Inflation: The Hidden Tax

Invisible hand taking savings
The Hidden Tax of Inflation

In the current political climate, proposing tax hikes in a campaign has become increasingly difficult due to strong resistance from the public. Consequently, governments face a conundrum: they must finance their spending, but traditional methods like raising taxes are no longer as feasible. Instead, they have resorted to more opaque methods, such as the printing of money. However, in economics, there is no free lunch. Instead, this seemingly effective solution manifests itself in the form of inflation, which diminishes the purchasing power of our money.

Inflation is often referred to as a 'hidden tax' because governments can effectively tax citizens through the gradual erosion of the value of our money and savings. In effect, inflation transfers citizens' purchasing power to the government to finance their spending. This hidden tax diminishes the real value of money (i.e. its purchasing power) while leaving the nominal amount (i.e. 1 dollar remains 1 dollar) unchanged. As a result, citizens may find the amount of money they have remains the same or even increases, but what that money can buy in terms of goods and services decreases dramatically.

The widespread adoption of money printing to finance government spending has entrenched inflation in the global economy, fueling a worldwide cost of living crisis. In the following sections, we'll explore the reasons behind this transformation of government spending, examine who bears the brunt of the inflation tax, and consider Bitcoin as a potential solution.

Facing Fiscal Challenges

The perpetual accumulation of debt has become a fact of life for governments around the world. Debt-to-GDP ratios, which measure a country's debt relative to their economic output, have reached levels well beyond 100% in most advanced countries, indicating that debt levels are growing at a faster rate than economic output on a global scale.

The state of global debt
Source: Visual Capitalist — Visualizing the State of Global Debt, by Country

The reason for this massive expansion in debt largely comes down to one thing — deficit financing. This is when a government spends more than it collects in revenues and must take on debt to cover the difference. The United States provides an exemplary example. The US government has not run a budget surplus (i.e. revenues exceed spending) since the year 2001, resulting in a debt-to-GDP ratio above 120%. In other words, every year for the past 23 years, the US government has run a budget deficit, where their spending exceeds their revenues, leading to an explosion in federal debt.

Federal debt FRED chart
Source: FRED Economic Data

To enable spending beyond their revenues, governments must borrow money by issuing debt. The debt is then purchased by various financial institutions and other countries, but most notably, it is purchased by the country's central bank, which prints money in order to buy the debt. This is referred to as Quantitative Easing (QE) which is just a fancy way to say money printing. In this way, governments effectively create new money when issuing and taking on debt, which is then circulated within the economy as a means of financing their spending. 

To quote economist Milton Friedman:

“Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

As governments resort to deficit financing to sustain their spending habits, the unchecked accumulation of debt places a heavy burden on future generations. This perpetuates a cycle of monetary expansion, leading to baseline inflation and the erosion of citizens' purchasing power to finance governments' unconstrained spending.

Increase Taxation

One strategy to make up for the difference between a government's spending and revenues is to raise taxes. Instead of printing money to cover the difference between its expenses and revenues, the government can raise taxes, increasing its tax base and subsequently its total revenue. If government revenue exceeds spending, it runs a budget surplus and could use that extra money to pay off and chip away at the debt over time. However, as discussed previously, raising taxes has become politically unpopular, as few people want to vote for someone who will take more money from their pockets. 

Fiscal Austerity

Instead of raising revenues through increased taxation, governments could instead decrease their level of spending to bring the budget back into balance. This would involve cutting expenditures on certain programs or areas, thereby reducing total spending and possibly running a budget surplus to help alleviate the debt burden. However, this strategy is not without major challenges. Determining which areas are less necessary or where spending can be reduced is a complex process. It is likely to face pushback from the public, especially amid high political polarization.

The challenges associated with increased taxation or fiscal austerity have paralyzed governments from taking remedial action toward federal debt levels. Instead, they have opted to kick the can down the road — neither raising taxes nor decreasing spending, allowing debt to reach dangerously high levels. 

What Is An Inflation Tax and Who Pays It?

Understanding the intricacies of inflation reveals its interconnected relationship with debt in economic systems. Debt accumulation catalyzes inflation, creating what people call the "inflation tax." This phenomenon results from governments indirectly taxing their citizens by inflating the currency through money printing. This opaque method of financing government expenditures earns inflation its name as a "hidden tax." While it may appear that governments are funding their activities without consequence, they are imposing a tax on citizens by eroding the purchasing power of their money. 

It's important to note that the inflation tax operates alongside conventional taxes on labor, property, and goods, further burdening individuals by reducing the value of their savings without their permission. The damaging nature of the inflation tax lies in its opacity and lack of consent. In contrast to explicit taxes, inflation operates without public awareness or permission, exacerbating its damaging effects. Clarity and transparency in taxation would provide citizens with a much better understanding of government spending and how our taxes are utilized, a far cry better than inflationary taxation which provides citizens with no accountability or transparency.

The Cantillon Effect

A significant result of inflation has been a rise in wealth inequality over the past few decades. While wealth inequality has existed to varying degrees throughout history, we have reached an inflection point, where the printing of money and the subsequent inflation are driving a massive wedge between the haves and the have-nots.

The Cantillon effect, coined by 18th-century economist Richard Cantillon, describes the uneven effect of monetary expansion (i.e. money printing). When new money enters the economy, it has disproportionate effects and serves to create “winners” and “losers” in the economy. Those closest to the money printer typically benefit the most since they get to utilize the new money to acquire the goods, services, and assets they desire before prices increase too much. 

In acquiring these goods, services, and assets, they push the prices up and by the time money ripples outward towards those on the periphery of the financial system, prices have already risen drastically, leaving them with no benefit from the monetary expansion. In fact, the people of the periphery are worse off since the increase in prices has decreased the purchasing power of their income and savings, which are often fixed in value.

In our current monetary system, governments, financial institutions, and individuals with assets are those closest to the money printer, and everyday citizens stand on the periphery. If this effect holds, as the money supply continues to grow (much like it has the past few decades), we should see governments get bigger, economies become more financialized, and the highest net worth individuals become even more wealthy — all while everyday people struggle to keep up.

Consequently, all of these things have come true — governments are bigger than ever before, economies are increasingly financialized, and wealth inequality is reaching levels not seen since the Gilded Age. The chart below shows a direct correlation between monetary expansion (as measured by US M2) and the net worth of the top 0.1% of US citizens.

Cantillon Effect in a FRED chart
Source: Jonathan Newman

The Role of Bitcoin

In the midst of these economic challenges, Bitcoin emerges as a potential solution, offering an alternative to traditional monetary systems. Bitcoin operates outside the power of central authorities, immune to inflationary pressures from monetary expansion. Its finite supply of 21 million coins, governed by a predetermined algorithm, prevents the erosion of purchasing power through the “hidden” inflation tax that is inherent to fiat currencies. 

Additionally, Bitcoin offers a potential solution to wealth inequality and the Cantillon Effect. Its decentralized nature and fixed supply of 21 million coins counteract the unequal distribution of wealth perpetuated by traditional monetary systems. With fiat currency, the Cantillon Effect results in monetary expansion disproportionately benefitting the wealthy, leaving everyday citizens behind. 

In contrast, Bitcoin, with no central authority controlling its issuance, prevents privileged access to new money, ensuring a fairer distribution. By removing the monopoly power over money from governments, Bitcoin resists the concentration of power and prevents money printing, thereby addressing the root causes of wealth inequality and disrupting the long-standing Cantillon Effect.

Furthermore, by circumventing centralized control, Bitcoin mitigates the risk of excessive debt accumulation driven by deficit financing and the monopoly power governments have over money. Its transparent and immutable ledger fosters fiscal responsibility and accountability, reducing the likelihood of unsustainable debt levels on a federal level. Embracing Bitcoin could usher in a shift towards financial austerity, helping nations escape the cycle of perpetual debt accumulation and safeguarding future generations from the burden of excessive indebtedness.

For the time being, governments will continue to grapple with fiscal challenges and burgeoning debt, but for citizens seeking refuge from the effects of inflation, Bitcoin stands as a viable solution — a sanctuary where wealth preservation, financial autonomy, and economic empowerment converge. By holding Bitcoin, individuals can move past the constraints of traditional monetary systems, protect themselves from inflation, and work towards a more equitable and prosperous future absent the perpetual accumulation of debt.