The reduction in the basket of real goods she is now getting as a result of inflation is similar to a tax she has paid to the government. In this case, the tax is equivalent to four hours of her time. It is not different from a rule requiring the teacher to work four hours a day for the government for nothing! That rule obviously reduces her welfare. She undergoes this reduction of her welfare not on her own accord, but involuntarily. Such involuntary reduction of welfare in favor of the government has been caused by inflation and, therefore, known as inflation tax. BIS Review 64/2007  1  How is the inflation tax imposed? Governments have appointed either central banks or currency boards as their agents for producing and supplying currency. Unlike currency boards which have to maintain a hundred percent reserve of valuable assets (gold and hard foreign currencies such as Dollars, Euros or Sterling Pounds) for issuing currency, central banks are peculiar animals. They do not have to have a reserve of an equivalent amount and can issue currency simply by making book entries. In other words, they can acquire any asset by assuming a liability on account of the currency they have issued. For instance, if a central bank has to acquire a building, all it has to do is to open its vault and issue the required amount of currency to the seller of the building.
But, borrowing from the central bank is just a single transaction and the Treasury could use it immediately for making payments. Second, because of the limitations of the tax bases in developing countries, there is resource paucity for governments to undertake much needed infrastructure projects. Hence, it has been argued that the governments in developing countries could initiate the development efforts by mobilizing resources through inflation. The initial inflation so created would get reversed once the new economic development increases the production of goods and services and raises the market supply. So, inflation would become a self-destroying process and, therefore, it is argued that there is no danger of using inflation for economic development. Third, taxes are mandatory payments and therefore, there is resistance on the part of tax payers to pay the taxes. Because of the pressure coming from the lobbying groups, political authorities too sometimes are unwilling to raise the tax rates to generate higher tax revenue. However, the resistance of the citizens to inflation tax is virtually nonexistent. This is because no one realizes that they are paying a tax to the government, when the prices move up. Any resistance by them is not against the  2  BIS Review 64/2007  inflation tax per se, but against the inflation. That again takes place after sometime when they have been very badly hit by inflation. Fourth, inflation is said to be bringing about some salutary effects to an economy from the point of view of its long term growth.