The “Infinite Tax” of Inflation

Some people argue that inflation causes high tax rates. In the obvious – and obviously correct – sense that taxes are progressive, resulting in bracket creep. But also in the more insidious sense that asset appreciation through inflation creates a nominal tax burden that must be paid out of a base of no real income. This is a point forwarded by the Tax Foundation, prominent economists, and just about every entry on the search entry “capital gains tax inflation”. These arguments all describe how inflation substantially increased the real tax burden between 1955 and 1990. Unfortunately, none of it is as straightforward as the writers make it out to be.

Let’s make a few assumptions. At the margin all taxes are proportional to value, that is no lump-sum levies. Assume there is no bracket creep, and that marginal government spending is restricted to transfer payments. The role of taxes in this world is, then, limited to assigning the distribution of income among various groups. The argument, then, is tantamount to claiming that the “inflation tax” perverts the tax system to skew post-tax income away from capitalists towards everyone else.

When you think of it this way, inflation doesn’t matter. If I own a security that appreciates $10 through inflation, generating a tax burden of $2 the natural reaction might be that the government is creating a real tax burden out of no nominal income. An “infinite” tax rate. Except inflation affects all future cash flows, including income from labor, which also increases in the state with inflation. If inflation affects most assets evenly over the long-run, not charging a tax on nominal gains would increase the relative distribution of income accruing to capital owners, necessarily at the expense of everyone else.

Another way to think of it is that the government has real liabilities – workers, indexed transfer payments, and material costs will all eventually rise with inflation – and to finance the larger nominal outlay it must also receive a larger nominal income from each group. To the extent taxes are levied as a percent of income this does not change the final distribution between capitalist and worker.

The truth of this simple claim can be noticed by taking the infinite tax argument to its logical conclusion. Suppose we have really high inflation for a while and taxed only real gains – out of concern for the Tax Foundation. If the stock of capital increased from $1 to $10, without any real gains, the capitalist faces no tax burden. Except everyone else – rentiers, workers, lenders – does face the nominal burden, and pay more in taxes. This naturally results in a capital subsidy.

One might argue that really we should tax only real gains on both capital and labor. This, of course, isn’t the argument that everyone cited above is making as they restrict the argument to an “infinite tax on capital” and believe there is something special about the nominal appreciation that makes capital different. Also note this would mean there was an “infinite tax” on labor, making the claim that there is some net inflation tax (i.e. change in distribution due to inflation) very likely false. More importantly – supposing the relative distance of various brackets were indexed – indexing real income on capital and labor is a really challenging strategy.

For one there’s a lot of error in these measurements, creating a political bias to understate inflation figures to juice tax revenue. It also assumes there is some measurable, true inflation ignoring the complex heterogeneity of various liability structures. Of course, ultimately, if we did figure out how to get around these problems and taxed everyone on t – 10 dollar values, the net distribution would change none at all since all income would be modulated by the same factor.

In reality, of course, some of the assumptions that led to this conclusion aren’t true. Inflation doesn’t affect everyone uniformly – at least not over any fixed period of time – and each individual has different preference for changing prices since the goods market may react more sensitively in one industry than the other, hurting some people more.

It might be worthwhile to study these assumptions, and figure out cases where higher inflation changes the distribution away from capitalists purely through the nominal tax rate. But the sort of work you saw from the Tax Foundation, apparently detailed, wonky, and evidence-oriented is misleading. It is either tautologically true saying absolutely nothing (inflation means bigger numbers) to certainly false (that inflation changes the net distribution without further assumption).

This isn’t particularly tricky to see, and is simply a consequence of efficient markets. If present value is the weighted sum of future cash flows, it makes no sense to argue that inflation affects the two sides of the equality any differently.