How Inflations Affect Taxes

By Revanza Almaas, a Directorate General of Taxes officer

Governments need money to function. Some of this spending is to purchase goods and services (like infrastructure and public safety) and some is to provide transfer payments (to low-income individuals and the elderly). To finance this spending, they have three main options:

• Taxes: This is the most common method, where individuals and businesses contribute a portion of their income to the government. Examples include income taxes, value-added taxes, and property taxes.
• Debt: Governments can borrow money from the public by selling bonds. This essentially means they promise to repay the borrowed amount with interest in the future.
• Printing Money: While less common, governments can create new money to cover their expenses. However, this increases the overall money supply, leading to inflation. Inflation tax is what the government collects from printing money.

Inflation as A Hidden Tax

Inflation might not seem like a tax at first glance, but it acts like one. Printing money to raise revenue is like imposing an inflation tax. At first, it may not be obvious that inflation can be viewed as a tax. After all, no one receives a bill for this tax. The government merely prints the money it needs. If this acts like a tax, who pays this tax? The answer is the holder of money, like you. As prices increase due to inflation, the value of your money decreases. This means the same amount of cash can buy less overtime. Therefore, when the government prints new money for its own use, it makes the old money in the hands of the public less valuable. Inflation is like a tax on holding money.

Inflation tax is one of several costs caused by inflation. The second costs arise when inflation leads to an increase in the frequency of price changes by firms, which incurs costs known as menu costs. These costs include expenses for calculating new prices, printing new menus and catalogs, changing price tags, and even addressing customer dissatisfaction over price adjustments. During periods of high inflation, businesses may need to change prices more frequently to keep up with rising input costs, leading to additional menu costs. The third costs come from sticky wage problem. Wages mostly are like stickers on contracts. These "stickers" don't change immediately with fluctuations in inflation. This mismatch can lead to reduced economic efficiency. 

The fourth costs are what we are going to discuss in the next section. These costs result from the tax system. Many tax laws do not take into account the effects of inflation. It means that as prices rise, you could end up paying more taxes without actually earning more. 

Bracket Creep 

Indonesia uses a progressive tax system. It means that to determine taxes owed, it uses a marginal tax rate. The marginal tax rate increases as a taxpayer's income increases, and there are different tax rates for various levels (brackets) of income. Taxpayers will pay the lowest tax rate on the first bracket of taxable income, a higher rate on the next bracket, and so on. Each tax bracket is a range of income with a different tax rate. For example, a tax bracket of IDR50.000.000 to IDR250.000.000 has a 15% rate. Rates available are 5%, 15%, or 25%, 30%, and 35%, and are referred to as the marginal rate. Tax brackets are used to determine the tax rate, and each bracket's marginal tax rate increases as the taxpayer moves into higher brackets.

Inflation causes distortions. The eminent distortion caused by inflation is known as a bracket creep. Here is the explanation. A taxpayer named Surya has his earnings increase. Price level where he lives also increases at the same rate. Then, Surya's nominal income has risen, but his real income is unchanged. This is because real incomes reflect the actual incomes after adjusting for price changes and living costs. Unfortunately, the current tax system is based on an individual's nominal income. Surya is pushed into the next tax bracket with a higher marginal tax rate. As a result, now the percentage of income that is taxed increases, although his real income (actual purchasing power) stays the same. This is what bracket creep is. And even if the inflation doesn't push into a higher bracket, he will still find more of his income taxed. This is the consequence of an unindexed tax system.

To prevent such bracket creep, tax provisions that have a progressive structure need to get adjusted for inflation regularly. Some countries have applied this on an annual basis. Price-level adjustments can be built into not only income tax brackets, but also standard deductions (PTKP), personal exemptions, etc. Deductions and exemptions intended to reduce our tax burden may lose their effectiveness over time due to inflation. As prices rise, its value shrinks, leaving us with less subtraction and potentially a higher tax owed.

The last update of the standard deduction in Indonesia was January 1st, 2022, and it was not based on inflation. Understanding the effects of inflation empowers us to suggest a regular inflation-adjusted change, similar to the models adopted by countries like Austria, Finland, and Iceland. That adjustment can ensure that the tax system remains fair and responsive by providing protection against real income erosion. This would not only benefit taxpayers but also foster a more stable and equitable economic environment for everyone.

*) This article is the author's personal opinion and does not reflect the attitude of the agency where the author works.

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