Entry Notes

Posted: 10252006
Author: Devin Mavro
Category: Taxes

Indexation is a method of controlling the income-redistributing effects of inflation.

Inflation is a decrease in the purchasing power of a unit of money. Households and businesses that supply commodities, credit, and raw materials under long-term contracts have revenues and incomes that are fixed regardless of what is happening to other prices. In an inflationary environment, revenues from long-term contracts diminish in real terms; that is, in real purchasing power.

Redistributive effects of inflation significantly harm important players in the economic system. With inflation, savers and lenders find their wealth losing value while in the hands of other households and businesses. The real losses to savers and lenders occur because their wealth is defined in terms of a unit of money that steadily, perhaps rapidly, buys less. Debtors stand to gain windfall profits from inflation that can reduce the value and burden of a debt, or, under hyperinflation, even eliminate a debt in practical terms.

Governments are suspected of generating inflation as a means of canceling vast public debts too large to service. In the aftermath of World War I the German government, shouldering a vast public debt from wartime expenditures coupled with war reparations, fueled an episode of hyperinflation that rendered its pubic debt null and void. The United States government emerged from World War II with a sizable public debt, perhaps removing government incentive to aggressively combat an inflation problem that continued until the early 1980s.

A system of indexation protects households and businesses whose wealth and income are at risk from inflation. Under indexation, escalator provisions automatically administer inflation adjustments to sources of income and assets fixed in money terms by contract. In the United States Social Security benefits automatically receive inflation adjustments geared to the Consumer Price Index, a limited application of the principle of indexation. Under a full-blown system of indexation, checking accounts, savings accounts, long-term and short-term bonds, mortgages, wages, and long-term contracts receive periodic adjustments to keep pace with inflation.

Some economists propose limited forms of indexation, applying only to government bonds and taxable income. This limited indexation automatically increases the maturity value of government bonds at a rate equivalent to the inflation rate, and withholds from government tax revenue paper profits due only to inflation. With limited indexation, government is spared the temptation to generate inflation as a means of canceling public debt, and levying a hidden tax.

As inflationary momentum increased during the 1970s prominent economists, such as Nobel Prize– winner Milton Friedman, proposed that the United States adopt a system of indexation. Brazil implemented a broad system of indexation, and Israel and Canada adopted indexation systems on smaller scales. Proponents of indexation felt it would lift the burden of forming accurate inflationary expectations and moderate economic fluctuations caused by discrepancies between actual and expected inflation. Strong anti-inflation policies often induce a bout of high unemployment because expected inflation remains high after the actual inflation rate has fallen. Indexation should moderate the high unemployment that often accompanies disinflation. Critics feel that the adoption of a system of indexation is equivalent to giving up the fight against inflation, and observe that inflation has often accelerated in countries practicing indexation. The United States never adopted indexation, and as other countries enacted market-oriented reforms, systems of indexation began to lose favor as another form of government interference.

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