The benefit of inflation to governments

Inflation tax is worth about £30bn a year to the UK government

The key benefit of inflation is that it reduces the real value of government debt. It does this because tax revenues increase approximately in proportion to inflation. Government’s fixed debt payments therefore become a smaller part of the tax take and more affordable.

The benefits to the UK government of inflation tax depend on the inflation rate and is currently around £29bn in 2014. Inflation at this time is lower than it has been and so the value of inflation tax is less than a few years ago despite the rising value of government debt. Cumulatively over the last five years, inflation tax has theoretically been worth an estimated £182bn to the UK government.

Inflation tax

Sources: Debt Management Office and ONS.

To calculate inflation tax, you multiply the total government debt excluding index-linked bonds (but including NS&I) by the inflation rate.

I say “theoretically” as this calculation omits one key thing. The Bank of England now owns £375bn of government debt acquired through the Quantitative Easing programme, and it pays the interest it receives back to the Treasury. Therefore the net inflation tax benefit to the government is not as high as these numbers might imply, but nevertheless it is still over £20bn per year currently. Furthermore, we have to assume that at some point fairly soon the Bank will return that debt to the private sector.

Moreover, government debt is projected to keep growing in the UK —increasing by £170bn in the next two years (2015 and 2016) alone according to the Office of Budget Responsibility, and the actual numbers could well turn out much higher. Therefore, if inflation persists at the same level, inflation tax receipts will increase further.

Other benefits of inflation to governments

Inflation benefits for government

In addition to debt relief, governments experience a number of other benefits from inflation. Note that in the current abnormal time of below-inflation interest rates and salary rises, some of these effects are temporarily negated. The normal benefits are:

  1. Increased personal tax revenue: Personal tax revenues and national insurance contributions increase as wages increase. They do so because governments rarely index higher tax thresholds in line with inflation – a concept called “fiscal drag”. This means inflation pushes more people into higher rate tax brackets and the government benefits from increased tax revenues accordingly. According to government statistics, the number of higher rate taxpayers in the UK more than doubled from 1.7 million to 4.1 million over the last 20 years.However, balanced against this trend is the fact that UK employers have been awarding pay rises below inflation over the last few years. Coming to an exact calculation of the extra tax benefit of this in the current economic climate is therefore more difficult than it is when wages keep up with inflation.
  1. Increased revenue from business taxation: As a general rule, provided inflation is fairly low and does not change too quickly, business profits increase in line with inflation in the economy. This is very useful for governments as it means corporation tax revenue also increases. The effect is enhanced further because the government tends not to increase tax threshold levels for corporations.For example, since 2006 the threshold for the lower level of corporation tax in the UK has remained at £300,000 and the higher one at £1.5 million. Therefore, any rise in profits which companies have made since then will have directly translated to increased tax revenue. Even assuming just 3 per cent (RPI) inflation going forward, the UK government gains extra corporation tax revenue of over £1 billion cumulatively each year.
  1. Extra revenue from saving account interest taxation: In “normal times”, interest rates on savings accounts are higher than the base level of inflation. For example, in the decade prior to 2010, the top savings rate in the UK averaged 5.6 per cent**, while the mean annual inflation rate was just 2.7 per cent. So, assuming basic rate tax was paid on all savings during that period at that rate, tax revenue would have been 5.6 per cent x 20 per cent tax – i.e. 1.12 per cent of all UK savings. Had there been near-zero inflation during that time, and assuming a similar premium for savings accounts (i.e. 5.6% – 2.7% = 2.9%), tax might have been just 2.9 per cent x 20 per cent tax – i.e. 0.58%. Therefore, inflation effectively doubled the government’s revenue from savings account interest over that decade.We currently live in a world of financial repression, where governments are artificially manipulating savings interest rates to be lower than the rate of inflation. In this climate, this extra revenue effect actually goes into reverse and governments make less tax revenue this way – an unfortunate by-product of the low interest rate policy. However, this is more than balanced by lower debt repayments because of the near-zero rates.
  1. Relatively lower public expenditure: A reduction in public expenditure is achieved by creating an official inflation measure that underestimates true inflation. In the UK the CPI index probably underestimates it by around 1-1.5 per cent.  The government then uses the official (lower) measure to pay increases in pensions and benefits whilst seeing revenues from taxation rise in line with the true inflation rate.
  2. Making GDP appear higher: Governments are judged in part on how successful they are in growing the economy, i.e. GDP growth. Before this is calculated, the raw GDP figure is adjusted for inflation***. This adjustment is summarised by the GDP deflator.The deflator should approximate to the true inflation rate in the country. However the key consumer prices element of GDP in the UK was switched recently to being adjusted not by RPI but by CPI, which produces lower estimates of inflation. Accordingly, UK GDP is now being overestimated by about 1 per cent per year.

    If that were not bad enough, the process by which prices for government services in the UK are adjusted for inflation is effectively a black box, not open to scrutiny. It also normally involves hedonic adjustments and is not based on real price changes. The net effect is that there is now a very wide disparity between the GDP deflator and true inflation rates in the UK. A comparison of the deflator versus the slightly more accurate RPI inflation rate in the UK in the last three years shows an average difference of 2.1 per cent****. This has massively enhanced apparent GDP growth in the UK. Similar enhancements can be seen in most countries around the world.

 

* For example, in 2003/04 the higher rate tax threshold was £30,500. In 2013/14, it is set to be £32,011 i.e. just a 5% increase, while inflation rose by 38% over that ten year period.
** Source: Author’s calculations in Comley, P., 2012, “Monkey with a Pin: Why You May Be Missing 6% a Year From Your Investment Returns”, Self-published. 
*** The adjustment occurs at the individual level of each aspect going into GDP. The overall effect can then be calculated by looking at the difference between the total GDP figure in pounds and the adjusted one where each aspect has inflation taken out of it. The government does this division and publishes it as the GDP deflator.
**** The respective figures for RPI/deflator for the last three years were: 2011- 4.6%/3.1%, 2012- 5.2%/2.3%, 2013- 3.0%/1.7%. The data sources were: ONS and the June 2014 National Accounts version updated in September 2014.

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