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Thursday, July 1, 2004

The Most Insidious Tax

Inflation Is a Subtle Second Tax

Dale Haywood is a professor of business at Northwood University and an adjunct scholar with the Mackinac Center for Public Policy, both in Midland, Michigan.

People don’t generally spend and invest other people’s money as carefully as they do their own. This single, simple fact goes a long way toward explaining why capitalism works and statism doesn’t.

Private property, which enables people to spend and invest their own money, is a central feature of capitalism. Indeed, private property is the key feature of capitalism.

But property can be eroded subtly. Specifically, people’s money can be quietly shifted from the private sector to the public sector. That constitutes a transfer of resources from profit-seeking investors to vote-seeking politicians.

This process weakens capitalism and strengthens statism. On balance, it is eroding the ability of millions of savers to buy homes, finance their children’s education, pay their bills during retirement, and, in myriad other ways, assume responsibility for themselves.

It’s usually in January and February that I’m reminded of this insidious transfer of wealth. For it’s typically during these months that thrifty people receive notices from the financial institutions to which they’ve entrusted some of their savings. (The official IRS designation for these notices is form 1099 INT.) The institutions send out these forms to remind their customers how much interest they earned on their deposits during the prior calendar year. They admonish savers to be sure to report this “income” on their tax returns.

This is, of course, when the reduction of private property and expansion of communal property begins. Imagine this hypothetical, but realistic, situation: On December 31, 2002, a saver invests $1,000 in a one-year certificate of deposit paying 2 percent a year. The certificate matures on December 31, 2003. Its maturity value is $1,020—$1,000 principal plus $20 interest. So in January or February of 2004, the financial institution mails a 1099 INT to the saver showing $20 interest. The saver, in turn, dutifully reports that $20 on his 2003 federal and state tax returns just as he is required to.

If the taxpayer is in, say, the 27 percent federal tax bracket and the 4 percent state tax bracket, his total tax on this income will be $6.20, or $20 times .31.

There’s nothing subtle about this aspect of the wealth transfer. The taxpayer may not like these taxes, but he’s not confused. Yes, he might even fervently resent what’s happening. And that’s understandable. For he knows politicians will spend the money on undertakings at least some of which he strongly disapproves. He also knows how differently he would have spent or invested the $6.20 if he had retained control over it. He clearly understands this wealth transfer that shrinks the private sector and expands the public sector by about 31 percent of his earnings on the certificate of deposit.

But, if we look more closely, we find there is another aspect to the wealth transfer. It is more subtle. We understand this feature of the transfer when we take inflation into account. And if an investor is realistically to maintain or increase his purchasing power, he surely must allow for inflation. (For the record, “inflation” originally referred to the expansion of money or credit by government fiat, which, other things equal, causes prices to rise generally. Today the term is usually applied to the effect, with the cause overlooked.)

Illusory Gain

Suppose there was 1.9 percent rise in prices during 2003. In that case, our hypothetical saver would need $1,019 on December 31, 2003, to have the same purchasing power he had with $1,000 on December 31, 2002. So, before paying the $6.20 in taxes, his real income on his $1,000 one-year certificate of deposit would be just $1 (The $1,020 maturity value of the certificate minus $1,019). After allowing for inflation, we find this saver’s combined federal and state effective tax rate on real income is 620 percent ($6.20 divided by $1).

That is worse than slavery! A master can’t tax his slave more than 100 percent, because he has to devote some of the slave’s production to feeding, clothing, and housing him.

The consequences of inflation are insidious. It is, in effect, a subtle second tax. However, our present tax laws don’t allow investors to take it into account when they report interest “income.” When we do take inflation into account, we discover that the private sector is contracting and the public sector is expanding at much faster rates than it first appears. Using the numbers in our example, we see that capitalism is eroded and socialism is fueled not by 31 percent of nominal income from fixed-dollar investments such as certificates of deposit, but rather by 620 percent of real income.

Surely it is irrational to expect to continue to get the benefits of capitalism if we acquiesce in either the overt or the covert erosion of private property.

  • Dr. Dale M. Haywood taught economics and philosophy at Northwood University from 1965 until his death in 2006. He was loved by students and faculty, and famous for his 12-cell matrix which the Mackinac Center for Public Policy believes properly "describes why private property, a free market, a profit and loss system and limited government are necessary components for allowing people to prosper." Dr. Dale M. Haywood served on the board of scholars for the Mackinac Center for Public Policy and delivered his 12-cell matrix speech to an audience of summer interns over two-days.