If you are under the impression that the “inflation tax” is only an allusion to the shrinking impact inflation has on the purchasing power of your income and savings, you should continue reading.
Inflation is a real tax, just as real and at times nearly as important as the individual income tax. While inflation clearly does reduce the purchasing power of your earnings and fixed-income asset values, it also redistributes purchasing power from businesses and households to the federal government. And in today’s economy, with inflation running at 5.4 percent, the inflation tax is no small matter. The amount the government will collect from the inflation tax in 2021 exceeds $1.9 trillion.
Most people understand that inflation can redistribute income and wealth. For example, many probably are aware that unanticipated inflation benefits borrowers at the expense of creditors. When inflation is higher than expected, borrowers repay debt with future dollars that have less purchasing power.
The inflationary impact on the wealth of borrowers and lenders depends on whether inflation is anticipated or unanticipated. When inflation is anticipated, creditors include a premium in the interest rate as compensation for the purchasing power lost to inflation. A well-functioning financial market without undue central bank intervention will tend to set nominal interest rates equal to the real interest rate creditors require to lend plus the expected inflation rate (the so-called Fisher Effect). Tax rates can also impact the size of the inflation premium, but to keep things simple I will ignore taxes.
Unanticipated inflation transfers wealth between debtors and creditors. If inflation is higher than expected, the inflation premium in rates is too small to recover the purchasing power lost to higher than expected inflation. When inflation is lower than expected, creditors gain at the expense of borrowers because the interest rate overcompensates for lost purchasing lower. The amount of wealth transferred by an unanticipated spike in inflation is approximately equal to the principal balance borrowed times the difference between expected and actual inflation rates. If inflation is 3.4-percent higher than expected, borrowers gain purchasing power equal to 3.4 percent of the principal balance at the expense of creditors….