The persistent post-COVID surge in prices has reignited interest in estimating inflation’s impact on households. The literature’s main focus, starting with Fischer and Modigliani (1978), has been on the distributional and allocative effects of inflation through price and wage adjustments (Doepke and Schneider 2006, Corsello and Riggi 2023, Ferreira et al. 2024). Less well understood, however, are fiscal burdens arising from nominal tax and benefit provisions that are either unindexed or indexed with lags.
The US fiscal system is far from inflation-neutral. Federal and state income taxation of nominal, not real, asset income is one important example. Another is the failure to index nominal income thresholds beyond which Social Security benefits are subject to federal and, in some states, state income taxation. A third is delay in the indexation of fiscal provisions, such as individual income tax brackets and Social Security benefits, that are meant to insulate real taxes and benefits from inflation. These and other fiscal non-neutralities would arise even if all private contracts were automatically indexed for inflation, leaving the private economy inflation-neutral.
Our paper (Altig et al. 2024) measures inflation’s hidden net taxation by applying the Fiscal Analyzer (TFA) to the 2019 Survey of Consumer Finances (SCF) under alternative assumed inflation rates. The TFA is a life-cycle consumption-smoothing programme that incorporates all major federal and state tax and benefit programmes. It constitutes a veritable Webb Telescope for viewing the US fiscal system’s myriad collective workings, including those on fiscal progressivity (Auerbach et al. 2023), work incentives (Altig et al. 2023), and suboptimal choices with respect to the timing of Social Security benefit receipts (Altig et al. 2022).
To isolate inflation’s fiscal impacts, we begin with baseline calculations that are modified to be inflation-neutral in the absence of fiscal policy. Next, we run these modified observations through TFA under assumed alternative permanent inflation rates. Table 1 summarises TFA’s tax and benefit programmes.
Table 1 Tax and transfer programmes included in the Fiscal Analyzer (TFA)
Our study runs each SCF household through TFA three times – for permanent inflation rates of 0%, 5%, and 10%. In each scenario, we fully adjust the financial system (e.g. wages, asset values, relative prices) such that, absent taxes and transfers, inflation would have no impact whatsoever on the household’s real spending path under any mortality path for spouses in the household. We then compare each household’s present-value lifetime spending for permanent inflation rates of 0%, 5%, and 10%.
Inflation’s fiscal impact is potentially quite large. For example, a permanent increase from 0% to 10% reduces the median US household’s lifetime spending by 6.8%. Surprisingly, lags in cost-of-living adjustments (COLA) explain only one-third of this reduction: with perfect, timely indexing, the impact is still 4.7%. An increase from 0% to 5% reduces lifetime spending by 3.6%.
More strikingly, we document significant progressivity in inflation’s increase in net taxation, as well as substantial heterogeneity, both within and across age cohorts. As shown in Figure 1, median changes in lifetime spending from inflation are larger for households with the highest amount of lifetime resources. Under 10% inflation, the 15.9% median lifetime spending loss of the top 1% of households is roughly 2.5 times that of the bottom resource quintile. This difference reflects the major impact of taxing nominal as opposed to real asset income.
Figure 1 Median percentage change in remaining lifetime spending by resource quintile, ages 20 - 79
As Figure 2 shows, inflation’s hidden net taxation is particularly high for households aged 50 to 59. This is to be expected. Middle-aged households, due to life-cycle saving, hold relatively more of their resources in the form of financial wealth. Hence, they are disproportionately exposed to the taxation of nominal rather than real asset income.
Figure 2 Median percentage change in remaining lifetime spending by age cohort
We also find major dispersion in inflation’s net tax impact on households. This holds even for households with very similar amounts of lifetime resources – the sum of human and non-human wealth. Much of this heterogeneity reflects differences by state of residence in the structure of tax and benefit programmes. With a permanent increase in inflation from 0% to 10%, a quarter of US households see their lifetime spending fall by more than 10%. In our sample, the maximum spending decline (increase) across all households is 64.9% (46.7%). In short, the distribution of spending and hence welfare is highly sensitive to significant, ongoing inflation.
Figure 3 summarises changes in remaining lifetime spending relative to the zero-inflation baseline. The largest absolute changes arise from a range of often surprising factors. One example, increasing net spending, is low-income households becoming eligible for Medicaid as their real Social Security benefits fall due to the system’s long cost-of-living adjustment (COLA) lag. A second example, which reduces net spending, is the non-indexation of the top Medicare Part B IRMAA brackets, which govern the progressive schedule of premiums. A third is households with extremely high asset holdings, but no municipal bond or stock holdings that would fully or partially shelter their nominal asset income from increased taxation.
Figure 3 Percentage change in remaining lifetime spending, ages 20 - 79
Our research has three main implications for the ongoing inflation policy debate. First, accepting a higher inflation target imposes non-trivial costs on households beyond the typical price and wage effects. A 3.5% long-term inflation target would, in expectation, lower US households’ standard of living by nearly a percentage point on average compared to the current 2% target. Second, the regressive wage- and price-channel impact of inflation is at least partially offset by progressivity of the fiscal channel. Therefore, it is likely that rising prices are considerably more progressive than implied by prior research, with the largest losses hitting households with the highest levels of lifetime resources. Third, aggregate estimates of inflation’s impact – both price-wage and fiscal – mask striking heterogeneity, both across and within age and resource groups. The complexity of the US fiscal system imposes huge costs – and, in rarer cases, gains – to some households.
In summary, even if inflation were fully anticipated and, thus, financially neutral, it would have a major and quite progressive impact on the average level and distribution of Americans’ lifetime spending. More research is required to understand the extent to which inflation’s fiscal and financial impacts work in unison or offset one another.
References
Altig, D, A J Auerbach, L J Kotlikoff, E Ilin and V Y Ye (2023), “The marginal net taxation of Americans’ labor supply”, NBER Working Paper 27164.
Altig, D, L J Kotlikoff and V Y Ye (2022), “How much lifetime social security benefits are Americans leaving on the table?”, Tax Policy and the Economy 37(1): 135-173.
Altig, D, A J Auerbach, E Eidschun, L J Kotlikoff and V Y Ye (2024), “Inflation’s Fiscal Impact on U.S. Households”, NBER Macro Annual, forthcoming.
Auerbach, A J, L J Kotlikoff and D Koehler (2023), “US inequality and fiscal progressivity: an intragenerational accounting”, Journal of Political Economy 131(5): 1249-1293.
Corsello, F and M Riggi (2023), “Inflation is not equal for all”, VoxEU.org, 26 November.
Doepke, M and M Schneider (2006), “Inflation and the redistribution of nominal wealth”, Journal of Political Economy 114(6): 1069–1097.
Ferreira, C, G Nuño, A Ortiz and T Rodrigo (2024), “The heterogeneous impact of Inflation on households’ balance sheets”, VoxEU.org, 11 March.
Fischer, S and F Modigliani (1978), “Towards an understanding of the real effects and costs of inflation”, Review of World Economics 114(4): 810–833.
