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Inflation as taxation

Monday, May 25th, 2015

ETM Feature Article: Quarter 1 2015

“‘No taxation without representation” was the rallying cry of the American Revolution, but nowhere has “no inflation without representation” inspired the same excitement. Despite both decreasing salaries, inflation is in the public mind rarely associated with taxation. This article gauges the burden of inflation on salary earners and explores the similarities between taxation and inflation.

Before diving into the intricacies of inflation – or the silent tax, which you will never see on a payslip – an initial estimation of its burden is in order. Measured against the Consumer Price Index (CPI), the most common yardstick for inflation, the real value of your last salary in 2014 was 5,3% less than 2014’s first salary. Taken together, your twelve monthly salaries decreased by 4,1% over the course of 2014. Put differently, in 2014, just according to the CPI, you were ‘taxed’ an additional 4,1%, over and above what the South African Revenue Service (SARS) took.

Defining and measuring inflation

Inflation is sometimes defined as “a general increase in prices and fall in the purchasing power of money.” For central banks, government statistic bureaus and most companies, employees, unions, investors and fund managers inflation is usually synonymous with the annual rate of increase of the CPI. Before highlighting why there are better ways of defining inflation, let us examine the CPI more closely.

Stats SA’s CPI can be most accurately described as a macroeconomic aggregate measuring the cost of living of the wealthiest 20% of households. It reflects predominantly the weighted average of prices of goods and services acquired by the highest income earners. Through time the index is reweighted away from items consumers purchase less (usually because their prices have risen particularly high) toward items they buy more because they can afford to.

As a result of the way in which it is measured, CPI can be seen as a narrowly defined ”cost-of-consuming” index. CPI does unfortunately have shortcomings and although it is an index that tracks the general loss of monetary purchasing power – debasement – it is very narrow in scope. This is due to the fact that it measures only consumer prices and disregards asset prices, productive input prices, raw commodities, and foreign currency exchange rates.

Technically, CPI understates consumer price inflation for at least two reasons.

  1. Current methodology does not account for ‘stealthflation’. Stealthflation is hidden inflation due to reduced product quality that hides nominal price inflation. Stealthflation is a certainty in inflationary times as companies protect margins while keeping their customers believing prices aren’t rising.
  2. CPI basket weightings are determined according to the Household Expenditure Survey conducted every few years. The more households spend on an item, the greater the weighting that item is assigned in the CPI. If spending on an item falls due to a rising price, its impact will be understated in the CPI. This methodology by definition also ignores prices of those goods consumers would like to buy, but cannot afford to buy, yet are arguably no less important to consumers’ value judgements. Less of a particular item might be bought, due to the declining purchasing power of consumers’ money. That they’re forced to switch to more affordable items with lower price increases allows them to survive. It contains their cost of living, but their quality of living deteriorates because their money’s purchasing power is dwindling. The measurement is skewed away from lower income households and adds to the underreporting of CPI in this regard.

Lower income households tend to spend a greater proportion of their income on staples and necessities which renders them less mobile in their purchasing patterns. A democratic weighting across households as well as goods and services tends to raise measured CPI increases.

bulk of sub-incides above overall CPI in feb

Since investment returns, earnings, wages, interest rates and the purchasing power of the rand are measured against CPI, its design as a measure of fair and true annual increases in general price levels as well as a measure of purchasing power, is thus flawed.

A more appropriate conception of inflation

The reason CPI does not accurately capture inflation, is because it is simply only one of inflation’s consequences. Fully explaining why this is the case is a topic for another day, but properly understood inflation should be regarded as a change in the money supply in an economy. Inflation is when everybody who holds money loses some of the value of that money because someone else creates new money. Extreme cases of this proper understanding of inflation include the work of counterfeiters, but it also includes the less obvious, but more prevalent cases such as when central banks digitally create new money to buy government bonds.

Understanding the deeper origins of inflation is important not only to compensate for the measurement shortfalls in mainstream inflation measures, but also because of the destabilising effects of inflation on the broader economy and society.

Consequences of inflationary taxation

Simply put, increasing the amount of money in an economy, or adding zeros to bank notes ultimately does not make a society more prosperous. It is a process that does not improve an economy’s ability to be more productive or produce more goods and services.

Increasing money supply in an economy does however result in an uneven distribution of “new money” within an economic society. This plays out as certain parts of the economy become “wealthier” relative to others, benefiting from fresh money creation. As the act of increasing money supply does not facilitate an underlying improvement in economic productivity, the newly created “wealth effect” will result in a redistribution or transfer of wealth to those in a position to benefit from the newly created money first, from the rest of the economy. This happens as more money chases fewer goods within the economy, creating a win-lose situation and one where the loser is effectively taxed by an act of the government for the sake of the winner.[1]

Although the redistribution of wealth eventually trickles down through the broader economic system, it is the late-receivers of the “new money” who are taxed to support early-receivers. This happens as increases in general price levels are pushed higher before their salaries or earnings are adjusted higher accordingly. It is at this point that a true measure of inflation, as highlighted earlier, becomes critical given the potential longer-term negative effects of benchmarking against an unrealistic and understated measurement of purchasing power.

Households save, attempt to save, or would like to save a portion of their salaries for an emergency subsistence or retirement fund, or simply because they want to postpone consumption until later. Historical data for South Africa shows that asset prices have risen much faster than the CPI. Specifically, since 1995 asset prices have risen nearly three times more than the CPI. Someone who does not own any assets, and whose salary is benchmarked to CPI only year after year would find it increasingly difficult to ever accumulate any assets.

CPI vs broader price inflation

The government is one of the earliest receivers of “new money” creation and a primary beneficiary of inflation. Through inflation (an expansion of money supply) a government or central bank can in effect devalue its currency, raise general price levels in an economy, aiding borrowers while punishing savers. Governments throughout the world operate on deficit spending, and inflation provides a quick-fix solution to reconcile ballooning accounts. In fact, debt and money printing are very closely aligned, with numerous examples and their effects playing out at present in economies such as Japan, the US, and the EU. While the ultimate consequences of the massive money printing schemes currently underway in these countries and regions may take some time to unravel, recent history is littered with examples of the destructive forces of money creation and the resultant inflationary episodes on the broader society (Germany in the 1920s, Zimbabwe in the late 1990s to mid-2000s and more recently Venezuela).

Conclusion

Inflation makes people poorer, just like taxation does; and it comes with severe, negative side-effects.

Governments are the main beneficiaries of inflation and its taxation effects on society. Inflation ultimately drains economic resources, and redirects these resources to less productive uses. It has the potential to extend an economically destructive business cycle, as price signals in an economy are distorted, leading to a misallocation of capital. The beauty and danger of inflation is that unlike taxes, it does not require the enforcement of specific legislation, it does not require a collection agency and does not “inconvenience” the general public with paperwork. It simply and stealthily transfers wealth to the first beneficiaries of the “new money”. Ultimately, unnatural money supply growth (inflation) leads to inefficient allocation of capital, which increases the likelihood that unsuitable products and services will be produced, causing a lower standard of living than otherwise would have been the case.

Whereas tax constitutes a direct transfer of wealth from people to the government, inflation achieves the transfer indirectly and with other side-effects. In both cases, however, wealth leaves the public’s pocket and enters the government’s.

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