One of the big problems with fiat money, the kind issued by governments and backed by nothing, is that it loses value over time. This shows up in everyday life as consumer price inflation, which can be thought of as an additional tax on the population. But the worst part is that investment gains are taxed, and many asset prices also go up faster with higher inflation rates. So price inflation results in a kind of double taxation on investors. It’s the world’s biggest tax scam.
Beating inflation is a large part of the challenge for savers and investors that want to preserve and grow their wealth. If your investments aren’t keeping up with price inflation, after you’ve paid taxes, then you are losing purchasing power. Depending on the country, and the currency it issues, the rate of loss can be slow and steady or fast and furious. But it’s pretty much always there.
Live in the USA right now and the government claims that consumer prices went up by 1.1% over the past year, measured in US dollars. That’s a really low rate. However, the genuine rate of price inflation is probably several percentage points higher, because government statisticians use tricks to bring the number down. But a rate of around 5% a year seems likely, plus or minus a couple of percentage points.
On the other hand, people that live in Argentina have to put up with annual price inflation of around 25%, measured in Argentine pesos. Of course the government claims the inflation rate is “only” around 10%, which is still extremely high by the standards of most countries.
So what’s the tax angle here? Well, certain investments, such as stocks, real estate and gold will go up more with higher inflation and less with lower inflation, in the long run.
The tax angle for Gold
Let’s look at gold to illustrate, and imagine that the price tracks inflation every year. This is actually unlikely over a short period of time. But historical data show it to be pretty accurate over long periods of time – across several decades. So let’s use it as an example to keep things simple.
Assume I invest $1,000 in gold, and the gold price moves in line with consumer price inflation over 10 years. Inflation averages 2%, which takes the gold price to $1,219/oz (with compounding). I sell the gold for $219 capital gain but have to pay 20% tax (say) on that gain, which is $44. So I’m left with $1,175.
But remember, consumer prices have gone up as well – in this example at the same rate as the gold price has risen. So I need $1,219 to buy the same amount of goods and services that I could buy with $1,000 originally, 10 years earlier.
However, because of tax on the inflation driven gains, I’ve only got $1,175. In other words, I’ve only got 96% as much purchasing power (1,175 divided by 1,219 equals 96%). This means I’ve lost 4% of my wealth, adjusted for inflation. I’ve been taxed on the inflation driven price gains and ended up worse off in inflation adjusted terms, net of taxes.
Now let’s do the same but with a higher inflation rate of 10%. I invest $1,000 in gold, the gold price still matches inflation, and at the end the gold is priced at $2,594. I sell for a gain of $1,594, but again have to pay 20% tax on that gain, which is $319. This leaves me with $2,275.
In this higher inflation example, I need $2,594 to preserve the purchasing power that $1,000 had at the start of the 10 year period. But I only have $2,275 after tax, which is 88% of $2,594. In other words I’ve lost 12% of my money, in inflation adjusted terms. This is because my dollar capital gains are higher in relation to the original investment outlay, and so I have to pay away more in tax relative to final price.
…inflation results in extra taxation in any country that charges tax on capital gains, which is most of them. Price inflation is bad enough for savers and investors…
This is why inflation results in extra taxation in any country that charges tax on capital gains, which is most of them. Price inflation is bad enough for savers and investors, as they struggle to preserve the purchasing power of their wealth. But the taxes levied on inflation-induced asset price rises make it even harder.
The world’s biggest tax scam
This is why weak currencies, which result in price inflation, can be thought of as the world’s biggest tax scam. It’s nothing to do with multinational companies effectively planning their tax strategies, or rich people keeping their money in low tax jurisdictions. The real scam is that ordinary investors are being taxed even if they don’t beat inflation because the tax on gains is calculated on nominal dollar amounts.
We can’t stop governments from keeping this scam going. But at least if we’re aware of it then we have a better chance of developing the right investment strategy to deal with it. You need to have really great long term returns to beat inflation and taxes.
At OfWealth we believe that long term value investing – buying assets when they are trading cheaply and holding them until they are no longer cheap – is the best way of beating inflation and the taxes that it generates.
Until next time OfWealthers,