The Truth About the Insidious Tax: Inflation

Friday, 17 October 2008

Someone has said, "Inflation means that your money won't buy as much today as it did when you didn't have any."

We smile, but inflation is no laughing matter. Some people even think that a small amount of inflation is good. They think it demonstrates that demand is slightly higher than supply -- or that the economy is growing.

Inflation is an increase in the price of a good or service without any corresponding increase in the quality of the good or service. In other words, you pay more money for the same exact item.

When you consider that definition, it's sometimes difficult to accurately measure inflation. Why? The government tries to establish the inflation rate using a static basket of goods that it measures each month.

What is wrong with that? The basket of goods does change. Take automobiles, for example. The price increases -- but you may also get "extras" like power steering, automatic transmission, and anti-lock brakes. Additionally, as certain prices increase, the consumer changes the mix of the goods he is buying: If the price of potatoes goes up, people switch to rice.

So let's look at inflation. First, inflation is a tax. American economist Milton Friedman called inflation "the one form of taxation that can be imposed without legislation." If we have 5 percent inflation, we have 5 percent tax. In fact, when we calculate the after-tax, after-inflation rate of return, the "tax" of inflation is even higher.

Want an example? Let's say your rate of return on an investment is 10 percent, and let's say you are in a 40 percent tax bracket -- how much of your 10 percent return vaporizes into taxes? Forty percent of it. That leaves you with a 6 percent return.

Now let's say we have a 4 percent inflation rate. Your 6 percent return now becomes a 2 percent return -- 4 percent of it vaporizes into inflation. Do you see what just happened? You lost 80 percent of your anticipated return to taxes and inflation. In other words, if you are in a 40 percent tax bracket and inflation is at 4 percent, you are in an 80 percent tax bracket. Your real return-after taxes, after inflation -- is 80 percent less. Four percent inflation destroyed as much of your return as a 40 percent tax rate.

Inflation is a highly regressive tax, impacting lower-income and high-consuming people the most.

Inflation is caused by a number of factors. A key factor is that the government wants it to be that way.

Think about it: Who is the greatest beneficiary of inflation? The government. Why? The government borrows. The government is the largest debtor. If inflation is high enough, they can repay their debt at pennies on the dollar. That means they can also increase the money supply and float debt to keep the government operating. Sir Frederick Leith-Ross, English economist and financier, said, "Inflation is like sin. Every government denounces it, and every government practices it." There is another reason why the government benefits from inflation.

The government is financed in two ways: directly by income taxes, and indirectly by debt and inflation. As long as we tolerate the government running deficits and financing their expenditures through borrowing, we are going to maintain the tax of inflation.

Deficit spending can work in the short term. Why? It is an artificial stimulus to the economy -- it produces a "high" that we get addicted to. It is the same thing as deficit spending within a family. They buy things, see a welcome improvement in their standard of living, and are then driven to buy even more on credit. It causes an artificial short-term improvement in their outward standard of living. But the day of reckoning comes.

When we play accounting games like the government does and we do not show that debt on our balance sheet, we are fooling ourselves. We do not understand that in the long term, we either get our spending under control or the deficit gets too far out of hand. If that happens, we have either fiat money and spiraling inflation or dramatically increasing taxes. That all falls upon the backs of future generations, namely our children.

John Maynard Keynes, the economist of Great Britain, wrote in his Essay in Persuasion, "Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.... Lenin was certainly right."

There are two different kinds of inflation: cost-push inflation and demand-pull inflation. In cost-push inflation, there is a shortage of supply, so costs increase. Want an example of cost-push? A drought in the Midwest causes a shortage of food, so farmers must charge more for the food they are able to produce in order to cover their costs. The increase in price is passed along to everyone along the manufacturing and distribution chain, until you pay more at the supermarket. Or, the cost of labor increases.

In demand-pull inflation, demand is so great that people will pay more for the same product. In the national economy as a whole, the cause of demand-pull inflation is best illustrated by the government increasing the money supply, resulting in too many dollars chasing too few goods.

How can you predict inflation?

Three basic resources go into any product in a capitalist economy: raw materials, labor, and capital. Approximately 89 percent of the cost of any good or service is labor. Capital and raw materials make up the other 11 percent. That applies to everything in the economy -- all the way from harvesting the raw material in the mine or forest to manufacturing, transportation, wholesaler, and retailer.

If 89 percent of the cost of any good or service is labor, and you want to predict inflation, what should you look at? Labor rates. The cost of labor is reported monthly on the front page of the Wall Street Journal in a graph entitled "Hourly Earnings." Watching labor rates helps predict cost-push inflation.

Which indicators help predict demand-pull inflation? The supply of money, which is reflected in the price of money. What's the price of money? Interest rates.

If you are interested in predicting inflation over the next six months to two years, look at short-term interest rates -- the prime interest rate, and the rate on Treasury bills. If you are interested in predicting inflation over the next five to 10 years, look at long-term interest rates -- those on Treasury bonds and home mortgages.

Regardless, remember that the price of money (interest rates) is always going to be determined by people wanting to lend out their money and have that money paid back to them, adjusted for inflation, plus one or two percentage points based on the risk premium. The premium is going to be lower with government T-bonds; it is going to be a little higher with mortgages.

Is that going to give us a better answer on the prognosis of inflation than you can get from any economist in the country? Yes. Why? What determines the price of money? Massive supply and demand forces in the economy. So, we are dealing with an equilibrium point to get those prices.

For a look into how inflation can affect us during these volatile years, please read our article on Understanding the Economy or download our free Special Report: How to Survive the Current Economic Crisis.

Hank Brock is President of Brock and Associates, LLC, a financial consulting firm specializing in asset protection and generational wealth preservation. Hank has been a part of the financial planning industry since 1979. Portions of this article were taken from Your Complete Guide to Money Happiness published in 1997.

Add this page to your favorite Social Bookmarking websites