise in market interest rates could be part of the process. Inflation tax collections are another part. And some equity owners might contain their enthusiasm by realizing that hikes in the effective rates of dividend and capital gains taxes could lie ahead even without a Democrat sweep election. Viewed over many years, the tax on business income would shift accordingly from upstream (where corporation tax collection occurs) to downstream. That is hardly a radical lightening of burden.

The effective rate of capital gains tax, expressed as the percentage of real profit on sale, rises with inflation even while the nominal tax rate remains unchanged. That is one of the modern forms of inflation tax collection. As an illustration, a 15-percent tax on a gain of 40% is 30% in real terms if cumulative inflation over the holding period (say 7 years) amounts to 20%. This capital gains tax grab is an important modern form of inflation tax. It is easier to measure than the government’s gain from interest rate manipulation as the market rate which would prevail in a hypothetical sound money regime is unknown.

Debasement: The Oldest Form of the Inflation Tax
The oldest form of inflation tax, also to be found in the present and likely to become more prominent in the future, is “debasement of the currency.” The origins of this lie in ancient times. The amount of the tax levy from debasement is distinct from the revenue which the government receives. The variable spread between the two is attributable to the response of the private sector where those who are most alert to a gathering inflation momentum gain a part of the levy on the laggards.

The revenue which the sovereign derived from debasing his or her coinage (by substituting new coins with reduced gold content but unchanged specification for the old) depends in part on how much the process remained secret from the public. Even if the truth seeped out, the demand for extra coinage was the source of revenue. Businesses and individuals who were quick to adjust upwards prices for their goods and services ahead of price rises elsewhere collectively restricted but could not halt the real revenue flow to the sovereign. Gresham’s Law (bad money drives out good) did not disable the inflation tax collectors. There was still demand for the new coins as the circulating medium.

Under fiat money regimes where monetary base is a highly distinct asset for which demand is closely related to the growth of nominal incomes, the levying of inflation tax has close parallels to the currency debasement of old. If everyone knows the monetary base is rising and prices are bid up accordingly the amount of tax collection in real terms is less than in the case of a well-kept secret.

Once we allow for considerable instability and volatility in the relationship between monetary base, broader money supply, and prices, the dynamics of inflation-tax collection becomes harder to determine. The existence of a market in short-maturity government debts, too big to fail banks, deposit insurance, lender of last resort, and interest payment on bank reserves add to the complicating factors — essentially because they make monetary base less distinct.

The levying of inflation taxes in traditional form under a fiat money regime starts with an acceleration or monetary base growth. Where demand for monetary base is highly interest elastic this could trigger a collapse of money market rates, causing currency depreciation and fuelling excess demand for goods and services. The rise of inflation imposes real losses on holders of fiat money (non-interest bearing) and on government bonds in so far as the interest rates fixed on those at the time of issue failed to reflect adequately the subsequent fall in money’s purchasing power.

The fall in real value of money balances brought about by inflation means an increase in demand for these as individuals and businesses seek to re-build their holdings. A counterpart increase in demand for monetary base provides scope for government to extract revenue (described as “seigniorage”). Likewise, the government can expand its issuance of debt to re-fill gaps in bond portfolios due to erosion by inflation without triggering a downgrade of its credit-rating.

Fast forward to inflation tax collection under the two-percent inflation regime in the presence of camouflaged inflation, and where reserves pay interest at the market rate. New forms of inflation taxation here include negative interest rates. But we should not neglect the older form of inflation tax magnified by potential surprise even though the dynamics are hard to determine. So long as inflation inertia persists (and such inertia is built in to the two-percent regime) the tax collector cannot make big takings from currency debasement. Yet when inertia snaps, the revenue could soar at least transitorily. This could be how the Republican tax cuts are ultimately financed.

Brendan Brown is the Head of Economic Research at Mitsubishi UFJ Securities International.

The above originally appeared at

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