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By Daniel R. Amerman, CFA
The higher the rate of future inflation – the more of your current net worth belongs to the government. Many investors do not realize the powerful financial incentives the government will have to boost inflation rates in order to pay for extraordinarily expensive Boomer retirement promises. From the government’s perspective, high inflation rates offer the ability to transform after-tax investor assets into pre-tax income, which can then be taken from individuals through the “Inflation Tax.” With substantial inflation, running the gauntlet of taxes once or twice is not enough, and even your after-tax net worth can be repeatedly raided under government tax policy, by using the pretext of non-existent income – that was itself created by government fiscal policy.
In this article, we will precisely demonstrate the way this deeply unfair wealth seizure strategy works, and the multiple levels of challenges it presents. We will review the particularly severe potential implications for conventional investors, and illustrate by example how the one-two combination of inflation and the inflation tax could mean that a DJIA of 75,000 by 2027 could translate into a 73% reduction in real investor net worth. We will briefly discuss investor solutions, some advantages of tangible assets, and close by introducing the concept of taking advantage of the government’s inflation blindness to Reverse the Inflation Tax, so that instead of paying real taxes on illusory income, investors can pay illusory taxes on real income.
A recent, well-publicized study by USA Today put the total of unfunded promises by federal, state and local governments at $59 trillion. That isn’t total promises or future dollars (which would be much higher), it is the present value anticipated shortfall compared to the current tax structure. The overwhelming majority of this total is federal promises to future retirees in the form of Medicare and Social Security.
That many trillions is hard to relate to, so USA Today put the numbers in per household terms. The average American household is in debt for $516,000 to cover unfunded government obligations, or more than four times the average mortgage and credit card debt per household. To pay off this debt, each household would have to pay $31,000 per year for the next 75 years. A link to this article is:
http://www.usatoday.com/news/washington/2007-05-28-federal-budget_N.htm
How will the impossible become the possible? One answer is that the system breaks down and collapses. The future could be multiple levels of government all reneging on their promises to retirees, as well as the major corporations. But, that is such a messy solution. Not just for average people, but worse – messy for the wealthiest and most politically powerful segments of our population. In fact, such a Doomsday scenario might jeopardize both their wealth and their power. It would also compound the problem through depressing the tax revenues, because everyone would be losing money, and you don’t pay taxes on (nominal) losses.
However, there is an alternative means of closingthe gap. A means that keeps the promises paid in form (if not in substance). A means that redistributes wealth from taxpayers to the government. A means that keeps the status quo intact. All you have to do is make it Doomsday for the value of the dollar – in the right way – and real costs (retiree benefits) will plummet, real tax collections will skyrocket, and the gap will close.
There are three intertwined methods the government can use in closing the fiscal gap through the use of inflation. The first is “Theft By Index Management”, where the official government rate of inflation rises at a different rate than the real rate, making inflation-indexed promises easier to keep each year. The higher the real rate of inflation, the faster this strategy delivers its benefits to the government. The second method is “Evaporate Paper Wealth Claims” where the government dilutes competing claims on future goods and services by retiree investors through making the real value of their assets plummet, even while their paper value soars higher than ever. Which opens the door for the third strategy, that we will devote the rest of this article to exploring.
The easiest way to illustrate the Inflation Tax is with examples. Let’s assume that through hard work and deferred gratification, you built up $40,000 in savings, which wasn’t easy after paying all the taxes on the income as you made it (we’ll keep the initial assumptions low to avoid too many zeros). Through judicious investing, you turned that $40,000 into a $100,000 current investment portfolio. Which again wasn’t helped by paying taxes on every dollar of gain, but you’ve made it, the $100,000 is yours after-tax, and the government has no tax claim on it.
So long as a dollar is worth a dollar, that is.
Chart I below illustrates how by changing the value of the dollar, part of your after-tax assets can be taken by the government.
(The rest of this article is available as part of the free Mini-Course, "Turning Inflation Into Wealth". The article has been placed in context as part of a series of ten to fifteen minute readings that will cumulatively build your understanding, in an educational process that will lead you towards uncovering new opportunities for personal actions and profits. More information on the free course can be found here.)
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