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:

a) Taxes must climb to confiscatory levels; or

b) Promises to retirees must increasingly be broken; or

c) The currency must be destroyed (through monetizing the deficits without sufficiently raising taxes), or

d) All of the above

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 first difference between this and the historical chart is that there is a lot more red. Not only in the inflation column, but the tax column as well. An inflation rate of 10% means that for a $100,000 investment you need to earn at least $10,000 over the year, just to have your money be worth the same as it was when you started the year. A lower rate of economic growth means that most investments that are based on the economy (and most are, in one form or another) won't be earning quite as much in real terms - $2,000 for this illustration, instead of $3,000.

To achieve this $2,000 real gain - we need to earn $12,000. Any less, and we don't get a real gain. For instance, earn just $6,000, then take off $10,000 for the dollar being worth 90 cents at the end of the year, and you didn't make $6,000, but lost $4,000. Make $9,000, then take off $10,000, then you just lost $1,000 in real terms. (The earnings themselves also need to be discounted for inflation, but we're trying to keep it simple here.)

Even though we are earning less money in real terms ($2,000 versus $3,000), the amount of nominal income that we are taking in has risen substantially, from $7,700 to $12,000. Which means that our taxable income just jumped substantially. Just in time for a substantial increase in the taxes on capital gains. Uh oh.

If we pay 25% tax on $12,000 in taxable earnings, then our taxes are $3,000. Of which, as shown in the chart, only $500 is real after-inflation earnings, and $2,500 is taxes on your attempts just to maintain the purchasing power of the assets that you started the tax year with. In other words, the government's tax on the destruction of the value of its own currency is a full 5 X larger than the tax on your real (after-inflation) earnings. (It's almost a little hard to see the blue of taxes on real income in the tax bar of the graph, because it is dwarfed by the inflation taxes that constitute 83% of the tax burden.)

Unfortunately, as you only had $2,000 in real earnings to begin with, but your taxes are $3,000 - you end the year with a $1,000 loss in the after-tax and after-inflation value of your savings (12% earnings less 3% in taxes is 9% net - but the value of your money dropped 10%, so you are 1% behind). This is shown on the graph by the light blue bar falling beneath the $0 mark. What the current rate of inflation does, when combined with a higher capital gains tax rate, or existing ordinary income tax rates, is to not only confiscate 100% of your real earnings, but actually take some of the starting value of your assets as well.

Now, keep in mind that you really did make money pre-tax in this example, just as we would expect the sum of all investors to make money in an economy that is growing. But because, with a sufficiently high rate of inflation - like we are experiencing today - the government fully taxes illusory income (income that does not exist in purchasing power or inflation-adjusted terms), that means that the government is able to not only seize all economic gains, but to also help themselves to part of the value of your starting assets.

Compare the effective tax rates in the chart below:

While you may not be used to seeing financial results presented in this manner, the chart above is not that difficult to follow, nor are our assumptions unrealistic. Just take the highest official inflation rate in 27 years, add in a projected reduction in long-term real economic growth rates for an aging population, and modify for the increase in taxes being proposed by a leading presidential candidate.

Again, this is no abstract theory, nor speculations about the distant future. This is real and this is today. For one example of how it could be worse, let's assume we are in a real recession (as we are), and we lose 2% a year in real terms, even as inflation is at 10%. What that means is that our nominal income becomes 8% a year (10% - 2%). However, the government does not include the inflation losses that occur as a result of its monetary and fiscal policies, but fully taxes you on the 8%, either at the (proposed) new capital gains tax rate of around 25%, or at a higher ordinary income tax rate. So you pay 2% of your net worth in taxes for the privilege of losing 2% on your investments.

The higher the rate of inflation, and the higher the tax rate, the more not only of income, but of your investment principal, that the government takes each year. This is illustrated in the chart below, where the red blocks all show confiscatory tax levels (all real income is taken, as so is part of the initial investment value).

Compounding The Problem

Let's go back to our example of the discrepancy between nominal compounding rates ("nominal" meaning inflation is not taken into account), and real after-tax and after-inflation compounding. If we simply take the naïve approach of compounding our 12% annual earnings, then $1.00 becomes worth $52.80 in 35 years! This $51.80 in compounded wealth is much better than the mere $12.41 we saw with 7.7% compounding, even if we do have to discount more inflation (or so most people would see it.)

However, when we do explicitly consider the intertwined effects of higher inflation and higher tax rates on inflation, then as we saw, our real after-tax and after-inflation return drops to a negative 1% per year. When we compound a negative 1% return for 35 years, then a dollar becomes worth 70 cents. So not only does our entire $51.80 in exponentially compounded wealth disappear, but the real purchasing power of 30% of our starting savings has gone as well.

In other words - the higher the rate of inflation, the more mistakes that will be made by the average investor, and the more disastrous the consequences for those who fail to understand these principles. The higher the inflation rate, the higher the financial price that you personally may pay for not knowing the principles for self-defense from inflation taxes.

As stated in the introduction, this is a non-political article about an intensely political subject. What creates the inflation tax is inflation, and Obama certainly can't be personally blamed for the long series of decisions that have led to the current inflationary crisis, nor can he be blamed for decades of impossible promises made to future retirees, that have created the looming Social Security, Medicare and pension crises. Simply refusing to raise taxes - without accompanying draconian cuts in future social benefits - has its own problems, because that approach accelerates the destruction of the value of the dollar through increasing inflation rates as government deficits are effectively monetized. There is no simple way out of the dilemma we all face, and while the particular choices made by whoever wins this and the following elections will be crucially important to determining how these factors play out in the future, these factors will exist regardless of who is elected. Indeed, the issues involved go far beyond the current presidential campaign in the United States, these relationships between real tax rates and inflation, are a problem with implications for many political parties across many nations.

Four Times The Penalty - Four Times The Benefits

As shown in the chart that compared historical and near future inflation tax rates, the real tax rate on capital gains next year may be four times higher than the average tax rate of the last several decades. Every time you see another banner headline that talks about the highest inflation rate in 17 years or 27 years - keep in mind that your real tax rate is jumping with every one of those headlines (even absent any increase in the nominal capital gains tax rate). That said, what can you do?

An excellent first step is to start by choosing asset classes that offer genuine inflation protection - and tangible assets are a good choice. However, tangible assets by themselves are as vulnerable to inflation taxes as any other kind of investments. To beat inflation taxes requires another essential step - and that is quite simply education. For something else goes up when the effective tax rate climbs by a factor of four - the cost of being unaware and uneducated just rose by four times.

If you are unaware, then your relationship with inflation taxes will be the same as most of the population - an unknowing victim.

The good news is that if you are fully aware of inflation taxes, and are willing to take personal action with your knowledged, then some of the powerful wealth destroying effects of this most unfair of taxes can be reduced or neutralized. Indeed, inflation taxes can be reversed, and in some circumstances, used as an actual wealth creation tool.

To achieve this ability will first require looking inflation straight in the eye and saying: "Inflation, you are likely to play a big role in my personal future, and instead of ignoring you or thoughtlessly flailing away at you - I will study you and your ways. I will learn the deeply unfair ways in which you redistribute wealth, and the counterintuitive lessons about how some investors will be destroyed by inflation and repeatedly pay taxes for the privilege, even while other investors are claiming real wealth on a tax-free basis. I will learn to position myself so that you redistribute wealth to me, and the worse the financial devastation you wreak - the more my personal real net worth grows. I will examine the official blindness to inflation within government tax policy that creates the Inflation Tax, and instead of raging or despairing, I will understand that a blind opponent is a weak opponent, and I will take advantage your blindness and use tax policy to multiply my real wealth."

(This is the shorter version of a longer article. The longer version is available through the free Turning Inflation Into Wealth mini-course.)

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.