Front Page Titles (by Subject) 6.6.: The Orthodox Discussion of Inflation as a Tax - The Collected Works of James M. Buchanan, Vol. 9 (The Power to Tax: Analytical Foundations of a Fiscal Constitution)
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6.6.: The Orthodox Discussion of Inflation as a Tax - James M. Buchanan, The Collected Works of James M. Buchanan, Vol. 9 (The Power to Tax: Analytical Foundations of a Fiscal Constitution) 
The Collected Works of James M. Buchanan, Vol. 9 The Power to Tax: Analytical Foundations of a Fiscal Constitution, Foreword by Geoffrey Brennan (Indianapolis: Liberty Fund, 2000).
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The Orthodox Discussion of Inflation as a Tax
It may be useful at this point to contrast our own discussion of inflation as a tax with the prevailing orthodoxy—that essentially follows the approach taken in Martin Bailey’s influential 1956 article.12 A brief review of that paper seems appropriate here. The central element in the Bailey discussion is a diagram similar to that of our Figure 6.3. However, whereas our construction embodies capitalized values for permanently available units of real money balances, Bailey’s basic diagram is constructed in a single-period or time-rate dimension. Bailey’s objective is to measure the welfare cost of inflation in a manner “which is fully analogous to the welfare cost or ‘excess burden’ of an excise tax on a commodity.”13 He does this by considering an increase in the rate of inflation from zero to i*, so as to produce a shift from S to T in Figure 6.3 where individuals expect the inflation rate i* to prevail over the indefinite future. Bailey measures the resultant welfare loss as area FGC, and by appeal to certain of Cagan’s results on European hyperinflations, he attempts to indicate the magnitude of the welfare loss per dollar of revenue raised from inflation at various levels. He also attempts to identify plausible maximum revenue rates of inflation for certain countries.
Subsequent criticism has succeeded in refining the Bailey analysis. As Tower14 points out, Bailey implicitly assumes that a zero-inflation regime is optimal, and he calculates welfare losses by reference to the zero-inflation “price,” r in his model, $1 in our construction. For example, Bailey measures the welfare loss involved in the move from an inflation rate of zero to i* as FCG, rather than FHK, the correct measure. This zero-inflation base has implications also for Bailey’s calculations of revenue-maximizing inflation rates. He derives the revenue-maximizing inflation rate as that rate which maximizes the revenue increment over and above the zero-inflation rate, rather than that rate which maximizes the total present value of the money-creation power.15
So much for a sketch of the prevailing theory of inflation as a tax. Our differences with this orthodoxy should be obvious. As we have been at pains to point out in the previous discussion, there is a fundamental distinction between the world in which a fixed monetary constitution (a money rule, perhaps) prevails, and the world in which there is no such constraint on government’s monetary behavior.
Given plausible assumptions about the behavior (or possible behavior) of government, it is only in the former world that the rational citizen’s monetary expectations are stable. When government has discretion to determine the money supply, the citizen’s expectations must be highly volatile. Any slight departure from the status quo may with equal plausibility be interpreted either as a minor anomaly or as evidence that major recourse to the printing press for revenue purposes is in the offing. The rational citizen’s response is, however, quite different according to which interpretation he adopts. The basic point is that, in the absence of a genuinely binding monetary constitution, any monetary equilibrium must be inherently precarious.
If the relevance and importance of this expectational difficulty is accepted, several conclusions follow. First, the Bailey model, essentially translated into our own construction in Figure 6.3, is only applicable in the strict sense to a world in which a binding monetary constitution is operative. The model can be used to determine the welfare implications of one monetary rule rather than another: one for example that involves a predicted inflation rate of i0 rather than i*. But it cannot be used to examine the welfare implications of an increase in inflation rates in-period, because such an increase is only possible when a binding monetary constitution is not in being. In the same way, the Bailey model, like our own, can be used to define that monetary rule from among the set of all possible rules that would maximize to government the present discounted value of the real money stock. Such a calculus might be relevant if government were required to select a binding rule and stick to it. But the basic Bailey model cannot be used to specify the revenue-maximizing monetary strategy of a government when no such money rule prevails, where no such precommitment need be made. One of the interesting anomalies of the Bailey analysis is the fact that in European hyperinflations to which he draws attention, actual rates of inflation were in many cases grossly in excess of those which seemed revenue maximizing in terms of the parameters of his model. Why governments might choose to inflate beyond revenue-maximizing limits becomes the obvious question. Were government decision makers malevolent, stupid, or irrational? One obvious answer is that they need have been none of these. They may, in fact, have been aiming to maximize revenue. Bailey’s calculations of revenue-maximizing strategy may have been inappropriate to the setting in which those governments were operating. The derivation of a revenue-maximizing monetary rule is irrelevant to the understanding of revenue-maximizing monetary strategy when no binding rule prevails. More generally, the “monetary-rule” analytics are, and can be, only marginally relevant to explaining what we observe in a world where no such rule prevails—and this particularly in relation to hyperinflationary situations. Equally, these “monetary-rule” analytics are of little use in deriving the welfare costs of inflationary finance in a setting where the monetary authority is not effectively constrained.
It can be seen therefore that our discussion and the orthodox inflation-as-a-tax discussion are addressed to different issues. We have been concerned to specify the implications of assigning to government constitutional authority to create money in the same way we have discussed the implications of assigning government the power to raise revenue from other sources, in Chapters 3 through 5. We have specifically examined this issue in a setting in which government has discretion to determine the use of its assigned money-creation power. The orthodox inflation-as-a-tax discussion, however, implicitly assumes that such discretion is precluded by some additional constitutional constraint that imposes a money rule, and seeks to derive the welfare implications of alternative money rules in this setting. Insofar as credibly binding money rules are not in practice operative, this orthodox discussion is dubious as a guide either to positive explanation of what we observe or to normative policy conclusions.
[12. ] See Martin Bailey, “The Welfare Cost of Inflationary Finance,” Journal of Political Economy, 64 (April 1956), 93-110; P. Cagan, “The Monetary Dynamics of Hyperinflation,” in Milton Friedman, ed., Studies in the Quantity Theory of Money (Chicago: University of Chicago Press, 1956), pp. 25-117; and Edward Tower, “More on the Welfare Cost of Inflationary Finance,” Journal of Money, Credit and Banking, 9 (November 1971), 850-60.
[13. ] Bailey, “The Welfare Cost of Inflationary Finance,” pp. 93-94.
[14. ] Tower, “More on the Welfare Cost of Inflationary Finance.”
[15. ] Geometrically, we could derive the Bailey “revenue-maximizing rule” by taking the rate at which Dm is tangential to a rectangular hyperbola that has as its vertical and horizontal axes the ordinate and zero-inflation or $1 line, respectively, in Figure 6.3. The true revenue-maximizing rate is determined where Dm is tangential to a rectangular hyperbola that has as its vertical and horizontal axes the ordinate and abscissa, respectively, in Figure 6.3. The latter rate must lie below Bailey’s, since the latter hyperbola lies everywhere below the former.