Benson's Economic &
Inflation: The Silent Tax
June 18, 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
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.
Finance Group, LLC
2505 S. Ocean Boulevard
- Suite 212
Palm Beach, Florida 33480