A government's optimal mix of tax and seigniorage revenues tilts towards inflationary finance as the ruling party is less inflation-averse, the cost of tax collection larger, tax evasion more widespread and financial repression greater. In Discussion Paper No. 741, Roel Beetsma and Research Fellow Frederick van der Ploeg develop a model of an unequal but democratic society in which a minority holds much of the debt, so a government representing the median voter has an incentive to create `surprise' inflation to erode its real value. When a government can commit itself, money growth and inflation are higher the greater are the output costs of an inefficient tax system, or if output costs from inflation or growth-corrected real interest rates fall. The distribution of assets has no effect. Under `discretion', however, inequality further motivates inflation surprises to redistribute wealth to the relatively poorer median voter. Since rational agents anticipate this, nominal interest rates are higher and welfare lower the greater is the inequality.

Beetsma and van der Ploeg regress average inflation during 1960-85 on two measures of inequality and find a significant positive relationship for democracies but no relationship for non-democracies, while the raising the public debt/GDP ratio also raises inflation. Also, in countries with high population growth much debt is held by relatively small groups of elderly and retired, which motivates surprise inflation, while the many OECD countries with greying populations should expect low inflation and high taxes. Capitalist dictatorships will combine high inequality with low inflation to protect rentiers' interests, while populist dictatorships will serve working class interests and induce high inflation. Finally, even anticipated inflation can have real effects if wages, pensions and benefits are not fully and immediately indexed to prices, and inequality in democracies will tend to reduce such inflation if it hurts the poor more than the rich.

Does Inequality Cause Inflation? The Political Economy of Inflation, Taxation and Government Debt
Roel M W J Beetsma and Frederick van der Ploeg

Discussion Paper No. 741, November 1992 (IM)