The Insidious Tax: Inflation
Someone once said, “Inflation means that your money won’t buy as much today as it did when you didn’t have any.” We may chuckle at this, but inflation is no laughing matter. Some people even think that a small amount of inflation is good, showing that demand is slightly higher than supply, indicating that the economy is growing.
By definition inflation is an increase in the price of a good or service without any corresponding increase in the quality of the good or service. In other words, you pay more money for the exact same item. I’m sure everyone has noticed the jump in prices at the grocery store and the gas pump, as well as in housing, cars, and even utilities, with electricity prices surging 4.2 percent in January alone. Inflation has risen 7.5 percent in the last year, which is the biggest spike since 1982.
As a teenager/young adult, I remember well the inflation of the 1970’s and early 1980’s. At that time housing was going through the roof in Los Angeles, where I was raised. Proposition 13 was put on the ballot to roll back property taxes and limit their increases, because property taxes had inflated so much due to the massive increase in home values.
During this same time period gas went up from about $0.36 per gallon in 1972 to over a dollar, around $1.19 per gallon in 1980. I did a lot of homework for my high school classes while sitting in gas lines on the odd numbered days of the month. Now we have a return to the highest inflation in the last 40 years.
Inflation is a regressive tax, meaning it is applied uniformly, taking a larger percentage from low-income earners than from high-income earners. This results in a heavier impact on people with lower-incomes or that are higher-consumers. This recent, steady rise in prices has left many Americans less able to afford food, gas, and other necessities.
It’s a bit like high blood pressure, known as the silent killer. It usually increases in such small amounts that a person doesn’t notice it, not until they look back and see how much it has increased over 20 or 30 years. Twenty years at two percent is a forty percent increase (not including compounding). It’s the large increases within a year that catches the attention. We all know what it does at the gas pump, here is how it works with investments.
Let’s say that your rate of return on an investment is 10 percent, and you are in a 24 percent tax bracket-how much of your 10 percent return vaporizes into taxes? Twenty-four percent of it. That leaves you with a 7.6 percent return. Now let’s say we have a five percent inflation rate. Your 7.6 percent return now becomes a 2.6 percent return, because five percent of it vanishes due to inflation. Do you see what just happened? You lost 74 percent of your anticipated return to taxes and inflation. In other words, if you are in a 24 percent tax bracket and inflation is at five percent, it’s like being in a 74 percent tax bracket. Your real return-after taxes, after inflation-is 74 percent less. Five percent inflation destroyed as much of your return as a 50 percent tax rate.
In spite of the dark shadow cast by inflation, there are ways to plan and protect your finances. You can establish a plan to overcome many obstacles created by inflation. Minimizing personal spending and creating a budget (and sticking to it) can create a cushion of security. Reducing housing costs by trading in a large home for a smaller one can reduce monthly outflow for items most subject to inflation: property taxes, utilities, insurance, and maintenance. Another tactic could be to add investments to your portfolio that are more likely to increase in value as inflation rises, while at the same time, balancing stock investments with conservative options to maintain stable returns. Above all, remember it’s how much you keep that matters most.