When central banks print notes and issue credit, they increase the amount of money available in the economy, usually as a reaction to worsening economic conditions. Through a change in real money balances, this causes inflation. Financing expenditure in this way is called seignorage and the effect of increasing the money supply and causing the holders of money to pay an inflation tax is the most obvious cost of inflation.
If the annual inflation rate in the United States is 5%, one dollar will buy $1 worth of goods and services this year, but it would require $1.05 to buy the same goods or services the next year; this has the same effect as a 5% annual tax on cash holdings, provided there is 0% economic growth, or other price-reducing factors, such as efficiency-enhancing technology. With price reducing factors at play, a 5% inflation rate indicates a tax rate of higher than 5%.
Governments are almost always net debtors (that is, most of the time a government owes more money than others owe to it). Inflation reduces the relative value of previous borrowing, and at the same time it increases the amount of revenue from taxes. Thus it follows that a government can improve the debt-to-revenue ratio by employing inflationary measures.
However, if the government continues to sell debt, by borrowing money in exchange of debt papers, these debt papers will be affected by inflation: they will lose their value, and therefore they will become less attractive for creditors, until the government will not find any willing to buy debt.
An inflation tax does not necessarily involve debt emission. By simply emitting currency (cash), a government will induce liquidity and may trigger inflationary pressures. Taxes on consumer spending and income will then collect the extra cash from the citizens. Inflation, however, tends to cause social problems (e. g., when income increases more slowly than prices).
Although not meant by the term "inflation tax", a related effect is the tax on interest and investment "income" when the tax is levied against the nominal interest rate or nominal gains.
For instance, if someone buys a bond with a nominal interest rate of 6% and the rate of inflation is 4%, their "real" interest is 1.89%.
If, however, they are taxed 25% of the 6% interest "income", or 1.5%, this can be thought of as composed of a tax on real income (0.5%) and a tax on inflation (1.0%). The same principle applies to capital "gains" taxes not adjusted for inflation. In any case, this "tax on the inflation tax" is essentially equivalent to a tax on holdings ("wealth tax") equal to the nominal tax rate times the inflation rate (in example above, 25% of 4% inflation equals 1.0%.) This "property tax" can even apply to non-monetary assets as well as money earning interest. Thus, money itself is subject to both the inflation tax and the tax on the inflation tax, while other assets, on which nominal profit or gains taxes are imposed, are subject only to the tax on inflation.
Another negative effect of this tax is that even inflation-indexed bonds carry inflation risk, as the inflation compensation is taxed.
If there is a negative real interest rate, it means that inflation is more than the interest. Suppose if the Federal funds rate is 2% and the inflation rate is 10%, then it means that the borrower would gain 7.84% of every dollar borrowed.
Besides the negative side effects such as devaluation of the currency, inflation has a business cycle effect. According to the Austrian Business Cycle Theory, inflation creates malinvestment from malallocation of resources of debitors. It creates wasteful investment where inefficient businesses succeed by inflation.
Inflation benefits businesses because they can lend the newly created money first. Poor people are last to get the money, and they invest less, and so are hurt the most by inflation.