Inflation hurts the poor most, and the arithmetic of a fixed paycheck

Here is the most successful tax in American history, and not one member of Congress has ever had to vote for it. It has no line on your W-2. It has no rate schedule, no deductions, no April deadline and no form to file. It simply arrives, quietly, at the grocery store, the gas pump and the landlord's front door, and it takes a little more every month. The politicians who cause it then hold a press conference to announce that they are very concerned about it.

Folks, I want to walk you through the arithmetic of that tax, because the arithmetic is the whole story. Inflation is usually described as an unfortunate weather event, something that "hit" the economy the way a storm hits a coast. It is not weather. It is the result of how much money is created compared with how much stuff there is to buy, and the people who create the money are people with names and offices. Once you see it as a tax, one fact jumps out at you that the coverage rarely says plainly: it is a regressive tax. It takes the largest bite from the people who can least afford it.

What inflation is, and who measures it

Let's define terms, because the fights over this subject are mostly fights over words.

Inflation is a sustained rise in the general level of prices, which is the same thing as a fall in what each dollar will buy. The Bureau of Labor Statistics measures it with the Consumer Price Index, the CPI, by pricing a large basket of goods and services every month: food, shelter, energy, clothing, medical care, transportation and more. When the CPI rises 5 percent over twelve months, the basket that cost $100 a year ago costs $105 now.

Two measures matter for this post. The CPI-U tracks the spending of all urban consumers. The CPI-W tracks urban wage earners and clerical workers, and it is the measure the Social Security Administration uses to set the annual cost-of-living adjustment. The CPI is an average. Your own inflation rate is different, and that difference is the heart of the matter.

Nominal wages are the dollars on your paycheck. Real wages are what those dollars buy. If your pay rises 3 percent and prices rise 5 percent, your nominal wage went up and your real wage went down about 2 percent. You got a raise on paper and a pay cut at the register. The headlines love the first number. Your refrigerator knows the second.

The arithmetic of a fixed paycheck

Now to the work. Everything below is a labelled hypothetical, with the arithmetic shown so you can check every line yourself.

Picture a worker who earns $50,000 a year and whose pay does not change. Suppose prices rise 5 percent a year for four years. That is a bad stretch, but not an exotic one: the CPI-U rose more than 9 percent over the twelve months ending in June 2022, the highest annual reading in about four decades, so a 5 percent assumption is gentler than what Americans actually saw at the peak.

To find what the paycheck buys after four years, divide by the cumulative price level.

• Year 0: price level 1.0000.
• Year 1: 1.05.
• Year 2: 1.05 x 1.05 = 1.1025.
• Year 3: 1.1025 x 1.05 = 1.157625.
• Year 4: 1.157625 x 1.05 = 1.21550625.

So $50,000 divided by 1.21550625 is about $41,135 in the original dollars. The paycheck is the same number on the stub, but it has lost roughly $8,865 of buying power, close to 18 percent. Nobody sent a bill. The money was taken anyway.

Now give that worker a raise, because workers do get raises. Suppose pay rises 3 percent a year while prices rise 5 percent.

• Year 4 pay: $50,000 x 1.03 x 1.03 x 1.03 x 1.03 = $50,000 x 1.12550881 = about $56,275.
• In original dollars: $56,275 divided by 1.2155 is about $46,298.

Four annual raises, and the worker is still about $3,700 behind where he started. If the raises had matched prices, he would be treading water. Anything less is a real pay cut dressed up as good news.

Try a sharper stretch: 8 percent a year for three years, again with a flat $50,000 paycheck. The price level is 1.08 x 1.08 x 1.08 = 1.259712. Divide: $50,000 / 1.259712 = about $39,692. Three years of 8 percent inflation takes more than a fifth of the paycheck's value.

Retirees and savers

The same arithmetic runs against two other groups that never make the evening news in this story.

A retiree draws a fixed pension of $2,000 a month, with no cost-of-living clause. After four years of 5 percent inflation, that $2,000 buys what $1,645 bought at the start (2,000 / 1.2155). Her check never changed. Her living standard fell by more than $350 a month.

A saver keeps $10,000 in a cash account that pays nothing, which is close to what a checking account pays. After four years of 5 percent inflation, it buys what $8,227 once did. After three years of 8 percent, it buys what $7,938 once did. The saver did everything the schoolbooks taught: worked, spent less than he earned, put the difference away. The reward is a quiet confiscation. Government borrowers, meanwhile, see the real weight of what they owe shrink, because they repay in cheaper dollars. A government that is the largest debtor in the country has a standing temptation to like inflation. Keep that in mind when you read the next soothing statement from Washington.

Why the bite is regressive

The CPI is an average of what everyone spends. But a family earning $35,000 does not spend like a family earning $350,000, and the difference is exactly where inflation does its work.

Lower-income households spend a much larger share of their budgets on food, energy, and rent, the things you cannot skip. The BLS Consumer Expenditure Survey, which you can read on the bureau's website, shows this pattern year after year: the lowest income fifth devotes a far greater share of its spending to food and shelter than the top fifth does. A higher-income family spends a larger share on things that are discretionary, such as travel, dining out, financial services and savings.

Take a labelled hypothetical to see the effect. Family A spends 60 percent of its budget on food, energy and rent. Family B spends 30 percent on those categories. Suppose those three categories rise 10 percent in a year while everything else rises 2 percent.

• Family A's cost of living rises 0.60 x 10 + 0.40 x 2 = 6.0 + 0.8 = 6.8 percent.
• Family B's rises 0.30 x 10 + 0.70 x 2 = 3.0 + 1.4 = 4.4 percent.

Same year, same economy, same average. One family is hit more than half again as hard. When the inflation is led by groceries and gasoline, which is exactly what people remember from 2021 and 2022, the headline number understates what the family at the bottom feels.

There is a second reason. A family with little cash and no assets cannot protect itself. It cannot rotate into real estate, equities, or other assets that tend to hold their value over time. It cannot refinance a mortgage at a fixed rate it locked in years ago, because it may rent. It has its paycheck, and its paycheck adjusts last.

The Cantillon effect: who gets the new money first

The deeper reason inflation is unfair was identified in the eighteenth century by Richard Cantillon, an Irish-French banker whose Essay on the Nature of Trade in General was published after his death, in 1755. His insight is simple and brutal. New money does not fall on the economy evenly, like rain. It enters at particular points, and prices rise gradually as it spreads.

Those who receive the new money first spend it at old prices. Those who receive it last find that prices have already gone up. Think of it as a line at the pump where the people at the front pay yesterday's price and the people at the back pay tomorrow's.

Who is at the front? Whoever sits closest to the source: the government that spends newly created money, the banks and financial institutions that first receive it, and those who own assets whose prices rise as money floods in. Who is at the back? The worker whose wage adjusts after the price level has moved, the retiree on a fixed income, and the saver holding cash.

This is why "inflation hits everyone equally" is wrong. Inflation redistributes. It moves purchasing power from late recipients of money to early ones, and from holders of dollars to holders of things. It is a transfer, and the direction of the transfer is not toward the working poor.

The strongest objection

Fairness requires that we state the other side's best case, and it has one.

The objection runs like this. First, some inflation is the normal price of a growing economy, and the Federal Reserve's stated target of 2 percent exists for a reason: a little inflation gives the Fed room to cut rates in a downturn and keeps wages from needing to be cut in nominal terms, which employers find hard to do. Second, wages in many periods do catch up, and in the years just after the 2021 to 2023 surge, the argument goes, wage growth for lower-paid workers outpaced that of higher-paid workers, so the poor were not simply losers. Third, deflation, the alternative, can be worse: falling prices can freeze spending, raise the burden of debts, and deepen a slump, as in the early 1930s.

Those are serious points, and I will grant what is true in them. A low, stable, predictable rate of inflation is a different animal from a surge. Debtors do benefit when prices rise, and a mortgage holder with a fixed rate was a quiet winner of the 2021 to 2023 period. And it is right that during tight labour markets, wages for lower-paid workers can rise faster than average.

But now the answer, point by point.

One. A 2 percent target still means the dollar loses about a third of its value in twenty years. At 2 percent a year, prices roughly double in 36 years (rule of 72: 72 divided by 2). A "stable" policy is still a slow tax on every dollar you save. Call it a small tax if you like. It is still not nothing, and it compounds.

Two. Wage catch-up is real in some stretches, but it is exactly that: catching up. The worker spends the first year behind and only some years later, if at all, recovers lost ground, and in the interim the cash savings he had are gone for good. Savings are not restored by later raises.

Three. The deflation worry is a worry about collapse in an economy with falling output, not about a government declining to inflate. Prices fell in many years of the nineteenth century while the economy grew rapidly, in large part because productivity was rising. Falling prices from rising productivity are what a prosperous, honest money looks like: your paycheck buys more each year without anyone passing a law. We have swapped that arrangement for one in which the government targets a permanent rise in prices and calls the result price stability.

Four. The whole case for tolerating inflation rests on the assumption that the authorities will hit their target. The record is mixed. Read The Great Inflation of the 1970s was a policy choice, not bad luck for a decade in which the target slipped, expectations followed, and it took very high interest rates and a painful recession to repair the damage. And for the more recent surge, what caused the inflation of 2021 to 2023, weighing the honest evidence weighs the competing explanations fairly.

Who decides: the Fed, Congress, and the printing press

Inflation is not a mystery. Over time, a rise in the general price level requires a growth of money and credit in excess of the growth of goods and services. Economists argue about the details, about the lags and about how much supply shocks matter, and an honest analysis admits that the 2021 to 2023 episode had supply-side causes as well as monetary ones. But two actors hold the levers.

The Federal Reserve sets short-term interest rates and, since 2008, has also used large-scale asset purchases that expand its balance sheet. Its job is defined by statute, and The Fed's dual mandate and the 1977 law that gave it two masters explains how a 1977 law gave it two masters, maximum employment and stable prices, which can pull in opposite directions. Congress, for its part, decides how much to borrow, and a government that runs deficits every year creates continuous pressure on the central bank to keep rates low enough that the interest bill stays tolerable. You can watch that bill grow on the national debt clock, and do the arithmetic on $40 trillion and the interest bill it carries works through what it means for the budget.

There is also a school of thought, popular among some who want to spend more, that deficits cannot cause inflation until the economy runs out of real resources. The 2022 experience did that theory no favours, as Modern Monetary Theory says deficits do not matter, and 2022 answered it explains.

What inflation does to the family budget over time

One more worked example, because it shows why the damage lingers after the headlines move on.

Suppose a family's grocery bill was $800 a month before a stretch of inflation, and prices for food at home rise 25 percent over three years. The bill is now $1,000. That extra $200 a month is $2,400 a year, and it does not go away when the inflation rate falls. A falling inflation rate means prices are rising more slowly, not that they are falling back. The prices stay where they got to. This is the single most misunderstood point in the whole debate: when the news says inflation has "cooled," it means the rate of increase slowed. The level of prices does not return to where it was.

For a household with a fixed weekly budget, the lesson is brutal and simple. The cost of living is a level, and levels are what you pay. The only way a family truly recovers is for its income to rise beyond the new level of prices, and that takes real growth, real productivity and sound money, not announcements.

Measure it against the Founders

The Founders knew all about paper money, and what they knew frightened them. The Continental Congress financed much of the Revolution by printing "Continentals," and the currency lost so much of its value that "not worth a Continental" became a saying. The men who wrote the Constitution remembered. Article I, Section 8 gives Congress the power "To coin Money, regulate the Value thereof, and of foreign Coin," and Article I, Section 10 forbids the states to "coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts." They were building a government that could not simply print its way out of its promises.

Whatever you think of the modern monetary system, the point of the clause was plain. The power over the value of money is the power over everyone's property, and it was meant to be held with care. When people say inflation is a tax, they are not being rhetorical. They are noticing that the power to debase the currency is a power to take, and that the Founders wanted every power to take to be answerable to voters.

That is also the strongest practical reason to demand clear, boring, rules-based money: predictable policy, a central bank held to its stated target, and a Congress that does not fund itself by quietly shrinking everyone's paycheck. If you want to check the history of how the nation's tax and monetary rules were built, the Constitution page has the text.

The case in brief

1. Inflation is a fall in what each dollar buys, and it works as a tax: it moves purchasing power from those who hold wages and cash to those who hold assets or receive new money first.
2. The arithmetic is unforgiving. A flat $50,000 paycheck loses about $8,865 of value after four years of 5 percent inflation, and about $10,300 after three years of 8 percent; even a steady 3 percent raise leaves the worker about $3,700 behind.
3. The tax is regressive because lower-income families spend more of their budgets on food, energy and rent, and because they hold fewer assets that rise with prices; in our worked example the same year costs one family 6.8 percent and another 4.4 percent.
4. The Cantillon effect explains the direction of the transfer: those closest to new money spend it at old prices, and those furthest away pay the new ones.
5. When inflation cools, prices do not fall back. The loss is permanent unless real incomes grow beyond it, so the only honest fix is sound money and a budget that does not depend on quietly shrinking the dollar.

What you can do: look up your own household's biggest categories (food, energy, rent) in the BLS Consumer Price Index tables, compare their rise to your last raise, and send that comparison to your member of Congress with a question about the deficit.