Part 2: Inflation and the Savings Disincentive

If you didn't catch Part 1 then read it here. I've recently updated it.

Again, let's start with some basic terminology:

Nominal vs Real -- There's a concept in finance theory that says the value of money today will not be equal to the same amount of money in the future due to factors like inflation. The nominal value is the amount unadjusted for inflation while the real value is the amount adjusted for inflation.

Inflation Index -- A tool used to measure the rate on inflation in an economy (e.g., CPI).

One of the common complaints about taxes on capital income is that the profit on a capital gain or the interest income on an investment are decreased due to inflation. As a result, an investor is paying tax on inflation (a.k.a., an "inflation tax"). There can even be situations where inflation grows at a greater rate than the nominal gain or nominal interest on the investment. In this case, the investor will still pay a tax on the capital gain profit (or interest income), when, in fact, the real gain (or real income) was a loss (or negative). This distortion is due to the fact that capital income is not indexed for inflation. This lack of inflation indexing is one of the reasons why people often say "inflation discourages savings and investment." Again, I find this statement a bit disingenuous since it's similar to saying, "Since inflation is going to reduce my after-tax gain or income on my investment, I'd rather make nothing, or even possibly lose money, by not saving and investing at all."

In addition, as Rick Ashburn from Creekside Partners reminds me, there's a paradox regarding saving that is important to understand: What works when examining a single household (think in terms of a single economic agent), doesn't necessarily work for the economy as a whole. The simple example is that any given economic agent can save most of their earnings and retire early. However, that doesn't work for the entire economy due to the need for consumption. So, the "save a lot and retire young" proverb can never be a societal goal. I mention this because the average American tends to think along the lines of what makes sense only from a microeconomic perspective and often overlooks the importance of what makes sense from a macroeconomic perspective.

Now, most features of the federal income tax system for wages are indexed for inflation, which means we can't necessarily say that taxes on wage income suffer from the same issue. However, many states do not index their income tax systems for wages. Therefore, it's important to understand that indexing for inflation is not something we do consistently for all taxes on wage income. Lastly, the lack of indexing can work in our favor too. A good example is a person with a fixed-mortgage payment will see that payment decline as a share of his income as inflation pushes up his wages.

So, does the lack of indexing for inflation justify lower rates for capital income? Of course it doesn't. We shouldn't fix a dynamic issue with a static solution. If we're genuinely interested in addressing the fundamental issue then I believe we should fix the problem by indexing for inflation, not by lowering rates on capital gains and interest to make up for the distortion.

Next up: Greater Risk-Greater Reward