The Olivera–Tanzi effect, occasionally called the Olivera effect or the O-T effect, is an economic situation involving a period of high inflation in a country which results in a decline in the volume of tax collection and a slow deterioration of real tax proceeds being collected by the government of that country.
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Definition of the effect
The most simple definition of the Olivera–Tanzi effect is as follows. During any period of high inflation, governments upkeep costs for everything rises. However, since inflation hurts both trade and diminishes buying power of the consumer, business revenues fall. The actual real tax proceeds gathered by the government, after adjusting for inflation, will be less than in a period of normal inflation, due to both increased operating costs and decreased tax revenues from businesses.
Importance
The primary importance of the O-T effect is the havoc it can wreak on unprepared economies that are hit suddenly with large amounts of inflation. This was common after World War I, when the first research was done. It became common again in the era of the World Bank and relief loans to Third World countries, who ended up taking on huge amounts of debt with no way to get out from under them while struggling with inflation.
Research
The effect has been known, informally and without much careful research, since the ending period after World War I, but two researchers Julio Olivera at the University of Buenos Aires, and Vito Tanzi who was then involved with the Economic Reform Project of the Carnegie Endowment for International Peace) were the first ones to put a good deal of research into it and formulate a paper on the subject, later working with the Group of Thirty to refine it.
Subsequent research has shown the O-T effect to be very wide ranging, but that its effects can be mitigated by proper macroeconomic measures taken to ensure a slow but steady decrease in inflation. Once inflation is reduced, the revenue will recover.