Tuesday, May 23, 2006

The Inflation Tax

One of my ec 10 students wonders whether it is possible to defend inflation:

Why is it such a bad thing for governments to rely more on the "inflation tax"? As long as it is applied within the context of an inflation-targeting Fed, all the negatives of inflation can be contained. That is, as long as the Fed sets a target inflation rate (say, 15%) and then uses open market techniques to bring inflation into line by taking into consideration the new money, there'll be no unexpected inflation, and therefore no inflation cost.

There are many advantages to the inflation tax, including: 1) Painless, free "collection." 2) Progressivity (those with the most accumulated assets pay the most.)

It is a provocative proposal. I don't know any economist who would endorse it, however. To explain why, let me make four points:

1. The inflation tax is not painless. There are various inefficiencies that inflation causes, even if it is steady and predictable. Those include the "shoeleather" costs of reduced real money balances, increased menu costs, spurious relative-price variability, and distortions in taxes due to the failure to have fully indexed tax laws. These are discussed in more detail in the textbook.

2. The inflation tax is probably less progressive than one might at first think. It is not a tax on all assets but only on non-interest-bearing assets, such as cash. The rich are able to keep their most of their wealth in forms that can avoid the inflation tax. (One exception is the rich in the underground economy; the inflation tax may hit criminals particularly hard.)

3. The inflation tax would raise only a modest amount of revenue. Here is a rough calculation. The monetary base is now about $800 billion. So an inflation rate of 15 percent would raise a maximum of $120 billion per year, or about 1 percent of GDP. That is an upper bound on the amount of tax revenue because, as inflation rose, the quantity of money demanded would fall, reducing the size of the tax base. (This is a standard "Laffer curve" argument, applied to the inflation tax.)

4. For reasons that are not fully understood, high inflation tends to be volatile inflation. A stable and predictable 15 percent inflation seems possible as a matter of economic theory, but it is rarely if ever observed. If we take this empirical regularity as a constraint, then choosing high inflation entails choosing volatile inflation, which increases uncertainty.

These are the reasons that most economists would be averse to a proposal of steady 15 percent inflation. But has some economist done a detailed and convincing cost-benefit calculation, weighing all the pluses and minuses, to figure out the optimal inflation rate? Not to my knowledge.

To read more about the inflation tax and the optimal rate of inflation, click here, here, and here.