What Is Inflation?

Inflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills.

Inflation is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power.

What Causes Inflation?

At the simplest level, inflation occurs when there is more money for the same amount of real goods and services, which forces an increase in prices.

The most straightforward way this can occur is when policymakers put more money into the economy, through either deficit-financed government spending or Federal Reserve action. Alternatively, inflation could occur because of a decline in output of real goods and services.

The last factor is how often a dollar is used to purchase goods and services in a given time period. If people keep less money waiting in the bank, that effectively means more money is available for the same set of real goods and services, even though the total amount of money in the economy as a whole has not changed.

Is Inflation a Bad Thing?

Inflation has a negative connotation, but economists generally think stable, low, and predictable inflation is ideal: the Federal Reserve targets 2 percent inflation per year. However, when inflation exceeds this estimate, it can have negative effects on the economy, consumers, and lenders.

It takes time for the economy to adjust to a high or unexpected increase in inflation. Prices for consumer goods typically adjust faster than wages and as a result, real incomes fall. The same paycheck can purchase fewer real goods or services and necessities like food, gas, or medication become less affordable.

The government is a huge money borrower and the taxpayer is the lender. Just like the limited purchasing power of your after-tax income on things like groceries, when inflation is high, your taxpayer dollars do not cover as much as they typically could for government projects and services.

Inflation benefits borrowers, who owe fixed payments. In real terms, the value of those payments is lower and lenders lose out. High inflation can encourage spending as consumers rush to buy goods now, rather than later, when prices may be even higher. Inflation can also be good for businesses that can expect to see higher profits as a result of higher prices, though some of this is likely offset by increased business costs as a result of inflation.

Inflation and Taxation

Not only does inflation resemble a tax, it impacts them too. Inflation can push taxpayers into higher income tax brackets or reduce the value of tax credits, deductions, and exemptions. This is known as bracket creep, which results in an increase in income taxes without an increase in real income.

Many tax provisions—both at the federal and state levels—are adjusted for inflation. Inflation indexing refers to automatic cost-of-living adjustments built into tax provisions to keep pace with inflation. Without indexing, inflation can change a taxpayer’s tax liability because inflation changes do not affect all taxpayers equally and happen regardless of initial legislative goals.

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