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September 26, 2010

Governments Hate Deflation – Should We?

Debtors, we all know, benefit from inflation since they are able to pay their loans back with dollars that are worth less than the dollars they originally borrowed. And debtors are hurt by deflation because the dollars they have to pay back are worth more – and harder to get – than the dollars they borrowed. OK, who's the biggest debtor you know? Right, the US government. The debt it needs to pay back would be reason enough for the government to fear deflation; but our government has even more to fear from deflation – it will cut way into both income and capital gains tax revenue.

Let's look at income tax first: suppose inflation is running at 3% and you put some money into a CD; you'll probably get about 6% interest. If you're in a 35% tax bracket, you will, of course, pay taxes on all 6% of the interest you get. But 3% of that interest doesn't represent a profit; it's just the compensation you get for anticipated inflation. So you are really paying taxes at a 70% rate on the 3% net of inflation that you're earning. By the way, the same is true of a 6% raise in times of 3% inflation; you pay tax on the whole 6% even though only 3% is real. Your INCREMENTAL tax rate is actually 70%, not the 35% that the government advertises.

As an example, if you put $100,000 in the CD for a year, you got $6000 of interest (ignoring compounding) plus your principal back at the end of the year - $106,000 total. You pay 35% in taxes on $6000, which is $2,100 (assuming you state doesn't have an income tax) so now you really only have $103,900. But these dollars are only worth 97% of what they were when you bought the CD or $100,783. After tax and inflation, you received less than 1% interest – but don't worry, your government had a bonanza.

What if there were neither an expectation of inflation nor deflation: you'd probably get only 3% interest on which, of course, you would pay tax. But at the same 35% rate, your tax is only $1,050; Uncle Sam gets only half as much. At the end of the year, you have $101,950 which is actually worth exactly that in purchasing power. You actually earned almost 2% net of taxes; in real terms this is twice what you earned in the inflationary scenario above. Good for you; bad for the government.

Now let's assume DEFLATION of 3%. You will get no or negligible interest. You pay no taxes on no interest. At the end of the year you still have $100,000; but that's a lot better than it sounds. Your $100k is now worth $103,00 in base year purchasing power. You gained 3% and paid no taxes. A good reason for government to hate deflation.

Capital gains is even simpler: you buy an asset for $100,000 when there's 3% inflation. You hold it for ten years during which inflation stays at 3%. Let's say the underlying asset neither gains or lose real value. But, when you sell it after ten years, its nominal price is $130,477. You, of course, have to pay capital gains tax on the $30,477 even though you really had no profit at all. Government gets an inflation windfall.

Of course inflation also pushes people into higher tax brackets and reduces the value of deductions.

Do you think this may be part of the reason why governments tend to follow inflationary policy? Could this be a reason the Federal Reserve is targeting 2% inflation rather than a stable currency?

BTW, though, the government is us. If inflation stays low, our deficit will be much more apparent. Hidden debts like pension promises will be even harder to fund. If you believe, as I do, that we need to deal with these problems anyway, then it's better to have them in the open. I think we can have a better future without inflation; but, ironically, the next couple of years may be harder at both the national and state level if inflation doesn't come back and perhaps excruciatingly painful if we have actual deflation. Need to be careful what we wish for.

Related post:

Deflation – Is It Really So Terrible?

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