The distinctive feature of the inflation tax, the feature that
recommends it both to developed and under-developed countries, is
that it is the only tax that can be levied without explicit legislative
enactment or executive announcement.
You believe in this country that taxes are determined in the Knesset.
You are wrong. This country has two tax authorities. The Knesset
is one, the Bank of Israel is the second. The Bank of Israel can
and does, explicitly or implicitly, intentionally or unintentionally,
impose taxes, and affect the rate of tax imposed by the Knesset.
If a country decides to impose an inflation tax, the treasury or
the central bank simply prints currency, or does the equivalent
by adding to its deposit liabilities. The government uses the additional
currency or created deposits to buy goods and services. The sellers
find themselves with larger cash balances than they desire, so they
purchase goods or services, or make investments, or make gifts,
which causes the created money balances to spread through the economy,
in the process perhaps multiplying as a result of the operations
of commercial banks. The increased flow of spending raises prices,
which reduces the real value of cash balances to the desired level.
The holders of cash balances have paid a tax, because they have
had to use part of their income or part of their non-cash wealth
to acquire additional pieces of paper or additional book entries
(deposits) to maintain their real balances at the desired level.
To look at it a different way, if prices rise at 10 per cent a year,
you must increase the number of Israeli pounds you hold by 10 per
cent in order to keep the real balances you have constant. Those
additional 10 per cent of pieces of paper are the exact equivalent
of tax receipts from the tax collector certifying that you’ve
paid your taxes. That’s what they effectively are. The rate
of the inflation tax depends on how rapidly the money stock increases.
If the money stock increases by 20 per cent a year, then the rate
of tax is 20 per cent. The yield of the tax to the government for
a given tax rate depends on how large cash balances are relative
Let me give you a very simplified example. Assume for the moment
that the inflation is fully anticipated, so that no unexpected results
happen, and that the only form of money is currency, pieces of paper.
Let’s suppose the government has been increasing the amount
of money at the rate of 10 per cent per year so that the tax rate
is 10 per cent. Suppose also that, when the quantity of money is
increasing at 10 per cent a year, the public chooses to hold an
amount of currency equal to one-tenth of a year’s income,
i.e., it holds about 5.2 weeks of income, in the form of currency
(income velocity of circulation is 10). The yield to the government
will then be the tax rate, or 10 per cent, times the tax base, which
is 10 per cent of a year’s income, or a yield of 1 per cent
of a year’s income. If the public were to hold money balances
equal to half a year’s income, then the yield would be 10
per cent of a half a year’s income or 5 per cent of a year’s
How rapidly prices will rise under these circumstances depends on
two things: first, how rapidly output is growing; second, whether
the community is seeking to raise or to lower the ratio of its cash
balances to its income.
Let me return to the earlier simple example again. Suppose output
in that hypothetical case is rising at 5 per cent a year and people
want to keep cash balances steady at 10 per cent of income (i.e.,
velocity is constant). Half of the annual increase in currency will
then be absorbed to match the rise in output, leaving half to raise
prices, so prices would rise 5 per cent per year.
If, as is more realistic for underdeveloped countries for moderate
rates of inflation, velocity is falling at roughly the same rate
as output is rising, i.e., if for every 1 per cent increase in output
people would like to hold 2 per cent more money in real terms (income
elasticity of demand for money equals 2), then the 10 per cent rate
of money increase I have assumed would be consistent with stable
prices. Five per cent would be absorbed by increased output and
5 per cent by the increase in desired balances per unit of output.
This example illustrates a very important and much neglected point,
that the government can get revenue from issuing money even though
there is no inflation. This is a very important point, particularly
for a country like Israel.
In a country like Israel, my guess is that if you could keep the
rate of money issue at something between 15 and 20 per cent a year,
you would have roughly zero inflation. Output in Israel has been
growing something like 10 per cent a year. Israel is at the stage
of development where the income elasticity of the demand for money
is about 2. In that case, if you were to increase the quantity of
money by let us say 18 per cent a year, to take a specific number,
prices would probably be roughly constant, half of the increase
in the quantity of money being absorbed by output and half by a
decrease in velocity. In that case the government would still get
revenue, and indeed, surprising though it may seem, the revenue
might be larger than it would be if you increase the quantity of
money by, let’s say, 50 per cent a year. If you increase it
by 50 per cent a year, the tax rate would be higher, but the people
would reduce their cash balances so much that the tax base would
be much smaller, and so you might end up with less revenue.
I warn you that this is a very sophisticated matter. In particular
you must not jump to the conclusion that, if instead of increasing
the quantity of money by 18 per cent a year, you increase it by
25 per cent, you will have 7 per cent inflation. You will not. You
will probably have something more like 14 per cent inflation. The
reason is that if you start increasing the quantity of money faster,
prices will rise, and as you very well know, everybody will try
to reduce his cash balances. As a result, the actual rate of inflation
will be much greater than the difference between the rate of increase
of the quantity of money and the 18 per cent that I assumed will
be consistent with stable prices.
Let me stress also that I have chosen the number 18 rather arbitrarily
for illustrative purposes. It would require a much more detailed
study of monetary relations in Israel than I have made to arrive
at an estimate deserving of much confidence. Needless to say, I
regard it as desirable that such a study be made, and perhaps it
already has been made by some of your able monetary economists.
The economic effects of the inflation tax depend partly on its
rate, but, in my opinion, much more on two other circumstances associated
with the tax. Hence I shall discuss these points first before coming
back to the question of what is the right rate of money creation.
The two other circumstances that I think are important are: first,
whether inflation is open or repressed; second, whether inflation
is anticipated, as I assumed in my simple example, or unanticipated