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Benson's Economic & Market Trends

 Inflation: The Silent Tax

 June 17, 2004 

With the Federal Reserve getting broad money growth, M3, back to around 11 percent a year, and the CPI heading to 3 or 4 percent, investors really need to start thinking about inflation. 

Some of you may recall how sky- rocketing inflation affected your life 20 to 30 years ago.  The younger generation, having no memory of inflation, can only use logic and imagination to rationalize what's virtually certain to happen.  (Voting records, investor polls, and general observations indicate that the attention span for 90% of the population is only 15 minutes; so anything prior to yesterday is basically ancient history to be soon forgotten.)

Inflation is a tax on financial assets. This tax is paid by those unlucky investors, corporations, and foreign central banks that hold financial assets denominated in the currency that is inflating.  A simple way of thinking about inflation as a tax is to consider investing in a mutual fund. The fund manager might charge 1 percent for the service and privilege of providing the investments in fund form.  If the fund returns 5 percent, the investor would obviously receive a net 4 percent. However, if the inflation rate was 4 percent, the real return to the investor would actually be nothing. In this case, the Fund manager gets his 1%, the U.S. Treasury - with the help of the Federal Reserve - takes 4% because of inflation, and the investor is left with nothing, except, of course, a tax bill for his 4%.  After taxes, the investor actually lost money! Inflation is a silent, and extremely efficient, robber of value

If you own stocks, bonds, mutual funds, REIT's, or even cash, you'll pay an inflation tax.  This tax is the result of the United States' Treasury spending far more than they collect in traditional taxes and issuing debt, which is then bought by the Federal Reserve.  The Fed then prints up brand new fresh dollars, out of thin air, to finance the government spending that is not paid for by direct taxes. Since someone owns the existing financial assets, someone will have to pay the tax.  The only way to avoid the inflation tax is to hold as much of one's wealth in non-financial assets, but this may be easier said than done.

Small countries, such as Argentina (that run massive budget deficits and need to borrow abroad), borrow in dollars, the world's reserve currency.  They have not yet figured out how to trick foreign investors into holding as many assets in their local currency as they would like.  Any country that can convince foreign investors to accept assets denominated in their country's inflating currency, effectively steals from them when the country uses the inflation tax and ultimately stage's a massive devaluation of their currency.  The inflation tax, for these inflating countries, is usually directed internally to domestic investors, as very few foreign investors can be "conned" into holding the assets of an inflating foreign currency, unless the interest rates offered are extraordinarily high.

U.S. citizens have been very lucky because the dollar remains the world's reserve currency. The fact that everyone will hold dollar investments " under the assumption that the dollar will remain good " has allowed American taxpayers to avoid paying taxes because the U.S. Treasury can borrow abroad.  This has allowed American consumers to keep spending because foreigners will extend credit to them!  

While the Fed has been playing off the deflation fear, our country has collected at least $3 trillion from foreign investors, endowments, pensions, and foreign central banks.  This staggering amount of money that we have gotten the rest of the world to give us, could never have been collected had the dollar not been the world's reserve currency.   Moreover, we need to finance the continuing massive U.S. consumer spending spree that encourages our government to foster a policy of sending American factories to Asia in return for their central banks' financing of our trade deficits. (The Asian central banks will take a massive hit on dollar devaluation.)

Unbeknownst to most investors, inflation also taxes financial instruments.    Consider the poor soul who wants to save enough to buy bonds that will generate enough income for a comfortable retirement. When inflation really kicks in, this imaginary interest on bonds is simply compensation for the falling value of the dollar.  On closer examination, to preserve one's capital in an inflationary environment, most of the interest earned must be reinvested or it will be inflated away.  But don't forget that the IRS taxes the interest that is paid for the use of the money, as well as the interest that is paid to compensate for the principal that is being eaten up by inflation. 

Another example of principal being taxed is when you own an asset, for cash, that keeps increasing in value with inflation. After a number of years when that asset is sold, technically its real value has stayed the same.  However, for tax purposes, the tax basis is on the  original number of dollars paid.  As an example, take a house. Years ago, the house cost $100,000.  Inflation comes along and the general price lever doubles, the dollar falls in half, and now it takes $200,000 to buy the same house.  When the house is sold, there is a "phony gain" of $100,000 upon which a tax is owed. 

Because the cost basis of assets in the U.S. Tax Code is not indexed upwards for inflation, an investor will have inflationary gains that are totally illusionary. While an investor will receive more dollars when he sells his investment, each dollar buys less!    The investor is taxed on these illusionary gains as if they were real gains.  In reality, inflation gives the government the power to tax wealth by taxing these phony gains!

Under inflation, our government is the biggest winner.  Not only is the Treasury's debt burden reduced, but inflation automatically raises taxes!

Inflation will allow major fortunes to be made and, unfortunately, lost.  With inflation on the horizon, incredible discipline will be required whenever possible to avoid the temptation of owning financial assets unless, of course, you wish to have your investment principal taxed until there is very little left.