Inflation and Taxes – A Primer

 Inflation and Taxes – A Primer
By: George Noga – September 20, 2010

         So – you think you understand inflation and taxes? Well, you are about to read analysis you haven’t seen anywhere else. There are counter-intuitive aspects to this twin-headed monster, both heads of which are brought to us exclusively by government. This exposé about taxes and inflation is part of our focus on the crisis of spending, debt and deficits. One possible outcome of the crisis is the government will monetize the debt by printing money and presto – we have high inflation. The last inflationary spiral under President Carter peaked at 15%. It likely will be worse next time.

“Inflation is an immediate and real cost; it affects not just your expenses but also your capital.” 
          Because we mistakenly believe we are familiar with inflation, it sometimes is necessary to look at it from an entirely different perspective to gain the needed insight. We will consider two examples. The first illustrates the impact of 7% inflation on a just-retired couple age 65 with $1 million of investable assets. Our retirees have no debts and own their home with no mortgage. They take 5% (actually far too much) from their investment portfolio and receive $24,000 social security; hence, their income is $74,000. Their living expenses are a modest $4,000 per month. They have it made; don’t they?
          From their $74,000 income we subtract living expenses of $48,000. Of course, they pay income taxes which at today’s rates would be $12,000; this makes their total cash outflow $60,000. Thus, they have a cash surplus of $14,000 after their first year of retirement. They can look forward to a carefree life of leisure; right? There is one niggling oversight, i.e. they failed to account for inflation. Unfortunately inflation is an immediate and real cost; furthermore, it batters and bloodies not just expenses but also capital.
Everyone understands that with 7% inflation something that formerly cost $100 now costs $107. What precious few people grasp is that inflation also savages capital. Hence 7% of the $1 million portfolio must be viewed as the cost of inflation during the first year of retirement. This $70,000 must be deducted from our retirees’ income and added to their capital; otherwise, they are devouring their principal and their capital loses purchasing power and rapidly is dissipated.

“After properly accounting for inflation, our retirees’ $14,000 surplus transmogrifies into a first year deficit of $56,000.”

          After properly accounting for inflation, our retirees’ putative $14,000 cash surplus transmogrifies into a first year deficit of $56,000. Our retirees’ story does not have a fairytale ending. Their principal increases for the first several years; but as inflation compounds (it is an exponential function) their capital inexorably begins to plummet and all too soon their once seemingly formidable capital base is totally gone – poof!

The Grotesque Mathematics of Retirement, Taxes and Inflation

          We now move on to an example of Mr. and Mrs. Ritz, fairly wealthy new retirees with a stash of $3 million in investments. The Ritzes have no debts and no home mortgage; they spend $10,000 per month for living along with income taxes of $30,000 in the first year of retirement. With the same 7% inflation, investments valued at $3 million must double to $6 million in 10 years just to maintain purchasing power parity. At 7% inflation for ten years, the value of the dollar is cut in half. This is akin to a tax on capital of $3 million.
           But whoa! The Ritzes haven’t yet factored income taxes into the equation. They would have to increase their assets not just to $6 million but to $8 million to allow for the ≈$2 million of taxes on the phantom, tax and inflation-induced investment gain of $5 million – from $3 million to $8 million. In the Ritzes’ first decade of retirement, $3 million of capital would have to grow to $8 million pretax – or by a compound rate of 17% – just for them to remain even with the ravenous tax and inflation monster. Even if the Ritzes made the $5 million ($500,000 per year), they would have gained nothing; this is the utter horror of taxes and inflation.

“Even if the Ritzes made $5 million in 10 years, they would have gained nothing; this is the utter horror of taxes and inflation.”

          Believe it or not, it gets even worse. The preceding data assume the Ritzes do not take any money out of their investments to pay for living expenses. If they take 5% a year out for expenses, they now need to earn about 21% – 22% per year just to break even – just to tread water. This is an impossibility; even Warren Buffet has averaged only between 15% and 18%.
          The preceding discussion focused only on the Ritzes’ first decade of retirement; imagine what fate would befall them in twenty or thirty years. They undoubtedly worked hard, saved money, lived within their means and had every expectation of a lengthy, happy and worry free retirement. Instead, they were brought to perdition by their own government via the train wreck of high taxes combined with the stealth tax of inflation.

Four Horsemen of the Apocalypse

            Prominent liberals and big government apologists writing in the blogosphere have opined with approbation that a decade of high inflation could be an acceptable solution to the debt crisis. One wonders if they comprehend the mortal damage to the fabric of our republic that 10 years of double digit inflation would wreak. If they, like you now should, comprehended the horrors of inflation, they wouldn’t write approvingly.
            As noted in The Crisis of Spending, Debt and Deficits (available on our website), inflation is but one of four major possibilities after the crisis reaches critical mass. I am reminded of the four horsemen of the apocalypse from the Book of Revelation. The four horsemen appear when the lamb (Jesus) opens the first of four seals of a scroll of seven seals. As each of the first four seals is opened, a different colored horse and its rider is seen by the apostle John.

“The four horsemen of the apocalypse today could auger inflation, deflation, repudiation and economic collapse.”

            When the first seal is opened a white horse appears; its rider is holding a bow symbolizing conquest. As the second seal is opened a red horse appears; its rider holds a sword for war. The third horse is black with its rider holding scales revealing famine. The fourth seal is opened and a pale horse appears; its rider is called death. Today, instead of conquest, war, famine and death, we may substitute inflation, deflation, repudiation and economic collapse.