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Sometimes preserving value doesn't preserve value [ClearOnMoney]
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Sometimes preserving value doesn't preserve value

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Commentary

Sometimes preserving value doesn't preserve value

8 Dec 2012 by Jim Fickett.

Under conditions of high inflation, even if an asset retains or increases its real value, tax on fictitious, nominal gains may result in an overall loss. High inflation favors income over capital.

The main point in this post was made in passing in the long recent post on platinum (Platinum mining costs are likely to drive the long-term price moderately higher), but is worth emphasizing separately.

Suppose, for example, that you buy an ounce of gold today at about $1700, because you want something that will hold its value in the face of high inflation. Your fears are realized, so that prices double by 2020. Your investment thesis turns out to be right, and gold does well; because people are worried by the inflation, gold's price goes up more than the average price level, not to $3400 but to $3800. But then you need the cash and sell, and here your troubles begin. Your real gain is just $400, in 2020 dollars, but your apparent gain, on which you are taxed, is $2100. If you are in the 30% tax bracket, you only get $3170 after tax, which is $1585 in 2012 dollars. So in fact you have lost a significant fraction of your money.

The problem is that, under high inflation, all investments appear, to the tax man, to have huge gains, just because the currency is worth less.

High inflation favors income over capital appreciation. A perfect solution would be to have a farm that you will hold throughout your life. Each year you should be able to sell the produce from the farm at current prices, and pay a normal tax on then-current income; i.e. your income from the farm is not affected at all by inflation. You may even come out ahead – if inflation is very high, by the time you pay your taxes the dollars are worth less than they were when the taxes were incurred.

Under moderate inflation there is enough volatility in the markets that you should be able to buy low and sell high, and thus get enough capital appreciation to beat tax and inflation. But under very high inflation, capital appreciation has to be impossibly high just to break even, and productive assets – a job, houses to rent, dividend paying stocks, bond ladders of appropriate duration, a farm or a forest – is where you want to be.

Incidentally, I've made the point before that tax-sheltered accounts may be, under moderate inflation, over-rated, particularly if you have very limited investment choices inside such an account (You might do better without tax deferral). However under very high inflation having your money in an IRA or 401(k) gives you important additional investment options since, in a tax-deferred context, capital can grow with inflation, and the total will be taxed at the same rate on withdrawal as it would have been had tax not been deferred.