The Inflation Tax Explained (Teshome Abebe)

By Teshome Abebe

An ‘Aide-Memoire’

As businesspersons, consumers and policymakers, it’s crucial to understand that inflation acts as a hidden tax on consumers. This Inflation Tax effectively reduces the purchasing power of money (income), and one of the most common ways to quantify it is by relating it to the change in the Consumer Price Index (CPI). The simplest and most direct approximation of that is: 

 Inflation  Tax= Gamma/( 1 + Gamma )

where = the annual CPI inflation; CPI = the Consumer Price Index. 

This provides a clear mathematical representation of how inflation taxes real purchasing power.

The expression represents the annual CPI inflation, which measures the general increase in consumer prices. This simple formula divides this change by (1 + ), showing that the inflation tax isn’t just a linear increase; it’s actually tempered by the growth in prices already factored in. Here is why:

Nominal Income vs. Real Income: The nominal income of consumers may rise as inflation increases, but real income, adjusted for inflation, does not keep pace if the CPI is increasing. The inflation tax is the portion of consumers’ purchasing power that gets eroded due to price rises.

Consumer Behavior: If inflation causes prices to rise, say, by 10%, = 0.10, consumers’ real income is reduced by a fraction determined by the formula. And in this case: 

Inflation Tax = (0.10) / (1 + 0.10) = 9.09%.

This means that even though inflation is 10%, the real effect on consumer’s purchasing power is just below that, at 9.09%. The intuition here is that consumers are not losing a full 10% of purchasing power because their nominal income (if it grows) absorbs some of the inflationary shock.

Example in Emerging Economies:

Inflation often has a greater impact on consumers in emerging economies where monetary systems can be less stable. Consider a country like Argentina or even Ethiopia, which has seen high inflation rates in recent years. Assume inflation in one year is 25% ( = 0.25). Applying the simple but elegant formula in (1) above:

Inflation Tax = / (1 + ) = 0.25 / (1 + 0.25) = 20%.

Even though inflation is 25% in the example, the actual loss in purchasing power from an inflationary tax perspective is 20%. This shows that the full brunt of inflation is somewhat mitigated by wage increases or adjustments in nominal income. However, in emerging economies, wages often fall to rise fast enough to offset inflation, meaning real purchasing power falls sharply, with poorer consumers bearing the brunt of this tax. Assuming we take the government’s figure of 39% inflation rate in Ethiopia, the above exercise yields a 28% inflation tax for Ethiopians over the past year (my own calculation is of inflation nearly at 70%–a 41% inflation tax).

What is the impact of the Inflation Tax on Gross Domestic Product (GDP)?

Inflation also affects the growth rate of GDP, especially in emerging economies where high inflation can be a severe drag on economic performance. Here is why:

Consumer Demand Falls: As inflation taxes purchasing power, consumers in emerging economies spend less. With 20% of their purchasing power eroded, they cut back on non-essential goods, reducing demand in the economy. Lower demand leads to slower growth or contraction in GDP.

Investment Decreases: Inflation creates uncertainty. In emerging economies, businesses become less willing to invest when they cannot predict future price levels. The inflation tax reduces their real returns on investment, further stalling economic growth.

Currency Depreciation: In many emerging markets, inflation erodes the value of the local currency. This forces central banks to hike interest rates to defend the currency, further reducing economic growth as borrowing costs rise.

A Real Case Study: Zimbabwe

Zimbabwe in the late 2000s experienced one of the most extreme cases of inflation, where inflation reached 89.7 sextillion percent per month. In this scenario, the inflation tax was catastrophic, virtually wiping out consumers’ purchasing power. Although hyperinflation is an extreme example, it illustrates the dangers of inflation tax in emerging markets. Even at a more moderate inflation rate, the inflation tax has significant consequences on economic stability.

The inflation tax represented in this short explanatory commentary is a powerful tool to assess the real loss in purchasing power due to inflation. The impact is especially pronounced in emerging economies, where inflation not only erodes consumers’ purchasing power but also stifles economic growth, hampers investment and leads to currency instability. Policymakers in these economies must be acutely aware of the inflation tax and its broader implications on the economy. Managing inflation through sound fiscal and monetary policies is essential to prevent it from becoming a destructive force to growth and development.

Teshome Abebe, Ph.D. is a former Provost and Professor of Economics

Editor’s note : Views in the article do not necessarily reflect the views of borkena.com

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