Taxes and Inflation: What if You had to Choose?

    

Two critical financial components that act in deadly unison are the twin evils of taxes and inflation.   However, because inflation can actually drive purchasing power into negative territory, making you poorer, it is the bigger enemy of the two.    

The gain or loss in real, after-tax, purchasing power for goods and services determines whether you become wealthy or not (much more so than whether you earn a high income).  Simply stated: if you gain real, after-tax purchasing power as time goes by, then you gain wealth; lose purchasing power over time and you lose wealth. 

Scenario:

Steven will earn 10% interest on a $1,000 riskless investment.  He will pay 0% income tax.  He lives in an economy that experiences 15% annual inflation.  Alternatively, Sally will earn just 7% interest on her money and will pay 40% income tax on her investment earnings.  Sally lives in an economy that experiences no inflation.

Question: Who will become wealthier between Steven and Sally?

Before looking to the answer, consider this:

Without the presence of inflation, income taxes can never drive a rate of return to zero (or worse) However, even in a society free of income taxes, inflation can not only drive returns into negative territory (meaning you become demonstrably poorer), but there is no readily apparent cap as to how deeply negative it can go.

Answer:

Sally gains 4.2% real purchasing power on a compounding annual basis; she earns $70 interest, pays $28 tax (40%) and nets $42, or a 4.2% after-tax, real rate of return.  The nominal return is the same as the real rate of return because there is no inflation where Sally lives.

Steven loses approximately 5% real purchasing power on a compounding annual basis; he earns $100 interest, and pays no income tax. However, during the period that Steven earned $100, prices for goods and services rose by $150. Despite the tax free status of his jurisdiction, Steven lost real purchasing power.  The loss of real purchasing power makes Steven demonstrably poorer than when he started; he cannot buy the same goods and services at the end of Year 1 that he could buy at the beginning of that year.   

Implications:

Always consider the question of change in after-tax, real purchasing power when making a decision about where to invest your saved earnings. If you concentrate on inflation and income tax issues, keep in mind that inflation, when present, will always provide the greater financial problem. If you are going to put your very best mental energy into fighting one or the other, inflation presents the greater financial peril.  From a policy standpoint, ill-conceived tax policy can never hurt you as bad as ill-conceived fiscal policy, if the latter ignites an economy of high inflation.