David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 22 Inflation, expectations and credibility
Taxes
Tax rates may not be fully inflation-adjusted. One problem is fiscal drag.
Fiscal drag is the rise in real
tax revenue when inflation
raises nominal incomes,
pushing people into higher
tax brackets in a progressive
income tax system.
Suppose income below £4000 is untaxed but you pay income tax at 25 per cent on
all income over that amount. Initially, you earn £5000 and pay income tax of £250.
After ten years of inflation, all wages and prices double but tax brackets and tax rates
remain as before. You now earn £10 000. Paying tax at 25 per cent on the £6000 by
which your nominal income exceeds £4000, you pay nominal tax of £1500. Wages and
prices only doubled, but your nominal tax payment rose from £250 to £1500. Fiscal
drag raised the real tax burden. The government gained from inflation. You lost.
For an inflation-neutral tax system, nominal tax brackets must rise with inflation.
The real tax exemption is constant if the nominal limit rises from £4000 to £8000. Everything is then
inflation-adjusted. You would pay £500 in tax - double what you paid before.
Percentage taxes on value, such as VAT, automatically raise nominal tax revenue in line with the price level.
However, specific duties, such as £5 on a bottle of whisky, must be raised as the price level rises. In the UK
there is no automatic formula for raising such duties. Each year the government decides.
Taxing capital
Income tax on interest income is also affected by inflation. Suppose there is no inflation. Nominal and real
interest rates are both 4 per cent. With a 40 per cent tax rate, the after-tax real return on lending is 2.6 per cent.
Now suppose inflation is 11 per cent and nominal interest rates are 15 per cent to keep a pre-tax real
interest rate of 4 per cent. Suppose lenders must pay income tax on nominal interest income. The after-tax
nominal interest rate is 9 per cent (0.6 x 15). Subtracting 11 per cent inflation, the after-tax real interest rate
is -2 per cent. This compares with +2.6 per cent when inflation was zero.
Inflation accounting
uses fully inflation-adjusted
definitions of costs, income
and profit.
When inflation was 11 per cent, nominal interest rates were 15 per cent. Eleven
per cent of this was not real income, merely a payment to keep up with inflation.
Only 4 per cent was the real interest rate providing real income. But income tax
applied to all 15 per cent. Higher inflation reduced the real return on lending
because the tax system was not properly inflation-adjusted, that is, it did not use
inflation accounting. The government gained more real tax revenue. You lost.
Capital gains tax is another example. Suppose people pay tax of 40 per cent on any capital gain made when
asset prices rise. When inflation is zero, only real gains are taxed. When inflation is 10 per cent, nominal
asset prices rise merely to preserve their real value. People pay capital gains tax even though they are not
making real capital gains.
Institutional imperfections help explain why inflation has real effects even when inflation is fully anticipated.
These effects can be large. Usually, the government is the winner.
Unexpected inflation
Previously, we assumed that inflation was fully anticipated. What if inflation is a surprise?
Redistribution
When prices rise unexpectedly, people with nominal assets lose and people with nominal liabilities gain.
Nominal contracts to buy and sell, or lend and borrow, can reflect expected inflation, but cannot reflect
surprise inflation.
Expecting inflation of 10 per cent, you lend £100 for a year at 12 per cent, expecting a real interest rate of
2 per cent. Unexpectedly, inflation is 20 per cent. The real interest rate on your loan is [ 12 - 20] = -8 per cent.
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