The Scourge of Taxes and Inflation

    

The Consummate Capitalist is ever vigilant in both preparing for and combating the continually debilitating combined effects of taxes and inflation.  For those less vigilant are doomed to wallow forever in permanently lower purchasing power. 

In his 1979 letter to the shareholders of the Berkshire Hathaway corporation, Warren Buffett wryly noted that one share of Berkshire Hathaway stock had made no real gain in purchasing power during the fifteen years that he and Charlie Munger had managed the company. This was a very sobering message; particularly because many stockholders had been reveling in the 20 percent average annual gain that Berkshire’s stock had jumped in nominal value during those years.¹ Buffett and Munger’s feat of earning 20 percent on an annual, compounding basis was repeated by extremely few (if any) companies in the United States during the same period. The Buffett-Munger accomplishment had far surpassed gains that were seen in savings accounts, bond-holdings, and any of the “blue chip” stocks on Wall Street during the same period. Nonetheless, Buffett asserted that the combined effects of inflation and income taxation on investment gains should be thought of as an “investor’s misery index”.² He noted that inflation was running at 14 percent annually and that anyone who wanted to translate the asserted gains into money would have to first pay income taxes. The nominal purchasing power left over after the income taxes were paid would be eaten away by the prevailing high inflation that was hammering the purchasing power of the U.S. dollar. The bottom line to Buffett’s investor misery index was that taxes and run-away inflation completely devoured what appeared to be outstanding results for a stock investor.³

Although Warren Buffett was specifically writing to shareholders, the principal remains for everyone… purported investment gains must be distilled using Buffett’s Misery Index before you can truly comprehend where you stand. A very stark reality eludes many people who work, spend, save, and otherwise are just trying to get on with their lives: the Government demands a significant portion of your income through taxes; and of the remaining purchasing power, either a fair amount always or a great amount sometimes will be consumed by a hidden tax, which is better known as inflation. You can only plan against this sobering truism after you learn of its devastating implications.

Here are some illustrations. According to the U.S. Government’s Bureau of Labor Statistics, the general price index in the United States rose almost 142 percent between 1980 and 2005.⁴ Goods and services that you could buy for $1,000 in 1980 cost $2,417 in 2005. These numbers reflect an annual compounded rate of inflation of approximately 3.6 percent each and every year for those 25 years. To fully understand the implications for purchasing power during this period, you must account for both the inflation rate and income taxes. If, in 1980, you had the foresight to choose a solid, long-term stock that did not pay dividends (saving you extra pain each year on your income taxes), then the stock’s price needed to appreciate by 166 percent during the 25 years. This aggregate amount works out to a 4 percent average compounding annual gain. Selling the stock at the end of the period, you would pay a maximum of 15 percent capital gains tax on the profit. After-tax income would leave you with exactly $2,416.10. Following 25 years of investing, you would find yourself with a nominally higher number of dollars; however, you would be left with exactly the same amount of purchasing power that you held in 1980, having adjusted for inflation. You would not be any wealthier for having invested for 25 years. From this example, you should see why Warren Buffett coined the combined result of inflation and income taxes on investment return as an Investor’s Misery Index.

A second example will illustrate that it doesn’t matter whether you think of yourself as an investor or not. Imagine yourself making the decision that all investing is too risky unless it is specifically guaranteed by the U.S. Government. So, you put aside a small amount of money from your disposable income and purchase Series EE Savings Bonds from the U.S. Government each month. If you paid $1,000 for your bonds and they were earning 3.5 percent annual interest, then you can realize an additional $1,000 of interest in approximately 20 years. By earning $1,000 of interest on top of the $1,000 that you paid for the bond, you would receive exactly twice as much money back as you invested.

At first blush, you made a cool $1,000 profit after holding your Bond for a little more than 20 years.⁵ However, every investment or savings return must pass through Warren Buffett’s Investor’s Misery Index. First, the $1,000 of profit (accrued interest), will be taxed at your marginal tax rate and will incur the ordinary tax rate. If you are in the 25 percent marginal tax bracket, then you must give the IRS $250 of your $1,000 gain.

Holding the tax implications at bay for a moment, imagine that you wanted to buy a product in 1985 for $1,000. According to the Bureau of Labor Statistics’ inflation calculator, the same goods or services would cost approximately $2,000 in 2005, an increase of exactly 100 percent in price. If you held our illustrative EE Savings bond from 1985 to 2005 and received $1,000 in interest on top of the $1,000 that you paid for the bond, then the problem should be readily apparent to your keen eye: the Government is going to tax you $250 on your $1,000 interest gained; however, you need the entire $1,000 earned just to simply maintain a zero gain in purchasing power. Since the Government is taking 25 percent of that gain in the form of income taxes, then you will be poorer than when you started. Yes, you will have less purchasing power than when you started. Even if you lived in Fairyland, and all income taxes were waived out of existence, your purchasing power would have gone exactly nowhere after you exercised all that discipline to hold your savings bond for 20 years. However, because of the cold, cruel world of income taxes, the real results are both inescapable and truly miserable. You will have 25 percent less purchasing power… you will be 25 percent poorer… 20 years in the future. The savings bond was secure in one respect, the payment of interest could be counted as money in the bank; however, it was quite insecure in a different financial respect… the bond lost ground to purchasing power. And the gain or loss of purchasing power is what determines whether you are getting richer or poorer.

Based upon all that you now know about inflation and taxes, you might reasonably think, “wait a minute, I shouldn’t have to pay taxes, I didn’t realize any profit in real dollars.” You would be absolutely right; however, the Government doesn’t care. Congress taxes you the same whether your purchasing power gains are real or just nominal. Bear in mind that the difference between your having realized substantial after-tax, real-dollar gains and those that are merely nominal-dollar gains will affect your financial life greatly.

Footnotes:

1 http://www.berkshirehathaway.com/letters/1979.html

5 The point of this illustration is to show what happens to purchasing power when you invest in savings bonds, bank deposits, or other fixed income securities. To be accurate, the U.S. Government will redeem EE bonds at their face amount after 20 years; unfortunately, your loyalty to the U.S. Treasury is rewarded with the highest rate of taxation when you redeem your bond, the ordinary tax rate.

 

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