This quote, purported to be from Warren Buffett, appeared recently in my Twitter feed.
“The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislature”
Most people are sensitive to tax and work at reducing the cost. Should you consider inflation in depth while planning your future?
As Buffett suggests, the arithmetic is very persuasive. A problem is that it is unclear who gained the benefit from what you lost. Let’s see what happens over long times anyway.
Suppose you could invest in equities and further suppose that you can earn 8% including capital gains and dividends. About the net long rate of return for the S&P 500. We assume an average effective tax rate of 25%. As we will see, the result is interesting and worthy of management.
If you pay just the tax each year, after 50 years you will control capital that is 39% of what it would be with no tax. When you consider that you owned 100% of the capital in the beginning, that is a significant loss. Do not miss any tax saving techniques that you have available to you.
Now look at inflation at 2.5% throughout the period. Close to the long term rate. With no taxes on income, the purchasing power of the capital you have at the end is just 29% of the ideal result of no tax and no inflation. Clearly inflation hurts more than a tax at 25% of income.
The reason of course, is that income taxes attack income, but inflation attacks both income and capital.
Now for the worst case. Both taxes and inflation. You keep 11% of the ideal amount. Still a little over five times your beginning capital. Here in the real world, this is your normal condition. Lose 89%.
When you realize that you save and invest to provide lifestyle and lifestyle depends entirely on purchasing power, inflation seems a worthy target for planning.
There are a few approaches. Every case will be different and will depend on your relationship to risk and your skill, time frame and other structural considerations.
First notice what happens if you cannot invest for more than the inflation rate. If you buy bonds that yield 4.5% in a 2.5% inflation world and pay taxes on interest at an effective rate of 35%, you will end up with just 1.2 times your original purchasing power in 50 years. You will have the same purchasing power or less at tax rates over 44%. That means you will be forced to save a great deal to have enough to live on in the future.
You know about investment alpha and you get the idea of tax alpha, now think about inflation alpha.
- Find investments that grow with inflation. There are several varieties. Stocks, precious metals sometimes, real return bonds, and real estate are the easiest to see and find. These are not idiot proof, but bank deposits and bonds offer no hope. They may be guaranteed, but the only guarantee you can rely on is the guarantee of the most they are going to pay you.
- Find ways to reduce your effective tax rate. If you grew your money at some rate and paid the taxes only at the end, the effective rate would be much lower. You would have earned income with money ordinarily paid in tax. Look for tax sensitive investments.
- Use leverage to minimize the effect of inflation. This is not for everyone. There are risks that you may not want to assume. Markets fluctuate in value while the principle you owe on a loan is an absolute number. Leverage works for some though and should not be dismissed just because Dave Ramsey says debt is always a bad idea. Seriously Dave? When you owe money, you pay it back someday, possibly in the far future and you pay back with money that is not worth as much as it was when you borrowed it. If the interest is tax deductible as you go, the time cost is not as material. To see the advantage of leverage means working out a big arithmetic question and making a decision. Then paying attention. Consider it.
Saving, investing and balancing capital with lifestyle needs and security is a difficult process. Consider all the variables that you can influence and you will find that yield, tax rate and inflation effects are at least partly within your control.
Use your controls.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772