The inflation tax

Did you know that we’ve all experienced an “across the board” 15% tax increase since 2020? The prices of goods and services we buy are about 15% higher than they were in 2020. So unless your income is up 15%, your actual income, what you can buy today with your 2020 income, is much lower. And with inflation at 7%, you’re still losing ground. If you had $10,000 in a savings account (IRA, 401k, etc.), you’re only buying about $8,700 worth of stuff today. Increasing income and/or returns on your investments could offset these losses, but not 100%, and not at all for too much.

For some workers, pay has grown faster than inflation, but not for most, even those with high incomes. Chart 1 shows that of the 5.5 million Main Street employer businesses, the percentage that increased their selling prices has not been higher since 1973 (when the NFIB first began collecting data). Corresponding inflation rates were higher in the early 1980s (13%) compared to an apparent peak to date of 9%. But the percentage of companies increasing workers’ compensation also reached its highest level since 1973. Compensation is the largest cost item for most companies and is a key driver in decisions to increase selling prices. And while lowering the prices of goods and services is quite easy, lowering wages is extremely difficult. This makes the prices very “sticky” and difficult to lower.

However, lowering prices is the only way to restore the real value of your income and savings and investments. Reducing inflation to 2% will reduce the tax burden on inflation going forward, but unless prices actually fall, your assets will be taxed away, at least 15% in any case. Even 2% inflation can wipe out a big chunk of any raise you get. Chart 2 illustrates the frequency of price reductions over the business cycle. Recessions clearly increase the level of price reductions (and reduce the number of firms and employment).

The Fed hopes to bring inflation back to 2%, much more manageable but even slightly higher than in 2020 (1.5%). History shows that this usually required a recession. The Fed hopes to achieve this with a “soft landing,” a slow-growing economy but no “recession.” Time will tell. Meanwhile, it has pushed up its interest rate to 4.5%, well below the rate of inflation (so earning higher interest on savings is still a lost cause). Some argue that inflation will only be crushed if the Fed rate is higher than inflation (i.e., interest rates are “real,” so your interest income is rising faster than prices). In November, price increases were widespread, 73% in wholesale, 69% in retail, 66% in construction and 63% in manufacturing. That’s a lot of inflationary pressure.

Until your income rises faster than inflation and the return on your assets is also higher than inflation, you will be ‘taxed’. There is no simple solution to the inflation problem, other than using policies to suppress private demand and, unfortunately, an inevitable rise in unemployment. This means that the Fed raises interest rates, but also that the government restricts spending, especially remittances to individuals. Delay, soft landing, recession, all possible outcomes of current policies.