Overview
US presidential candidate Barack Obama has proposed increasing the capital gains tax from 15% to 25%. Unfortunately, the biggest component of investment taxes during inflationary times is not taxation of economic income, but taxation of the government’s destruction of the value of its own currency. As we will explore in the article below, the 1-2 combination of higher inflation and higher investment taxes may mean a quadrupling of the effective real tax rate in 2009. This will have the effect of turning the capital gains tax into an effective asset tax, where all real economic earnings plus a percentage of investment principal are taken through taxation – unless investors take self-defense measures.
Please note that this is a nonpartisan article about finance and economics, with no political judgments made, and with implications that go far beyond just the United States. The heart of the problem for the coming years is the bipartisan problem of impossible promises that the United States government has made for Social Security and Medicare – promises with equivalents that are even more impossible in many other developed nations. At some time over the coming years, regardless of who is elected, either:
The Essence of Inflation Taxes
The essence of inflation is that the value of the dollar (and other currencies) is worth less every year. To keep the same net worth means that you have to earn enough money that year to offset the loss in purchasing power of your investment. Briefly, if you have a $100,000 investment, and inflation takes 10% of your purchasing power, then at the end of the year, your $100,000 will only buy $90,000 worth of goods and services.
$100,000 - $10,000 inflation loss = $90,000 purchasing power
To break-even then, you must earn $10,000.
$100,000 - $10,000 inflation loss +10,000 earnings =
$100,000 purchasing power
To achieve a real profit – you must earn more. So that if you want to come out ahead by $4,000, then you have to earn $14,000 instead of $10,000, to compensate for your (very real) inflation loss.
$100,000 - $10,000 inflation loss +$14,000 real earnings =
$104,000 purchasing power
Moving our need for investment returns from 4% up to 14% just to achieve a real return of 4% in what our investment will buy for us is challenging enough. Unfortunately, we have been leaving out a rather important “technicality” – we don’t keep what we earn, we keep what we earn after paying taxes. And the government doesn’t see $4,000 in income in our simple example above – but $14,000 in income, all of which is taxable. Effectively, the government taxes us not just on our real earnings, but on the government’s destruction of the value of its own currency.
The amount of damage inflicted by this grossly unfair inflation tax is based on the combination of three factors: the inflation rate, the tax rate, and the real (after-inflation) return on investment. Using historical statistics, we will demonstrate below that the existence of the inflation tax means that the average person has achieved much lower real returns over previous decades than usually stated – and the situation is likely on the verge of getting much worse, perhaps four times worse within the year.
The Past: Lower Inflation, Lower Tax Rates
(For this analysis of the real effects of increasing capital gains tax rates during a time of increasing inflation, we will use a methodology developed at more length in the article “Real Investment Tax Rate Is 256% Higher Than Stated”. Hopefully, the methodology will be clear even without reading this earlier article.)
For our historical case, we will say that as an owner of the economy, an average investor earned the average economic growth rate of the economy in real terms. This has been equal to about 3% on average in real terms – meaning after the effects of inflation have been subtracted (source: United States Bureau of Economic Analysis, q3 1972 to q3 2007). Over the last 35 years, inflation has cumulatively destroyed 80% of the value of the dollar (source: United States Bureau of Labor Statistics, 9/72 – 9/07). This 80% destruction of the value of a dollar (meaning a 2007 dollar will only buy what 20 cents did in 1972), is equal to a 4.7% annual drop in the value of a dollar, which is another way of saying our historical inflation rate averaged 4.7%.
If you owned investment assets that generated the same 3% after-inflation return that the overall economy did during those years, then there was really only one way to do so. You had to do the same thing the overall economy did from 1972 to 2007, and grow by a rate of 7.7% per year in total terms. It is a very simple relationship: the economy grows by 7.7% per year in simple (nominal) dollar terms, we subtract 4.7% per year because that is how much of the value of our dollars is being destroyed by inflation each year, and we are left with 3% real growth. (The relationships are actually multiplicative, not additive, but we’re keeping things simple, for better communication.)
In other words, you take your starting dollars, add your total returns, subtract how much of the value of your starting dollars was destroyed by inflation, and you are left with your real pre-tax gain (or loss). Not in simple dollars, but in purchasing power, or what those dollars will really buy for you.
Note the above key words “pre-tax”. What happens when we add the effect of taxes to the picture? When we take the current capital gains tax rate of 15% (which has not been constant over the last 35 years), what we get is the graph below:
As illustrated above, we take 3% in real income, add 4.7% in inflation, and we have a total return of 7.7%, or $7,700 in historical income and/or asset appreciation (which, by no coincidence, is not all that far off from what historical financial asset investment returns were over that time period). Take off 15% taxes of $1,155, and we are keeping 85% of the income, or $6,545. Seems straightforward enough, and that is exactly what appears on our tax returns, and in our checking and brokerage accounts. We make a 7.7% rate of return, or $7,700, we keep 85% of that return, and we pay out 15% in taxes to the government.
Except… that last bar on the right is a bit troubling. On the far left, our graph shows $3,000 in real pre-tax income. When we deduct the annual $4,700 loss on the value of our investment assets due to inflation’s steady destruction of the value of a dollar, earning $7,700 does leave us coming out only $3,000 ahead each year. However, on the right, our after-tax share of that $3,000 in growth is only $1,845. If we were truly paying only a 15% tax rate, then we would owe $450 in taxes on our $3,000 in real income, and would keep $2,550. This is shown on the bottom line of the chart beneath the graph, as well as the light blue portions of the bars.
Now take another look at that tax bar. Most of it is red, not blue. What that shows is that we have to pay taxes on the money we earn just to keep up with the government’s steady destruction of the value of it’s own currency. The 80% destruction of the value of the dollar between 1972 and 2007 worked out to a 4.7% annual loss, and if we were to just run in place, and keep up with that destruction, we had to earn 4.7%. The $705 in taxes on the 4.7% of illusory earnings that really just maintains the starting value of our portfolio in purchasing power terms (the red bar) are about 1.5 X higher than the $450 taxes on our real (after-inflation) earnings (the blue bar). So, when we add taxes on inflation to taxes on real income, then our total taxes of $1,155 are about 2.5 X larger than the nominal tax rate.
Meaning that we are only keeping 62% of economic growth, and the government has been taking not 15%, but 38% of the real growth in the economy through taxes. For the past 35 years, using official economic growth and inflation statistics, our effective tax rate has been about 2.5 X the official capital gains tax rate. (All of the steps are explained in more detail in the previous article referenced, “Real Investment Tax Rate Is 256% Higher Than Stated”.)
Reality, Not Economic Abstraction
If you’ve been an investor for many years, and it doesn’t seem like your real wealth, the purchasing power of your savings, has compounded like the newspaper columnists say it should have, or the financial planning models had predicted – this is why. The conventional financial planning approach, which ignores the effect of inflation taxes, is at its core, based entirely on the mathematics of exponential compounding. What inflation taxes do, even at moderate levels, is slash the rate of compounding.
If you take the economically naïve (but almost universally practiced) approach of compounding 7.7% for 35 years, then $1.00 becomes $13.41. Such is the magic of compound interest and financial planning! However, if you take the real world approach of looking at what your savings dollars will buy, after you’ve paid (only) 15% in taxes, then our after-inflation and after-tax compounding rate is 1.8%. When we compound 1.8% for 35 years, then $1.00 becomes worth $1.87. Meaning $11.54 out of our magical $12.41 in exponentially compounded wealth just went “poof” and disappeared.
This is no economist’s abstraction. The average price of an average house in June of 1972 was about $18,000 and the price of a gallon of gas in 1972 was 36 cents. Life and money do not get any more real than the difference between those prices then, and the prices we pay today.
The Future: Higher Inflation, Higher Tax Rates
You may have noticed several things about our historical analysis that don’t quite jibe with conditions today. Such as, even official government statistics are increasingly showing a rate of inflation that is surging out of control. As of June of 2008, the yearly Producer Price Index, the official measure of wholesale inflation rate reached 9.2%, which was the highest 12 month rate of inflation experienced since 1981. (The figure was much worse for June alone, with a 1.8% monthly price rise, which would be over a 21% rate of inflation if annualized). The July official measure of consumer inflation (the CPI) was less at 5.6% and a “mere” 17 year high, but consumer inflation levels tend to follow wholesale inflation levels. More importantly, it is getting harder and harder to find people who completely believe government inflation statistics, particularly those retirees who pay real bills based upon real price levels every month, even as the size of their checks are adjusted by the “official” inflation rate . (More on the powerful incentives for the government to subtly and not so subtly manipulate the way inflation is calculated, and the way that the pressure will build for still greater manipulations as the Boomers retire, can be found in my article “Inflation Index Manipulation: Theft By Statistics”.)
So let’s call the current real rate of inflation 10%, with that estimate likely being on the low side.
Another difference is that our economy is in many ways looking more like the 1970s right now, than it does the 1990s. Again, official government measures (in an election year) claim that the United States is not in a recession, but many people (perhaps most people) believe otherwise.
The short term issues of a recession in 2008 and 2009 are not the larger problem – which is that we have an aging population. A long-term economic slowdown caused by an aging population is not a particularly controversial assumption but fairly widely expected among economists. Indeed, even Benjamin Bernanke is on the record as saying (in an October 4, 2006 speech to the Washington Economist Club):
“In coming decades, many forces will shape our economy and our society, but in all likelihood no single factor will have as pervasive an effect as the aging of our population.”
“…the aging of the population is likely to lead to lower average living standards than those that would have been experienced without this demographic change”
“…each worker’s output will have to be shared among more people. Thus, all else being the same, the expected declines in labor force participation will reduce per capita real GDP and thus per capita consumption relative to what they would have been without population aging.”
A long-term reduction to a 1.5% - 2.0% real growth rate in the GDP is not particularly controversial among economists, so we will assume an economic growth slowdown to about 2% a year in real terms.
Finally, we have that very important consideration of what tax rates will be. Which brings us back to the start of our article, the 2008 election, and the proposed increase in the capital gains tax to 25%.
So start with the highest official inflation rate in 27 years, and round up just a notch. Add in the projected reduction in long-term real economic growth rates, as expected by the Chairman of the Federal Reserve, among others. Add in the increase in taxes being proposed by the presidential candidate currently leading in the polls. Take this combination of what could almost be called quasi-official numbers (and cases can be made for each of the three assumptions that they could turn out far worse in the next several years ahead), mix them together, and we get the chart below:
(The explanation of the chart above and the many consequences for investors can be found in Part II of this article.)
Do you know how to Turn Inflation Into Wealth? To position yourself so that inflation will redistribute real wealth to you, and the higher the rate of inflation – the more your after-inflation net worth grows? Do you know how to achieve these gains on a long-term and tax-advantaged basis? Do you know how to potentially triple your after-tax and after-inflation returns through Reversing The Inflation Tax? So that instead of paying real taxes on illusionary income, you are paying illusionary taxes on real increases in net worth? These are among the many topics covered in the free “Turning Inflation Into Wealth” Mini-Course. Starting simple, this course delivers a series of 10-15 minute readings, with each reading building on the knowledge and information contained in previous readings. More information on the course is available at InflationIntoWealth.com .
Contact Information:
Daniel R. Amerman, CFA
Website: http://InflationIntoWealth.com/
E-mail: mail@the-great-retirement-experiment.com
This essay and the websites, mini-course, books and audio recordings, contain the ideas and opinions of the author. They are conceptual explorations of general economic principles, and how people may – or may not – interact in the future. As with any discussion of the future, there cannot be any absolute certainty. What this website does not contain is specific investment, legal or any other form of professional advice. If specific advice is needed, it should be sought from an appropriate professional. Any liability, responsibility or warranty for the results of the application of principles contained in the website, pamphlets, recordings, books and other products, either directly or indirectly, are expressly disclaimed by the author.