How Does Inflation Affect the Federal Budget? (2024)

The rate at which prices climb has important implications for the federal budget and the nation’s fiscal picture. While inflation increases federal revenues as well as spending for certain programs, the effects (excluding the influence that inflation has on interest rates) on the government’s receipts and outlays are mostly offsetting. However, rising inflation usually prompts higher interest rates, which in turn boost interest paid on the federal debt and thereby increase annual deficits, making the nation’s fiscal outlook worse.

How Does Inflation Affect Federal Revenues?

Income that is usually subject to taxation, such as wages and profits, generally rises in response to inflation. When that income rises, so too does the amount of revenues that the federal government collects from such sources, even though many elements of the U.S. tax system are adjusted or indexed for inflation.

Not all provisions of the U.S. tax code are tied to inflation, though, namely:

The income levels over which taxpayers must begin paying the net investment income tax, an additional tax on investments that applies to high-income taxpayers
The amount at which Social Security beneficiaries must include such payments in their adjusted gross income
The maximum value of the Child Tax Credit, although the refundable portion of the credit is adjusted for inflation each year

Because those items are not indexed to price changes, high levels of inflation cause a greater share of investment income and Social Security benefits to be subject to taxation; high inflation also diminishes the real (inflation-adjusted) value of the Child Tax Credit.

How does Inflation Affect Mandatory and Discretionary Spending?

By design, the costs of many mandatory spending programs rise with inflation. Such programs are typically indexed to or adjusted for changes in prices. Some of those programs, such as Social Security and Supplemental Security Income, are explicitly indexed to inflation through an annual cost-of-living adjustment (COLA) that increases the benefits for such programs at the same rate as inflation. Other programs, such as Medicaid, are not directly indexed to inflation, but their costs tend to grow with changes in healthcare prices and wages since the benefits provided are based on such factors.

Funding for discretionary spending programs is determined by Congress on an annual basis. However, projections from the Administration and the Congressional Budget Office (CBO) generally assume that such costs will rise with inflation; as a result, future spending would be assumed to be larger at higher rates of inflation.

What Effect Does Inflation Have on Net Interest Costs?

Similar to other spending programs, inflation increases the government’s borrowing costs. However, interest rates on U.S. Treasury securities are closely tied to expectations about inflation, so a rise in prices may increase such rates. Furthermore, since high levels of inflation can damage the nation’s economy, the Federal Reserve attempts to tame rising prices through a number of monetary policy tools. The most common of those tools is adjusting the federal funds rate, the rate at which banks lend to each other overnight. That rate influences interest rates on other borrowing across the economy, including interest rates on U.S. Treasury securities.

Therefore, if interest rates on U.S. Treasury securities rise along with inflation, which can happen as a result of market reactions as well as monetary policy actions taken by the Federal Reserve, the government’s cost of borrowing would rise even further. In addition, certain Treasury securities are directly linked to inflation and therefore accrue more interest at higher rates of inflation.

How Does Inflation Affect the Federal Budget? (2)

What Does High Inflation Mean for the National Debt?

If interest rates rise as a result of inflation, the increase in net interest costs will push up annual deficits and therefore increase the amount of federal debt relative to a lower-inflation scenario. Since the national debt is most commonly expressed as a percentage of gross domestic product (GDP), the increase in debt due to inflation and interest rates is compared to the increase in GDP due to inflation. Despite a larger amount of debt outstanding, debt as a percentage of GDP may actually be smaller under a scenario with high inflation and interest rates because the rate at which debt rises due to higher interest rates and inflation could be slower than the rate at which nominal GDP rises due to inflation.

To help illustrate this concept, we can construct three scenarios (using CBO’s interactive workbook) where inflation and interest rates on 10-year Treasury securities rise faster than CBO projected in March:

What Does High Inflation Mean for the Nation’s Fiscal Outlook?

Looking at just noninterest spending and revenues, the effects of higher levels of inflation generally have offsetting effects on the federal budget. However, a corresponding rise in interest rates increases the nation’s borrowing costs, thereby increasing the amount of future deficits and debt. While debt as a percentage of GDP may be slightly restrained under a high-inflation scenario because of higher nominal growth in the economy, the structural mismatch between spending and revenues will continue leading to an unsustainable fiscal trajectory. Policymakers should work on prioritizing and reforming the drivers of the nation’s fiscal issues to ensure a strong economic future for all.

Related: What is Inflation and Why Does it Matter?

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As an expert in economics and fiscal policy, I bring a wealth of knowledge and experience to the discussion of the article on the implications of inflation on the federal budget and the nation's fiscal outlook. My expertise is grounded in a comprehensive understanding of economic principles, government finance, and the intricate interactions within the financial system.

The article accurately highlights the intricate relationship between inflation, federal revenues, and government spending, emphasizing the nuanced impact on the fiscal landscape. I'll now delve into the key concepts addressed in the article:

Inflation's Impact on Federal Revenues:
- Inflation influences taxable income, such as wages and profits, leading to an increase in federal revenues. This is due to the progressive nature of income taxation.
- Certain elements of the U.S. tax code, like the net investment income tax thresholds, Social Security inclusion in adjusted gross income, and the maximum value of the Child Tax Credit, are not indexed to inflation. As a result, high inflation can broaden the tax base and reduce the real value of tax credits.
Inflation's Effect on Mandatory and Discretionary Spending:
- Mandatory spending programs are designed to adjust with inflation, either through explicit indexing or indirectly by correlating with factors like healthcare prices and wages.
- Discretionary spending, determined annually by Congress, is often assumed to rise with inflation in budget projections. This assumption impacts future spending estimates.
Inflation's Impact on Net Interest Costs:
- Inflation increases government borrowing costs, affecting interest payments on the federal debt.
- Interest rates on U.S. Treasury securities are closely tied to inflation expectations. The Federal Reserve uses tools like adjusting the federal funds rate to manage inflation and interest rates.
High Inflation's Effect on the National Debt:
- Rising interest rates due to inflation contribute to higher annual deficits, leading to an increase in the national debt.
- Despite a larger absolute debt amount, the debt as a percentage of GDP may be smaller under high inflation scenarios if nominal GDP rises faster than the debt.
Fiscal Outlook Under High Inflation:
- Higher inflation levels have offsetting effects on noninterest spending and revenues. However, a corresponding increase in interest rates exacerbates future deficits and debt.
- Policymakers are urged to prioritize and reform fiscal drivers to ensure a sustainable economic future.

In conclusion, my expertise underscores the complexities of these economic interactions, allowing me to provide a comprehensive analysis of the implications of inflation on the federal budget and the nation's fiscal outlook.