Government profits from inflation
High and rising inflation is a very bad thing. For many people, prices are going to rise by more than their wage, leading to a lower standard of living. Savers will see the value of their savings decrease. Some businesses will not survive the increase in input costs. People on fixed incomes will be particularly vulnerable. Price signals will become less accurate, leading to mal-investment, business failures and lower productivity. Increased uncertainty will lead to lower investment and less long-term planning.
Australia hasn’t experienced sustained high inflation for almost 40 years, which may have lead some people to underestimate the risks that comes from irresponsible monetary policy. We are about to learn the hard way.
However there is one organisation that does well from inflation: government.
Unlike business, the government doesn’t have to worry about being efficient or profitable or the threat of shutting down. Unlike regular workers, the government can simply award itself pay rises to match (or exceed) inflation, as federal politicians just did for themselves this week. Unlike regular citizens, the government can simply shift their risk on to current and future taxpayers. For most politicians and bureaucrats, the problem of inflation is mostly a theoretical issue that happens to other people.
Indeed, the government actually benefits from inflation. Each year the revenue from income tax goes up by more than the increase in national income. That is because each year inflation pushes people into higher tax brackets, causing people to pay more tax even if their real (inflation-adjusted) income has not increased. This hidden tax increase is called “bracket creep” and it is embraced by both sides of politics as an effective way to subtly increase tax without having to tell the public. Higher inflation means higher bracket creep… which is terrible for ordinary taxpayers, but represents a revenue boon for the government, which is raking in billions of extra taxpayer funds thanks to the runaway inflation.
The government also benefits from seeing their debt devalued in real terms. Government debt is high and getting higher, and there is no sign that politicians plan on returning to fiscal responsibility any time soon. A simple (but terrible) solution to their debt problems is to inflate the currency and repay debts in devalued dollars, which amounts to a partial default without having to admit they are defaulting.
While small business and ordinary people suffer under high inflation, the government is able to avoid most of the costs while secretly increasing taxes and avoiding responsibility for their irresponsible borrowing. They can’t be trusted. To align the incentives properly, the government should:
index income tax brackets to inflation and put an end to the bracket creep rort;
index government worker pay to the 2% inflation target midpoint rather than actual inflation, so that they share the pain of inflation and have a strong incentive to support responsible monetary policy; and
index government department budgets to the 2% inflation target midpoint rather than actual inflation, for the same reason as above.
By making sure that the government shares in the pain of inflation, less of the pain will fall on ordinary families, and the government will be more motivated to fix the inflation problem that they helped create in the first place.