We have taken a look at the effect of inflation on your money’s purchasing power and the importance of having some your assets in stocks, bonds, or an investment vehicle that is indexed to inflation. Clearly, it is not possible to have all cash reserves indexed or protected against inflation. Inflation has many ways of decreasing purchasing power, and these effects are collectively referred to as the Inflation Tax. The inflation tax is a form of seigniorage, or all the revenue the government obtains due to its power over the creation of central bank money. Seigniorage itself is a very complicated topic; however, I think the effect it has on an individual is meaningful.
The first and most obvious way the inflation tax affects the individual is by decreasing your purchasing power. If a person held $100,000 for 5 years with an inflation rate of 5%, then by the fifth year the real value of the $100,000 would be $78,353. This is considered a tax because the government is the biggest debtor in our nation. For every dollar of purchasing power that the individual citizen loses, the government gains. This is the equivalent of a wealth transfer to the government, or a tax. In our previous scenario, the individual has been “taxed” $21,647. Of course, the simple solution to this is to put extra money into inflation protected assets. However, this does not work if you are an employee with a long-term contract for salary. If you earn $100,000 a year for 5 years per your contract, then by the fifth year you will only be earning $78,353 in real money. This highlights the importance of indexing contract pay to inflation.
We have said that the simple solution to protect against inflation is to put cash into assets like stocks and bonds indexed to inflation, or Treasury Inflation-Protected Securities (TIPS). This should work right? Well…the answer is not a definitive yes. Let’s say that you have $1,000,000 in stocks, and you earn a return of 5% for five years with an inflation rate of 5%. By the fifth year you would have $1,276,282 in nominal value but only $1,000,000 in real value. This is perfect. You have successfully protected your assets against inflation, right? Yes and No. You can see that in a scenario such as this you can increase your nominal value and earnings a lot while only maintaining your real value and earnings. However, the tax brackets stay right where they are. It is possible to jump into a higher tax bracket while not increasing your real value of wealth one penny. Again, these extra tax dollars go straight to the government. While it may not have a huge impact for the government, it can and does affect individuals quite a bit. It also affects how sophisticated investors choose to invest.
One thing I need to get better at is structuring my investments for the best possible tax advantage. Taxes can certainly diminish long term wealth building. If your investments are in a tax-advantaged account, then you do not have to worry about jumping into higher tax brackets due to inflation. This can mean a difference of millions of dollars over a lifetime. If you started with $100,000 at age 20 and invested that money at a rate of return of 10% until age 65 then you would end up with $7,289,048. If taxes reduced the total return rate to 7% then you would only end up with $2,100,245.
Some of these losses to the individual due to inflation are offset if the individual has fixed rate debts such as a fixed rate mortgage. Eventually they will be able to pay off their debt with weaker dollars and save themselves money. They are in effect short the US dollar with fixed rate debts. The inflation tax isn’t all bad though as a steady inflation rate can promote economic growth which provides many benefits of its own such as decreased unemployment rates. That is what we are taught in the textbooks at least. For the individual… deflation can be a powerful tool, especially for savers. However, deflation has a downright menacing effect on the government due to their huge debt burden. It’s no wonder the Federal Reserve is petrified of deflation!