The Inflation Tax


 

With 10% inflation, the average family can expect to lose 7% of its lifetime income to government.

This is the startling conclusion of a first-ever study by Laurance Kotlikoff and Alan Auerbach and their colleagues. The sources of the loss: (1) large parts of the tax code are not inflation indexed, (2) those parts that are indexed are indexed with a lag, and (3) Social Security benefits and other entitlements are also indexed with a lag.

Our fiscal system is so incredibly complex that it has been impossible to measure the overall effects of inflation before now. Given the 20 largest federal/state entitlements, all administered differently by 50 states, that gives us 1,000 fiscal systems– to say nothing of all the different tax regimes.

Hats off to the economists who spent several years developing the model that could give us a reliable answer.

Most people dislike inflation for obvious reasons. If the prices of the things you buy are rising faster than your income, you are clearly worse off. But even if your income is keeping up, most people tend to think they deserve their pay raises, but don’t deserve the higher prices.

There is another aspect of inflation that people tend to overlook. When there is inflation, the government gains and most people lose a result.

Why the Government Gains from Inflation and You Don’t

One reason government gains is that large sections of our fiscal system are not indexed—that is, they do not adjust for inflation. The tax on Social Security benefits is one example. When this tax was first adopted in 1983, it hit only 10 percent of seniors. But because the income thresholds for the tax are not indexed, more than half of all seniors are paying the tax today. Every time the inflation rate ticks up, more beneficiaries pay more taxes to the government.

Capital income is another example. Interest payments on bonds, dividends on shares of stock and capital gains on any asset are all taxed on inflationary gains, even if there has been no increase in real income.

When Joe Biden says the rich aren’t paying their fair share of taxes, he can take partial credit for making them pay more. Above $200,000 of income, wage earners are subject to a 0.9% additional Medicare tax. But since that amount is not indexed, inflation under the Biden administration has made more people and more income subject to it. Similarly, higher-income enrollees are paying higher Medicare premiums because inflation has made them subject to income-related rates.

Even Inflation “Protection” Is Much Less than We Think

Even those parts of our fiscal system that are indexed for inflation don’t offer people the protection they might think they have.

Take Social Security benefits. As is well known, benefits are increased each year, through a cost-of-living adjustment (COLA) that is supposed to protect people against an inflationary reduction in their standard of living. But these adjustments are made with a lag.

The Social Security administration calculates the COLA adjustment by comparing prices from October to the previous October. Then, the adjustment in benefit levels is not made until the following January. This creates a fifteen-month lag.

Suppose a beneficiary is receiving a monthly Social Security check of $3,000 and suppose the annual rate of inflation is 10 percent. Each month, this person is losing $300 to inflation. A fifteen-month lag in the COLA adjustment means this individual has lost $4,500. If the inflation continues, this “inflation tax” also continues – every year.

Inflation in this case helps the government because it pays less than it was supposed to pay and beneficiaries receive less than they should have received.

The income brackets in the federal income tax code are also supposed to be indexed. Here, the adjustment process is a bit more complicated. But roughly speaking, there is about a 12-month lag in making the adjustment.

Suppose that a household’s tax liability is otherwise $10,000 and suppose that liability rises by 10 percent because of 10 percent inflation. A 12-month lag in inflation indexing means that the household will pay (and the government will receive) $1,200 more than should have been paid – all because of inflation.

Inflation also affects taxable business income. Instead of expensing an investment at the time it occurs, firms are generally required to depreciate the expense over time. But when inflation reduces the real value of those tax-deductible amounts, real after-tax profits will be lower. That hurts shareholders and workers in the process.

Virtually all entitlement programs base eligibility on income in one way or another. Suppose a family’s income from the government rises with the rate of inflation, but the criteria for eligibility are adjusted with a lag. In that case, a family that would otherwise be eligible for benefits might find itself perpetually ineligible because of inflation alone.

The System Is Enormously Complicated

Our fiscal system is enormously complicated. In addition to federal taxes, each state has its own state and local taxes, along with such state-run programs as Medicaid and Food Stamps. Since the 20 largest entitlement programs can be administered differently by 50 different states, there are in principle 1,000 different entitlement spending programs.

Estimating how nationwide inflation affects people living under all these different systems would seem to be a complex impossibility. Yet this herculean task has been tackled by Boston University economics professor Laurence Kotlikoff and his colleagues in a multi-year study.

To simulate the effects of inflation, the authors assume that we begin with zero inflation and increase the rate to 5 or 10 percent. The higher inflation rate affects all wages and prices evenly and persists indefinitely for all future years.

How Inflation Shifts More Money to the Government

The authors find that a permanent increase in inflation from zero to 5 percent reduces the average household’s lifetime resources by 3.62 percent. An increase to 10 percent permanent inflation reduces lifetime resources by 6.82 percent.

Note that, in these simulations, the country’s real income doesn’t change. A 10 percent inflation rate is a way of imposing a tax of almost 7 percent on the real wealth of the average family and transferring that amount to government.

These numbers are averages. For some households (especially higher income households), the inflation tax can be much worse. Take a simulated Delaware couple, in their fifties, both working and earning a combined income of $190,000. With 10 percent inflation, the present value of the couple’s lifetime loss from Social Security is $142,000. Their loss from income and other taxes is almost $170,000. In this case, inflation imposes a 17 percent lifetime tax on the couple’s wealth.

In the worst cases, the authors find that California households with large capital gains can face a lifetime inflation tax of over 50 percent!

This last example illustrates one more effect of inflation. It gives people strong incentives to relocate to lower-taxing states. One answer to these problems is instantaneous indexing – both in private contracts and in public programs. That is inflation adjustment with no lags. Another option is to avoid inflation in the first place.

Milton Friedman once said that persistent inflation is always and everywhere a monetary phenomenon. Since government controls the money supply, responsibility for controlling inflation begins and ends with government itself.


 

See John Goodman’s original explanation of the study at Forbes.

 

 

 

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