Friday, October 13, 2023

Inflation as a tax

Last week I explored how Henry VIII resorted to coin debasement as a way to raise revenues in order to fight his wars. This provided Henry with the financial firepower to annex the city of Boulogne from the French in 1544, albeit at the price of England experiencing one of its greatest inflations ever.

Zoom forward five hundred years and Rishi Sunak, the Prime Minister of the UK, has ignited a controversy by referring to inflation as a tax, and further suggesting that the "best tax cut I can deliver for the British people is to halve inflation." His BBC interviewer disputed the claim, saying that inflation isn't a tax, a stance that the BBC upholds on its fact checking page.

If you recall, my previous article showed how Henry VIII's debasement functioned very much like a tax, say a new customs duty on wine or a beard tax. It did so by incentivizing people to flock to English mints to have their precious metals turned into coinage, Henry extracting a small fee on each coin. But the 21st century monetary system is very different from that of the middle ages. Is Rishi Sunak right to characterize inflation as a tax?

First, we need to better define our terms.

What do the BBC interviewer and Sunak mean by inflation? In the western world, prices have been rising at a regular pace of 2-3% each year for decades as result of central bank policy, which targets a low and steady inflation rate. Is this the definition they are using? Alternatively, Sunak and his interviewer may be referring to inflation as a *change in the change* in price. Since 2022 or so, that 2-3% rate has leapt to 8-9% all over the western world. Is it this jump that Sunak and his interviewer are talking about?

For the sake of this article, we'll assume that the conversation between Sunak and the BBC refers to the latter, a spike in the rate of inflation.

Secondly, what is meant by the word tax? Sometimes when we say that something is a tax we mean that it causes suffering. That is, inflation is taxing: it makes people's lives harder by increasing the cost of living, with salaries failing to keep up. It creates unfair changes in winners and losers.

Fair enough. But the more precise view I want to broach in this article is that inflation is actually a tax, where we define a tax as a formal charge or levy, set by the political process, that leads to cash flowing from the population to the government.

What does the data show?

Interestingly, a surprise jump in inflation leads to the very same effects as a new tax. All things staying the same, a new tax leads to an increase in government revenues. This improves the government's fiscal balance, or the difference between its revenues and expenses. A recent IMF paper by Daniel Garcia-Macia using data from 1962 to 2019 shows how an inflation shock typically achieves this exact same end result, boosting government revenues and improving its fiscal balance. This effect lasts for a few quarters, even up to two or three years, then recedes.

The IMF's chart below breaks down exactly how an inflation shock tends to improve government finances using quarterly data going back to 1999:

Charts source: IMF

Total tax revenue (the first panel) immediately begins to rise after the inflation shock at about the same rate as inflation.That's because most taxes are set by reference to values or prices, say like the prices of goods and services, or the price of labor, or the value of corporate profits. Since inflation pushes these amounts higher, this gets quickly reflected in tax revenues.

Income taxes and profits taxes (the second panel) rise particularly fast. Inflation is presumably pushing tax payers into higher income tax brackets, a process known as "bracket crreep," and so the government very quickly starts to collect a proportionally-larger amount of income tax.

Meanwhile, the government's total expenditures, the third panel, typically stay flat or only marginally rises in the quarters after the inflation shock hits. Notably, the amount of wages that are paid to government employees and social benefits (panels 4 & 8) tend to fall.

The net effect is an improvement in the government's fiscal balance. More specifically, for a 1% increase in inflation, the government's overall balance tends to improve by about 0.5% of GDP. And so an inflationary shock ends up at the same endpoint as a new tax: higher revenues and a better budget. That doesn't necessarily mean that inflation is itself a tax. Taxes have a degree of intentionality. They get implemented through a political process that has a certain set of goals in mind. By contrast, the extra revenue that an inflation shock raises is often (though not always) accidental, the result of external forces rather than political decision making.

So while it may not fall under the dictionary definition of a tax, the tax implications of a modern inflation shock resemble that of a new tax.

Everything I've written above applies to an inflation shock, say a rise from a 2-3% to 8-9%. Next I want to show that even constant 2-3% inflation can have the same revenue implication as a tax. Here's how.

Banknotes and seigniorage

Governments usually have a monopoly over the issuance of two key financial instruments: banknotes and settlement balances (also known as reserves). We all know what banknotes are, but what are settlement balances? Commercial banks find it useful to keep a stock of settlement balances on hand to make crucial large-value payments to other banks. The central bank, which the government controls, is the monopoly provider of these balances. (Sometimes banks are required by law to keep a a fixed number of settlement balances on hand, often above and beyond their day-to-day needs, a policy referred to as required reserves.)

Historically, interest rate on both types of central bank-issued money have been set at 0%. At the same time, the rates on short-term credit instruments (Treasury bills, commercial paper, bankers acceptances, etc) are determined by the market, typically hovering at a positive rate ranging between 0.25% to 5% over the last thirty years. These yields are priced to compensate investors for inflation.
The interest rate gap this gives rise to allows central banks to earn a steady stream of revenues, borrowing at an artificially cheap rate of 0% from both the banknote-using public and banks, and reinvesting at, say, 3%. Most of the revenues that the central bank collects from this interest margin flows back to the government. Economists usually refer to these revenue stream as seigniorage.

So seigniorage performs the same function as a consumption tax or an income tax: it takes resources from the public and gives it to the state. Likewise, a reduction in seigniorage would be very much like a tax cut.

If politicians wanted to, they could do away entirely with this form of raising government revenues. They have two ways of going about this. One way would be to have the central bank reduce price inflation to zero. By doing so, the interest rate on short-term credit instruments like Treasury bills would also fall to 0%, or thereabouts, since these instruments no longer need to compensate investors for inflation. And so the gap between the 0% rate at which central bank fund themselves and the rate at which they reinvest would cease to exist, seigniorage effectively shrinking to zero.

Over the last few decades, governments have taken a second route to removing seigniorage: they have begun to pay a market-linked yield on settlement balances. Canada, for instance, adopted this policy in 1999, and the Bank of England did so in 2006. By paying a market-based return, central banks no longer extract seigniorage from banks by forcing them to hold 0% assets. 

However, that still leaves banknotes as a significant source of seigniorage. We can calculate how much the UK government roughly earns from banknote seigniorage. With £95 billion in banknotes outstanding in October, and interest rates at 5.1%, the Bank of England's banknote-related seigniorage comes out to around £5 billion per year, much of which flows back to the government. That sounds like a lot, but it's only a small chunk of the £790 billion in taxes the UK government collected last year.

Banknote seigniorage isn't set in stone. It's a policy choice. If governments wanted to, they could reduce this form of seigniorage by paying interest on banknotes. One way to go about this would be to introduce a banknote serial number lottery. This lottery would offer around £5 billion in cash prizes to holders of winning banknote serial numbers, equating to a 5% interest rate on banknotes. Doing so would be akin to enacting a tax cut on British citizens.

To sum up, the fact that both an inflation shock and steady 2-3% inflation have implications for government revenues suggests that while inflation may not quite qualify as a tax, it is certainly tax-like.


  1. Interesting post linking tax, inflation, and seigniorage. When BOC and BOE started paying yield on settlement balance, you say it eliminated seigniorage. But by paying yield on what used to be 0% yield, what do you think was the effect to inflation? Does it add to inflation by adding to monetary base? Did it just counteract the deflationary effect of taking a resource (money in the balance) from the public? Or is it deflationary because it encourages banks to just put more money in the settlement balance instead of lending out?

    1. I don't think paying interest on reserves is inflationary or deflationary; it's probably neutral. But let's say for argument's sake that it isn't neutral. The BoC and BoE both target inflation, so whatever the effect of paying interest on the rate of inflation (inflationary or deflationary/disinflationary), the central bank would compensate in the opposite direction to make sure that the actual inflation rate stays close to target.

    2. Thanks. Settlement balances should really only be determined by their use, settlement of accounts. Mixing it with CB inflation objectives can add bank costs that get just get passed on to borrowers.

  2. This is an interesting question, JP! Thanks.

    Please allow me to look at this from the money-as-a-recordkeeping-device perspective (a.k.a. accounting view), in hope it could shed some additional light on it.

    A tax is a resource you give up for communal use, without earning the right to receive an equivalent (real) value later. From the government's point of view, these are resources received/taken from the members of the community (taxpayers), to be used for the good of the community. (What happens on the "monetary level" is just accounting which is done to achieve the outcome I just described.)

    Take a simple society with 12 members. One of them is a horse breeder. The society needs 6 horses for road building. The government could ask all 12 taxpayers to deliver 1/2 horse each as a tax payment. This would require 11 members, the non-breeders, to trade something with the horse breeder, so that she gets 5 and a 1/2 horses' worth of resources from her fellow taxpayers (1/2 a horse is her tax payment). They would in return get 5,5 horses from her. They would together deliver the 6 horses to the government. Taxes paid & received.

    OR: The government could go straight to the horse-breeder and requisition 6 horses. Then it would credit her with the value of those (let's say $1,000 a piece). This could be done by issuing her 12 notes worth $500 that say "I have paid taxes worth $500" (I think there are historical examples of this in England). Then the government would impose a lump sum tax of $500 on each taxpayer and the taxpayers would be required to prove their payment (ie. giving up resources worth $500) by presenting a $500 note at the tax office. To acquire these notes, the non-breeders would need to give resources priced at $5,500 (the price of 5,5 horses) to the breeder. The outcome is the same as above: the government got 6 horses, this time given up by the breeder directly, while the other 11 taxpayers gave resources worth 5,5 horses to the breeder. Each taxpayer thus ended up giving $500 worth of resources for communal use (directly or indirectly).

    All of the above assumed no inflation -- or all trades taking place more or less at the same moment in time.

    If we add inflation, and delay in the trades, the picture would look something like this:

    The breeder gives (aka. selling) 6 horses to the government. But the government delays taxation and the breeder holds on to the (0 %) notes until the general price level has risen 10 %. At this point a $500 tax is imposed on all 12. The breeder still receives $5,500 worth of resources from the non-breeders, but that is the equivalent of only 5 horses. The outcome is that the breeder gave up 1 horse for the "common good", while the 11 non-breeders only delivered 5 horses. Compare this with half a horse each.

    So inflation made the breeder's taxes higher, while lowering the taxes the non-breeders had to pay. The government received the same.

    This is in line with standard theory: creditors without sufficient inflation protection lose, while debtors without sufficient inflation "penalty" gain. The 11 taxpayers were debtors through public debt incurred when the government bought the 6 horses.

    Based on this scenario (one can think of different ones, with different outcomes), I would say that inflation is not a tax. It does lead to a similar outcome for unprotected credit-holders of all kinds: they end up giving more resources than they later receive. But the recipient of these extra resources is not the government, as is the case with taxation, but debtors whose rates stay below inflation.