Wednesday, April 27, 2011

Who Cares About Inflation?

Copyright, The New York Times Company

Normally, inflation is one of the most harmful taxes, but these days inflation may do less harm than good.

During most of our lifetimes, the prices of things we buy have generally increased over time. We can name some exceptions, but most items (even houses) have prices that are higher now than they were 10, 20 or 30 years ago. This general increase in consumer prices is called inflation.

The Federal Reserve is charged with limiting the rate of inflation, which it can do over the long run by limiting the supply of money and similar assets in the hands of the public.

Inflation is widely disliked. A number of economists think that inflation’s bad reputation is undeserved, and that, while people complain that inflation makes things more expensive, they fail to recognize that inflation also raises their wages.

The net result of inflation could be to increase wages and prices in the same proportion, without harming consumer’s purchasing power.

A person on a fixed income, such as a pensioner receiving a specific number of dollars a month – a so-called “defined benefit” pension – does have less purchasing power when prices rise. However, Social Security benefits automatically increase with wages in the economy, and thereby automatically increase with inflation in the long run.

And these days defined-benefit pensions are less common than they used to be (and even many defined-benefit pensions were adjusted for inflation on an ad-hoc basis).

We also have to remember that for everyone receiving a payment specified in dollars, there’s someone else making those payments. For example, a worker with a fixed mortgage payment sees that payment decline as a share of his income as inflation pushes up his wages. For this reason, inflation is said to favor debtors and harm creditors.

The government is a major debtor, and some people suggest that sudden inflation would relieve the government’s debt burden and permit the government to spend more (prolonged inflation would just require the government to pay higher interest rates on its debt).

More government spending is bad news for those who want the government to spend less, and good news for those who want the government to spend more. In any case, my research suggests that inflation is not associated with more government spending.

Even if our government had no debt, inflation would increase tax revenue. Ronald Reagan famously complained about “bracket creep”: the personal income tax was not automatically indexed to inflation, so taxpayers moved into higher tax brackets as inflation raised their incomes, even though the extra income was barely enough to keep up with rising prices.

Much of the personal income tax is now indexed to inflation. But interest and capital gains are not indexed (neither are some provisions of the corporate income-tax code), so inflation increases the tax burden on saving and investment.

Consider, for example, a zero-inflation economy in which homes and business normally sell for what the seller paid when he originally purchased the property. According to our tax laws, those sellers would owe no capital gains tax.

In a 10 percent-inflation-rate economy, assets would appreciate in dollar terms at about 10 percent a year, even though their inflation-adjusted values were constant. When the assets were sold, their accumulated value, including that annual 10 percent gain, would be taxed.

With saving being less profitable thanks to inflation’s back-door income tax hike, people will save and invest less. Inflation’s harm to capital accumulation reduces productivity, and ultimately the inflation-adjusted wages workers receive. Martin Feldstein of Harvard has stressed that America’s capital accumulation was the major loser from 1970s inflation.

Without offsetting Congressional action to revise the tax laws, inflation today would increase the tax burden on capital, and that by itself would reduce investment. But what’s different today from the 1970s is how mortgage debtor troubles – foreclosures of underwater mortgages and the harmful economic activity surrounding them – have reduced gross domestic product and living standards.

At this point, an inflation that harmed banks and helped homeowners might be an overall improvement.

1 comment:

GeneHayward said...

This is an excellent explanation of inflation and I will use it in my Advanced Placement Macroeconomics class as a resource. I visit your site often and find very useful examples to use with my classes. Nice work!!