Inflation tax

Most people know these two types of taxes - Direct taxes (Income tax, Corporate tax, capital gains tax, etc.) & Indirect taxes (GST, Customs duty, etc).

But people generally don't think of inflation as a tax. It actually is one and can be seen as a hidden tax.

First let's learn what inflation is and why it occurs.

We understand inflation as a general increase in prices. Actually it's not that. It's the devaluing of your money.

I mean if your money is devalued, of course prices will increase relative to it. But our understanding is backwards. Prices of cars, houses and other things don't increase when measured in gold or silver.

Historically money was issued in metal coins such as gold, silver and bronze.

The government then devalued your money, by demonetizing it and issuing fresh coins which were thinner, mixed with some alloy, or removing bits and pieces of your coin. So your money had the same denomination but had less of the precious metal in it.

But there is a limit to how much you can devalue it.

In the modern day, money is either paper money or digital money (numbers in a computer). This is also called fiat money. Because of this, there is no limit to how much fresh money can be issued by the government.

And the value of money is not governed by anything intrinsic like that of a precious metal. Its value is governed by supply and demand. The more money floating around, the less value it has. Every year the money in circulation is increased by the central banks of their respective countries.

The above image will give you some sense of the increase in the money supply. There are different types of money (M0, M1, etc.) which we will not go into.

Economists think that a slight inflation is good for the economy because as money loses its value people are forced to spend or invest it thus generating jobs, rather than keeping it at home.

So money losing its value over time is built into our modern monetary system. It's by design.

Now we will understand how it's a tax. As your money gets devalued, you're forced to invest it just to make up for the loss in value.

Let's say you invest in an FD and get a return of 7%. But inflation is 5% (assuming). So your effective return is only 2%. But you're taxed on total returns not the effective returns. This is an example of inflation tax.

This works not just in this but everything.

Your salary increases by a certain percentage every year. But most of that increase has an inflation component built into it. You end up falling into a higher tax bracket. Your tax burden increases even though your effective salary increase could have been minimal.

The Government of India in its latest budget removed the indexation benefits during property sale. So your property might have appreciated in good part because of inflation. But people who sell their property will not be able to adjust their purchase price to account for it and reduce their capital gains tax.

Inflation also reduces the real value of government debt. If a government borrows money, inflation decreases the real value of the debt over time, making it easier to repay. This is a form of subtle taxation, as it benefits the government at the expense of creditors and the general public, whose purchasing power is eroded.

So there you have it. Inflation tax demystified.

Please let me know me know in comments on what you think about this surreptitious form of taxation.