8. On Tax

On tax structure of the economy, inflation creates two distortions:

(i) Tax-payers suffer while paying their direct and indirect taxes. As indirect taxes are imposed ad valorem (on value), increased prices of goods make tax-payers to pay increased indirect taxes (like cenvat, vat, etc., in India).

Similarly, due to inflation, direct tax (income tax, interest tax, etc.) burden of the tax-payers also increases as tax-payer’s gross income moves to the upward slabs of official tax brackets (but the real value of money does not increase due to inflation; in fact, it falls). This problem is also known as bracket creep—i.e., inflation-induced tax increases.39 Some economies (as in the US and many European countries) have indexed their tax provisions to neutralise this distortion on the direct tax payers.

(ii) The extent to which tax collections of the government are concerned, inflation increases the nominal value of the gross tax revenue, while real value of the tax collection does not compare with the current pace of inflation as there is a lag (delay) in the tax collection in all economies.

But governments get an advantage on their interest burden, on their borrowings as inflation benefits borrowers. This benefit, however, depends upon the contemporary levels of fiscal deficit and the total national debt.

In the case of a government incurring high fiscal deficit (increased borrowing, printing currency), inflation functions as a tax, i.e., inflation tax via which the government fulfils its expenditure by cutting down the expenditure and consumption of the people.