SEIZING YOUR ASSETS TO COVER RETIREMENT PROMISES:
How the Government May Do It
Daniel R. Amerman, CFA
September 19, 2007
The higher the rate of future inflation – the more of your current net worth
belongs to the government. Many investors do not realize the powerful financial incentives the government will have to boost
inflation rates in order to pay for extraordinarily expensive Boomer retirement promises. From the government’s perspective,
high inflation rates offer the ability to transform after-tax investor assets into pre-tax income, which can then be taken
from individuals through the “Inflation Tax.” With substantial inflation, running the gauntlet of taxes
once or twice is not enough, and even your after-tax net worth can be repeatedly raided under government tax policy, by using
the pretext of non-existent income – that was itself created by government fiscal policy.
In this article, we will precisely demonstrate the way this deeply unfair wealth
seizure strategy works, and the multiple levels of challenges it presents. We will review the particularly severe potential
implications for conventional investors, and illustrate by example how the one-two combination of inflation and the inflation
tax could mean that a DJIA of 75,000 by 2027 could translate into a 73% reduction in real investor net worth. We will briefly
discuss investor solutions, some advantages of tangible assets, and close by introducing the concept of taking advantage of
the government’s inflation blindness to Reverse the Inflation Tax, so that instead of paying real taxes on illusory
income, investors can pay illusory taxes on real income.
A recent, well-publicized study by USA Today put the total of unfunded promises
by federal, state and local governments at $59 trillion. That isn’t total promises or future dollars (which would be
much higher), it is the present value anticipated shortfall compared to the current tax structure. The overwhelming majority
of this total is federal promises to future retirees in the form of Medicare and Social Security.
That many trillions is hard to relate to, so USA Today put the numbers in
per household terms. The average American household is in debt for $516,000 to cover unfunded government obligations, or more
than four times the average mortgage and credit card debt per household. To pay off this debt, each household would have to
pay $31,000 per year for the next 75 years. A link to this article is:
How will the impossible become the possible? One answer is that the system breaks
down and collapses. The future could be multiple levels of government all reneging on their promises to retirees, as well
as the major corporations. But, that is such a messy solution. Not just for average people, but worse – messy for the
wealthiest and most politically powerful segments of our population. In fact, such a Doomsday scenario might jeopardize both
their wealth and their power. It would also compound the problem through depressing the tax revenues, because everyone would
be losing money, and you don’t pay taxes on (nominal) losses.
However, there is an alternative means of closing the gap. A means that keeps the
promises paid in form (if not in substance). A means that redistributes wealth from taxpayers to the government. A means that
keeps the status quo intact. All you have to do is make it Doomsday for the value of the dollar – in the right way –
and real costs (retiree benefits) will plummet, real tax collections will skyrocket, and the gap will close.
There are three intertwined methods the government can use in closing the fiscal
gap through the use of inflation. The first is “Theft By Index Management”, where the official government rate
of inflation rises at a different rate than the real rate, making inflation-indexed promises easier to keep each year. The
higher the real rate of inflation, the faster this strategy delivers its benefits to the government. The second method is
“Evaporate Paper Wealth Claims” where the government dilutes competing claims on future goods and services by
retiree investors through making the real value of their assets plummet, even while their paper value soars higher than ever.
Which opens the door for the third strategy, that we will devote the rest of this article to exploring.
Seizing Assets Through Inflation Taxes
The easiest way to illustrate the Inflation Tax is with examples. Let’s assume
that through hard work and deferred gratification, you built up $40,000 in savings, which wasn’t easy after paying all
the taxes on the income as you made it (we’ll keep the initial assumptions low to avoid too many zeros). Through judicious
investing, you turned that $40,000 into a $100,000 current investment portfolio. Which again wasn’t helped by paying
taxes on every dollar of gain, but you’ve made it, the $100,000 is yours after-tax, and the government has no tax claim
So long as a dollar is worth a dollar, that is.
Chart I below illustrates how by changing the value of the dollar, part of your
after-tax assets can be taken by the government.
The left column represents nominal dollars. You buy almost any kind of asset for
$100,000, and hold it long enough to be eligible for capital gains tax treatment. During that time, inflation destroys half
the value of the dollar, meaning it now takes $2 to buy what $1 used to. Our key assumption is that your asset exactly keeps
up with the surge of inflation – meaning it likely did better than most investments. So you get $200,000 when you sell
it – even though in purchasing power or real dollar terms, the asset is unchanged in value (the right column, and the
dark green blocks and bars are real dollars).
The government does not generally recognize inflation in its tax policy, it sees
nominal dollars only (the pale yellow bars and boxes). What the government sees is that you just made $100,000, and it wants
its share, in the form of $15,000 in capital gains taxes. Now, as long as we ignore inflation, that’s not so bad. We
still have $85,000 in “profits”. Indeed, that 85% after-tax return on investment may look pretty sweet.
The problem is when we adjust our 85% after-tax return for the technicality of
a dollar only buying what fifty cents used to. When we look at our real wealth in terms of the goods and services we can buy
with the proceeds of selling our asset. When we go down the real dollar column on the right, and look with our dark green
economic “eyes”, then we see that we bought for $100,000, we sold for $100,000, and in terms of real wealth –
our pre-tax gain is zero. But, we still have to pay taxes. When we discount those future taxes to bring them back to current
dollars, at least it drops the real cost in half, down to $7,500. Unfortunately, once we pay those taxes – in purchasing
power terms, we only have $92,500 left.
Meaning that instead of making $85,000 – we lost $7,500 out of our $100,000
investment in real terms. When we adjust for inflation and look at what a dollar will buy – our sweet 85% return vanishes,
and what we are left with is a 7.5% loss on our investment.
We just met the “Inflation Tax” – and it ran over us.
Let’s review what just happened here. Through its fiscal policies, the government
created inflation that cut the value of our dollars in half. Meaning that everything that we owned in dollar terms, such as
bank accounts and bonds, just had half the value taken away from us. However, we were smart enough not to put our $100,000
into a dollar denominated investment. We put it into another type of asset, an asset that kept up with inflation. We didn’t
actually make any real money, we just protected the purchasing power of our assets against the effects of unwise government
So how does the government react? By stripping us of part of the wealth we did
preserve, on the grounds of illusionary profits. With the illusion that created the pretext for seizing our assets having
been created by the government in the first place.
Transforming After-Tax Assets To Pre-Tax Income
There is a very important principal that long-term investors of all kinds are wise
to remember: the higher the inflation rate – the greater the percentage of your assets that belongs to the government.
This applies not just to taxes on ongoing income, but after-tax assets as well.
In the first chart above, we looked at what happened with a 100% rate of inflation.
The nominal value of our asset doubled – and we moved from having 100% of our $100,000 asset being after-tax, to having
$100,000 in pre-tax income (50% of our asset), and $100,000 in an after-tax asset (50% of our asset). The government just
transformed 50% of our assets from after-tax to pre-tax. Income that the government is then entitled to tax us upon whenever
we trigger a tax effect, by moving our investment to a different form, or trying to spend part of it. Income that doesn’t
economically exist in purchasing power terms, but was artificially generated through the government destroying the value of
What the chart below demonstrates is the government’s powerful incentive
to increase the inflation rate, if it wants to maximize tax dollars. As shown, the higher the rate of inflation – the
more of your assets becomes pre-tax income that is subject to taxation.
With the example $3 million portfolio, a 10% rate of inflation raises the nominal
value of our portfolio to $3,300,000, meaning we have incurred $300,000 in pre-tax income – even though the real value
of our investments haven’t budged. This means that 9% of our real $3 million in after-tax assets just became taxable
income. The percentage of assets transformed steadily increases with the rate of inflation, until we reach the bottom row
where we see that inflation of 1000% will have the effect of transforming 91% of our assets from after-tax to pre-tax, as
we are now subject to taxation on a full $30 million in illusory income.
Compounding The Problem – Repeated Raids
There is a particularly unfortunate aspect to the inflation tax – it isn’t
a one-time tax. For instance, let’s say we own an asset for five years, inflation turns 50% of our asset from after-tax
assets to pre-tax income, we sell the asset, pay the taxes, buy another asset – and then we start over again. Because
further future inflation will again create another level of pre-tax income, that will be taxed again. This principle is illustrated
in the chart
To show how the chart works, let’s say you start out with $1 million, inflation
averages an annual 14% over the next 20 years, and through excellent asset choices you are able to do what most investors
are not and earn 14% annually, so that you keep up with inflation – on a pre-tax basis, anyway. You try your best to
follow a long-term investment strategy that minimizes tax consequences, but the world is in financial turmoil, and you do
need to turn your portfolio over into new investments an average of once every five years.
For the first five year period, inflation and matching investment success on your
part have raised the value of your portfolio to $1.9 million. The economic value is still $1 million, but inflation has created
$900 thousand in nominal income, meaning 47% of your portfolio has been converted from after-tax assets to pre-tax income.
You pay a little shy of $200 thousand in capital gains taxes at a rate of 20% (tax rates are assumed to rise by 5% every five
years as the Boomers increasingly reach retirement age and everyone pays more), and you are left with $1.7 million in after-tax
assets. When adjusted for inflation, you have about $900,000 of your original $1 million in purchasing power remaining, and
this means the inflation tax has claimed about 10% of your assets.
Then it starts again, as 41% of your after-tax assets are converted to pre-tax
income, you pay a little higher tax rate, and lose a little more than another 10% of your after-tax real net worth. Repeat,
and repeat again – and after 4 rounds and 20 years, you have ending assets of $7.8 million, but they are only worth
$570 thousand in purchasing power, and you have lost 43% of the real value of your starting $1 million in assets to repeated
rounds of the Inflation Tax. Keep in mind as well that these assumptions are relatively benign in some ways, for a five year
turnover is very slow by many standards, and for simplicity and conservatism we’ve kept all your income qualifying for
capital gains tax treatment – the bite of the inflation tax is much worse when applied on an annual basis and at short
term tax rates.
Conventional Investments May Fare Much Worse
The worst pain from the inflation tax may be reserved for conventional investors.
Let’s illustrate by using the chart below, and making a few simple assumptions. Let’ s assume that the stock market
rises by 9% a year, and that a $1 million investment has increased to $1.5 million in the next five years (call it the DJIA
reaching 20,000). That 50% profit looks great at first glance. Except the problem is that average annual real inflation levels
rose at a 14% annual rate instead of a 9% annual rate, for total compounded inflation of 90%. So the real value of the Dow
in purchasing power terms has in fact dropped to 10,500, even while the paper value soared. The stock investor has fared significantly
worse than a tangible asset investor who has succeeded in staying even in pre-tax, real dollar terms.
Now, let’s assume that the $1 million in assets had been purchased with after-tax
dollars, so the government had no right to the assets. However, the government does have rights to the $538 thousand increase
in the nominal value of the assets, even though the real value was falling in purchasing power terms. Again assuming that
capital gains tax rates rise as Boomer retirement finance problems soar upwards, the investor would pay $107,000 in taxes.
That leaves $1.4 million – but the $1.4 million is only worth $743 thousand in 2007 dollars. So the combination of government
fiscal policy destroying the value of the dollar, and government tax policy taxing non-existent profits created by the destruction
of the dollar, have taken 26% of the investor’s portfolio.
Then it happens again, and again, and again. Until at the end of 20 years, the
Dow now stands at 75,000 (with triumphant newspaper headlines every step of the way) – and the investor has lost 73%
of the value of their assets on an inflation-adjusted and tax-adjusted basis.
Note that in some ways our assumptions are quite conservative. For instance, change
the trading frequency to once every few months and the tax treatment to short term rates, and losing only 73% of your investment
may begin to sound quite attractive. Also, we did leave dividends out of the discussion, which are the stock market’s
historical method of keeping up with inflation. Which is appropriate, as the compounded historical dividend rates of 1X to
2X long-term bond yields that created most of the historical stock market’s long-term profits and resiliency…
are long gone.
Solutions: Shelter & Speed
While a detailed discussion is beyond the scope of this article, tax-deferred accounts
such as IRAs, Roth IRAs, and Keoghs, do have some powerful advantages in dealing with the Inflation Tax. Technical rules and
limitations aside, it may be worth considering the bigger picture as well. When your assets are in these accounts, your wealth
is totally “inside” the government tax system, where the terms of the withdrawal can only occur on the terms the
government specifies and with the taxes the government says – at the time you are actually withdrawing the money.
We have the rules as they are set up now. We also have the government’s own
chief accountant, Comptroller General David Walker, trying to tell everyone who will listen that a financial “tsunami”
is on the way, and the government cannot possibly pay for its retirement promises to Boomers. So, the rules – they will
have to change. The retirement accounts will be a very attractive target for rule changing, simply because there is so much
wealth there (if you need wealth, then wealth is where you go.) The exact form of the changes is of course currently unknown,
but to complacently make long-term investment plans based on today’s rules – when we know there will be overwhelming
pressures to change the rules down the road – may turn out to be a bit too trusting of politicians.
Another strategy is to try to out-run inflation, by making such good investments
that you leave technicalities like inflation and tax treatments in your dust. Always worth a try, but if you are investing
in dollar-denominated investments, you might want to be sure you’ve got your running shoes on and laced up tight. As
covered in the article “Finding Beauty Within The Inflationary Beast” (available in the archives here), with a
40% tax bracket and ordinary income treatment, you would have to earn 17% per year just to stay even with 10% inflation and
the inflation tax.
Solutions: Tangible Assets
If Doomsday for the dollar is how the government can pay impossible promises while
still maintaining the status quo – then getting out of dollar-denominated assets is the obvious and necessary move for
many investors. Gold, silver, commercial property and energy are all possible choices, with advantages for each category,
with the best strategy likely being a diversified contrarian portfolio.
While the tangible asset investor has some strong inherent advantages relative
to conventional investors caught in the inflation and tax net worth “meat grinder” shown in Chart IV above, the
inflation tax can still be a real problem. For the investor who is investing in tangible assets specifically because of inflation
concerns, it is incumbent upon them to also have a personal strategy for dealing with inflation tax issues. This strategy
could involve seeking to turn inflation to your advantage, so that inflation is actually producing real wealth rather than
just preserving wealth, or taking actions to reduce tax exposures to the inflation tax, or combining the approaches.
Solutions: Turning Problems Into Opportunities
There is an alternative to trying to shelter from inflation, or outrun inflation
– embrace inflation instead. Look inflation straight in the eye and say:
“Inflation, you are likely to play a big role in my personal future, and
instead of ignoring you or thoughtlessly flailing away at you – I will study you and your ways. I will learn the deeply
unfair ways in which you redistribute wealth, and the counterintuitive lessons about how some investors will be destroyed
by inflation and repeatedly pay taxes for the privilege, even while other investors are claiming real wealth on a tax-free
basis. I will learn to position myself so that you redistribute wealth to me, and the worse the financial devastation you
wreak – the more my personal real net worth grows. I will examine the official blindness to inflation within government
tax policy that creates the Inflation Tax, and instead of raging or despairing, I will understand that a blind opponent is
a weak opponent, and I will take advantage of the government’s blindness to create strategies such as the one below:”
Please note that the above is not a replacement for tangible asset strategies,
but an enhancement that can be applied in combination with tangible asset strategies.
This is a theoretical discussion of taxes from an economic perspective, and is
not tax advice for the particulars of your personal situation. For specific tax advice, you should rely upon the services
of a tax professional.
© 2007 Daniel R. Amerman, CFA
Daniel R. Amerman, CFA
Email | Website
Daniel R. Amerman is a futurist and financial consultant with
a unique approach to helping individuals and organizations prepare for and profit from an upcoming time of generational change
and likely financial turmoil. He is a Chartered Financial Analyst and former investment banker, with MBA and BSBA degrees
in finance and over 20 years of financial experience.
Do you know how to Reverse the Inflation Tax? So that instead of paying
real taxes on illusionary income, you are paying illusionary taxes on real increases in net worth? The exact, step-by-step
specifics of how to use the government’s inflation blindness to get from the problem shown in Chart I above to the solution
shown in Chart V, are within one of the readings midway through the “Turning Inflation Into Wealth” Mini-Course.
Starting simple, this free course delivers a series of 10-15 minute readings, with each reading building on the knowledge
and information contained in previous readings. More information on the course is available at MortgageSecretPower.com .
Also available is “Commercial Property Balance Point: Achieve Deep Protection
From Economic Turmoil While Turning Inflation Into Wealth”. This 47 page report is about a powerful optimization technique
for turning inflation into personal wealth and increased safety even while simultaneously weathering potentially severe economic
This essay and the websites, including the pamphlets, books and audio recordings,
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