Inflation as a tax

Last week I explored how Henry VIII resorted to coin debasement as a way to raise revenues in order to fight his wars. This provided Henry with the financial firepower to annex the city of Boulogne from the French in 1544, albeit at the price of England experiencing one of its greatest inflations ever.

Zoom forward five hundred years and Rishi Sunak, the Prime Minister of the UK, has ignited a controversy by referring to inflation as a tax, and further suggesting that the "best tax cut I can deliver for the British people is to halve inflation." His BBC interviewer disputed the claim, saying that inflation isn't a tax, a stance that the BBC upholds on its fact checking page.

Rishi Sunak, "The best taxt cut that I can deliver for the British people is to halve inflation."

Laura Kuenssberg, "Inflation is not a tax"

Rishi Sunak, "Inflation is a tax" pic.twitter.com/6LgMbeaprY

— Farrukh (@implausibleblog) October 1, 2023

If you recall, my previous article showed how Henry VIII's debasement functioned very much like a tax, say a new customs duty on wine or a beard tax. It did so by incentivizing people to flock to English mints to have their precious metals turned into coinage, Henry extracting a small fee on each coin. But the 21st century monetary system is very different from that of the middle ages. Is Rishi Sunak right to characterize inflation as a tax?

First, we need to better define our terms.

What do the BBC interviewer and Sunak mean by inflation? In the western world, prices have been rising at a regular pace of 2-3% each year for decades as result of central bank policy, which targets a low and steady inflation rate. Is this the definition they are using? Alternatively, Sunak and his interviewer may be referring to inflation as a *change in the change* in price. Since 2022 or so, that 2-3% rate has leapt to 8-9% all over the western world. Is it this jump that Sunak and his interviewer are talking about?

For the sake of this article, we'll assume that the conversation between Sunak and the BBC refers to the latter, a spike in the rate of inflation.

Secondly, what is meant by the word tax? Sometimes when we say that something is a tax we mean that it causes suffering. That is, inflation is taxing: it makes people's lives harder by increasing the cost of living, with salaries failing to keep up. It creates unfair changes in winners and losers.

Fair enough. But the more precise view I want to broach in this article is that inflation is actually a tax, where we define a tax as a formal charge or levy, set by the political process, that leads to cash flowing from the population to the government.

What does the data show?

Interestingly, a surprise jump in inflation leads to the very same effects as a new tax. All things staying the same, a new tax leads to an increase in government revenues. This improves the government's fiscal balance, or the difference between its revenues and expenses. A recent IMF paper by Daniel Garcia-Macia using data from 1962 to 2019 shows how an inflation shock typically achieves this exact same end result, boosting government revenues and improving its fiscal balance. This effect lasts for a few quarters, even up to two or three years, then recedes.

The IMF's chart below breaks down exactly how an inflation shock tends to improve government finances using quarterly data going back to 1999:

Charts source: IMF

Total tax revenue (the first panel) immediately begins to rise after the inflation shock at about the same rate as inflation.That's because most taxes are set by reference to values or prices, say like the prices of goods and services, or the price of labor, or the value of corporate profits. Since inflation pushes these amounts higher, this gets quickly reflected in tax revenues.

Income taxes and profits taxes (the second panel) rise particularly fast. Inflation is presumably pushing tax payers into higher income tax brackets, a process known as "bracket crreep," and so the government very quickly starts to collect a proportionally-larger amount of income tax.

Meanwhile, the government's total expenditures, the third panel, typically stay flat or only marginally rises in the quarters after the inflation shock hits. Notably, the amount of wages that are paid to government employees and social benefits (panels 4 & 8) tend to fall.

The net effect is an improvement in the government's fiscal balance. More specifically, for a 1% increase in inflation, the government's overall balance tends to improve by about 0.5% of GDP. And so an inflationary shock ends up at the same endpoint as a new tax: higher revenues and a better budget. That doesn't necessarily mean that inflation is itself a tax. Taxes have a degree of intentionality. They get implemented through a political process that has a certain set of goals in mind. By contrast, the extra revenue that an inflation shock raises is often (though not always) accidental, the result of external forces rather than political decision making.

So while it may not fall under the dictionary definition of a tax, the tax implications of a modern inflation shock resemble that of a new tax.

Everything I've written above applies to an inflation shock, say a rise from a 2-3% to 8-9%. Next I want to show that even constant 2-3% inflation can have the same revenue implication as a tax. Here's how.

Banknotes and seigniorage

Governments usually have a monopoly over the issuance of two key financial instruments: banknotes and settlement balances (also known as reserves). We all know what banknotes are, but what are settlement balances? Commercial banks find it useful to keep a stock of settlement balances on hand to make crucial large-value payments to other banks. The central bank, which the government controls, is the monopoly provider of these balances. (Sometimes banks are required by law to keep a a fixed number of settlement balances on hand, often above and beyond their day-to-day needs, a policy referred to as required reserves.)

Historically, interest rate on both types of central bank-issued money have been set at 0%. At the same time, the rates on short-term credit instruments (Treasury bills, commercial paper, bankers acceptances, etc) are determined by the market, typically hovering at a positive rate ranging between 0.25% to 5% over the last thirty years. These yields are priced to compensate investors for inflation.
 
The interest rate gap this gives rise to allows central banks to earn a steady stream of revenues, borrowing at an artificially cheap rate of 0% from both the banknote-using public and banks, and reinvesting at, say, 3%. Most of the revenues that the central bank collects from this interest margin flows back to the government. Economists usually refer to these revenue stream as seigniorage.

So seigniorage performs the same function as a consumption tax or an income tax: it takes resources from the public and gives it to the state. Likewise, a reduction in seigniorage would be very much like a tax cut.

If politicians wanted to, they could do away entirely with this form of raising government revenues. They have two ways of going about this. One way would be to have the central bank reduce price inflation to zero. By doing so, the interest rate on short-term credit instruments like Treasury bills would also fall to 0%, or thereabouts, since these instruments no longer need to compensate investors for inflation. And so the gap between the 0% rate at which central bank fund themselves and the rate at which they reinvest would cease to exist, seigniorage effectively shrinking to zero.

Over the last few decades, governments have taken a second route to removing seigniorage: they have begun to pay a market-linked yield on settlement balances. Canada, for instance, adopted this policy in 1999, and the Bank of England did so in 2006. By paying a market-based return, central banks no longer extract seigniorage from banks by forcing them to hold 0% assets. 

However, that still leaves banknotes as a significant source of seigniorage. We can calculate how much the UK government roughly earns from banknote seigniorage. With £95 billion in banknotes outstanding in October, and interest rates at 5.1%, the Bank of England's banknote-related seigniorage comes out to around £5 billion per year, much of which flows back to the government. That sounds like a lot, but it's only a small chunk of the £790 billion in taxes the UK government collected last year.

Banknote seigniorage isn't set in stone. It's a policy choice. If governments wanted to, they could reduce this form of seigniorage by paying interest on banknotes. One way to go about this would be to introduce a banknote serial number lottery. This lottery would offer around £5 billion in cash prizes to holders of winning banknote serial numbers, equating to a 5% interest rate on banknotes. Doing so would be akin to enacting a tax cut on British citizens.

To sum up, the fact that both an inflation shock and steady 2-3% inflation have implications for government revenues suggests that while inflation may not quite qualify as a tax, it is certainly tax-like.

Why the American taxpayer might prefer a large Fed balance sheet

David Andolfatto and Larry White have been having an interesting debate on the public finance case for having a large (or small) Federal Reserve balance sheet. In this post I'll make the case that American taxpayers are better off having a large Fed balance sheet, perhaps not as big as it is now, but certainly larger than in 2008.

To explain why, we're going to have to go into more detail on some central banky stuff.

The chart below illustrates the growth of the Fed's balance sheet. Prior to the 2008 credit crisis, the Fed owned around $900 billion worth of assets (green line), these being funded on the liability side by $800 billion worth of banknotes (red line), a slender $10-15 billion layer of reserves (blue line), and a hodgepodge of other liabilities. The Fed now owns an impressive $4.5 trillion in assets. These are funded by around $1.5 trillion worth of banknotes and $2.3 trillion worth of reserves. So the lion's share of the increase in the Fed's assets is linked to the expansion in reserves, which have ballooned by around 25,000%.


There's a problem with the above chart. It shows reserves clocking in at just $10 billion prior to 2008, but it's important to keep in mind that this *understates* the quantity of reserves issued by the Fed. Prior to 2008, the Fed would typically lend out tens of billions worth of reserves to banks during the course of the day, these amounts being paid back before evening. These loans are referred to as "daylight overdrafts." Because the above chart uses end-of-day data, it omits daylight overdrafts, thus making the balance sheet look smaller than it actually was.

How big did the Fed's balance sheet actually get during the course of a day thanks to overdrafts? Prior to the 2008 credit crisis, daylight overdrafts typically peaked at around $150 billion. So if we recreate the chart using intraday Fed data, the pre-2008 balance sheet would be around $800 billion + $150 billion, or 20% larger than if we use end-of-day data. And rather than a relatively flat pattern, we see a pulsing pattern. I've drawn out the chart by hand to give a sense for how the balance sheet would have looked, although its not to scale and doesn't use real data.

So why does the Fed offer daylight overdrafts? One of the business lines in which a commercial bank participates is the processing of payments on behalf of its clients to other banks, these recipient banks in turn crediting sent funds to their clients. To make these interbank payments, banks use deposit accounts at the central bank, or reserves.

In the U.S., legally-stipulated reserve requirements force banks to hold small quantities of central bank reserves overnight. So when the U.S. banking system opens in the morning for business, a bank will typically already have some funds in their reserve accounts that can be used to make client payments. However, the ability of this small layer of required reserves to carry out the nation's payments will soon be swamped—after all, the quantity of transactions conducted on a single day using reserves is massive, currently clocking in at $3 trillion.

In theory, banks might choose to hold an excess quantity of reserves overnight (i.e. more than the legally mandated minimum) in preparation for the next day's payment cycle. However, the Fed has historically kept the overnight interest rate on reserves at 0%, far below the market overnight interest rate. So no bank wants to hold reserve overnight if they can avoid it. If they did, their profits would suffer.

To ensure that banks have the ability to carry out the nation's business come morning, the Fed has typically provided the necessary reserves via daylight overdrafts. When the banks close for business in the evening, the Fed then sucks the reserves it has lent to banks back in. Alex Tabarrok once fittingly described banks as inhaling credit during the day, "puffing up like a bullfrog" —only to exhale at night.

As I mentioned earlier, before the credit crisis hit Fed-granted daylight overdrafts used to rise as high as $150 billion over the course of the day. Since 2008, the quantity of daylight overdrafts has declined quite dramatically. See the chart below:

source

Why have banks stopped applying for overdrafts? In 2008 the Fed began to pay interest to any bank that held reserves overnight. Rather than "exhaling at night," it suddenly made sense for banks to hold reserves till the next morning. This new demand for overnight balances was not met by daylight overdrafts, which must be paid back by the end of the day. Rather, a new permanent supply of reserves began to emerge thanks to the Fed's policy of quantitative easing. Under QE, the Fed created reserves and spent them to purchase bonds, these reserves staying outstanding as long as the Fed did not repurchase them, potentially for decades. The upshot is that banks are now quite happy to hold huge amounts of Fed-issued reserves on a permanent basis. As such, they no longer need to make use of daylight overdrafts to carry out the nation's payments. 

So let's bring the conversation back to the taxpayer. As you should hopefully see by now, the debate between keeping a big balance sheet and returning to its pre-2008 size is closely intertwined with the following question: do we want our central bank to provide daylight overdrafts or not? Because if we are to go back to 2008—i.e. to a period when overnight reserves were "scarce," as Larry White describes it—then by definition we are advocating daylight overdrafts.  

I'd argue that taxpayers might prefer that the Fed not provide daylight overdrafts. To begin with there is the question of credit risk. If a bank that has been granted an overdraft were to fail during the course of business, the Fed would be out of pocket. Since the central bank is ultimately owned by the taxpayer, that means taxpayers could take a big hit when a bank fails.

The Fed could protect itself by requiring banks provide collateral as security for access to Fed overdrafts. Now when the offending bank goes under, the Fed has a compensatory asset in its possession that it can use to make good on the loan, thus sparing the taxpayer. However, the protection afforded the Fed by collateralized daylight overdrafts comes at the expense of the nation's deposit insurance scheme, the Federal Deposit Insurance Corporation, or FDIC. To ensure that depositors of a failed bank are made whole, FDIC typically sells off the bank's assets. If the Fed has taken one of those assets for itself as collateral for a daylight overdraft, FDIC will have one less bank asset at its disposal and may have to dip into taxpayer funds to make up the difference. The overall risk faced by the taxpayer has not been reduced.

By maintaining the status quo—i.e. a large quantity of reserves—the taxpayer gets more protection from bank failures. Banks must buy reserves, or tokens, ahead of time to ensure that they can meet the payments needs of their clients. So the Fed acts as a seller, not a creditor, and therefore does not expose taxpayers to risk of bank failures. At the same time, FDIC does not face the prospect of having risk shifted onto it should the Fed seize collateral from a failed bank with unpaid daylight overdrafts.

Now the preceding discussion might seem to tilt me towards David Andolfatto's position of keeping a large balance sheet, albeit for different reasons than him. Not entirely. While a large quantity of reserves will be sufficient to insulate the taxpayer from bank failures, it needn't be as large as the current $2.5 trillion in outstanding reserves. As I pointed out earlier, prior to the 2008 credit crisis the Fed would typically grant around $150 billion in daylight overdrafts. This was sufficient to facilitate ~$2.7 trillion in payments (see data here). So each dollar in reserves was able to support 18x that value in payments. The Fed currently processes around $3.1 trillion in payments, a task that could probably be discharged with ~$200 billion in daylight overdrafts, assuming that the 18x ratio still prevails. So as long as the Fed were to keep at least $200 billion of the $2.5 trillion in reserves outstanding, that amount should be sufficient to replace the need for daylight overdrafts.

---

Sources:

1. How the High Level of Reserves Benefits the Payment System and Settlement Liquidity and Monetary Policy Implementation, both by Bech, Martin, and McAndrews
2. Divorcing Money from Monetary Policy by Keister, McAndrews and Martin
3. Turnover in Fedwire Funds Has Dropped Considerably since the Crisis, but It’s Okay by Garratt, McAndrews, and Martin

Shadow banks want in from the cold

Remember when shadow banks regularly outcompeted stodgy banks because they could evade onerous regulatory requirements? Not any more. In negative rate land, regulatory requirements are a blessing for banks. Shadow banks want in, not out.

In the old days, central banks imposed a tax on banks by requiring them to maintain reserves that paid zero percent interest. This tax was particularly burdensome during the inflationary 1970s when short term rates rose into the teens. The result was that banks had troubles passing on higher rates to savers, helping to drive the growth of the nascent U.S. money market mutual fund industry. Unlike banks, MMMFs didn't face reserve requirements and could therefore offer higher deposit rates to their customers.

To help level the playing field between regulated banks and so-called shadow banks, a number of central banks (including the Bank of Canada) removed the tax by no longer setting a reserve requirement. While the Federal Reserve didn't go as far as removing these requirements, it did reduce them and allowed workarounds like "sweeps." But the shadow banking system never stopped growing.

In negative rate land, everything is flipped around. Central bank reserve requirements no longer act as a tax on banks, they can be a subsidy. The Danmarks Nationalbank, Swiss National Bank and Bank of Japan have resorted to a strategy of tiering, where only a small portion of bank reserves are charged a negative rates (say -0.5%) while the rest (the inframarginal amount) can be deposited at the central bank where it earns 0%. Setting a 0.5% penalty on the marginal amount has been enough to drive interest rates on short term government bills and overnight lending rates to -0.5%. Banks that can invest some portion of their funds at 0% rather than the going market rate of -0.5% are getting a nice gift. They can in turn pass this windfall on to their customers by protecting them from negative rates. Shadow banks, which don't have  access to these subsidies because they don't have accounts at the central bank, are at a competitive disadvantage; they must invest all their funds at the going market rate of -0.5% and will therefore have to share the pain with their customers by reducing deposit rates into negative territory. This growing deposit rate gap should lead to retail and corporate flight from shadow bank deposits into protected regulated bank deposits.

We've certainly seen this in Japan. Around ten MMMFs quickly closed their doors to new funds after the Bank of Japan reduced rates to -0.1%. And now money reserve funds (MRFs) are clamouring for protection from negative rates. So while it used to be a disadvantage to be a subjugated bank and good to be a shadow bank, in negative rate land it's the exact opposite. Better to be shackled than to be free.

By the way, I'm wondering if this is why the ECB decided not to introduce tiered deposit rates last week, pointing to the "complexity of the system." Europe has a relatively large MMMF industry compared to Japan; perhaps it wanted to avoid any financial turbulence that might be set off by subsidies that benefit one set of bankers but not the other.