Inflation, Capital & Capital Gains Taxes

An inflation that reduces the value of the dollar against a more constant measure of value--such as gold--by only 3% a year, destroys 2/3 of the value of assets, defined by a constant number of dollars, every 36 years. During the 75 years since Roosevelt confiscated private American gold, and redefined the dollar for the rest of the world in terms of one ounce of gold for $35, inflationary policies have reduced the value of the dollar by an annualized rate far in excess of 3% per year. Over that period, the value of gold against the dollar has appreciated an average of 4.36% per annum, compounded. Put the other way, the dollar has depreciated at a compound rate of 4.18% per year against the more constant measure. [N.B. These figures are calculated on the basis of gold at $860 to the ounce. If gold is still over that price at the time, you read this, the calculations below understate the essential point.]

When we use the term "inflation," of course, we refer not to the price level of goods or services at a particular moment in time, but to the increase in the supply of the circulating medium--i.e. money--both in the form of currency and money substitutes, such as loans from financial institutions. While inflation of the money supply will usually cause a rise in the level of prices, that effect may not be immediate, nor parallel the extent of the inflation. The market, understood in its fullest context, is a very complex aggregation of human action; indeed, incredibly complex, because it is an aggregation of individual actions, driven by the unique circumstances, needs, desires and capabilities of all who participate in one way or another. Thus, while the effect of pumping air into a tire is immediate; the effect of increasing the supply of money is only one part of a more fluid, pulsating, ever changing dynamic of individual actions. While inflation will always decrease the value of the monetary unit, unless the totality of those things that the market seeks money to purchase increase by an equivalent proportion, one can never precisely measure that decrease--certainly not in the short term, and never perfectly.

Yet it is possible to suggest a conceptual formula to help understand the aggregate dynamic. Consider: $V=$U/$T, where $V equals the real value of the American dollar (or British Pound or Euro, etc.), $U equals the total desired uses for the dollar (or other currency, being valued) at any moment in time, and $T equals the total supply of dollars and dollar substitutes (or other currency, etc.), at that same moment. It is, of course, impossible to precisely measure the $T denominator; the least of the problems being lost currency, or a debate over how to treat coins and bills withdrawn from circulation by numismatic collectors. The major problem is in obtaining a meaningful estimate of the volume of money substitutes, which must await later compilation from periodic bank reports. But the greater difficulty is to even estimate the $U numerator. Yet it is in this phenomenon that we find the principal explanation for the lack of an immediate upsurge in prices with a major inflation in the supply of dollars.

There are many purchases, both of contraband and various types of service, that are never recorded in any manner that may be audited. But the desired uses of money also include saving for the future, whether as a reservoir against the possibility of hard times, a specific future use, a vehicle to pass capital resources on to one's posterity, a contemplated act of charity, not yet completed, or some other deferred purpose. When the aggregated prices of commonly used goods and services decline, even while the money supply is being artificially pumped up, the cause is almost certainly to be found in an increased diversion of monetary resources to such effect. [Note, for a current example of the latter phenomenon, as well as the folly of the Keynesian theorists, consider the recent accusation that banks receiving "bailout" money were "hoarding" same, because they were not lending enough! In a crisis brought on by inane over-leveraging of assets--the reckless lending of the money substitutes, thus created, to those representing poor risks--the theorists, who promoted the original bubble, want no return to more frugal or provident conduct.]

This recognized, it nowise contradicts the expectation, whenever the monetary authority floods the market with unconvertible, or fiat, money, of substantial price increases in the not too distant future; the rapidity of which to be governed by the rapidity with which the market comes to expect further price rises to follow. Whether this leads to what may be properly called a "panic," or simply an inexorable loss of purchasing power over an extended period, will always remain to be seen. But a disproportionate increase in the supply of money in relation to all that money can buy, must eventually & inevitably lead to what the popular media has always confused with "inflation." That simply reflects the laws of supply & demand.

While some incredibly expensive events, such as World War II & the Vietnam War (coupled with LBJ's domestic spending attempts to make FDR seem a miser in comparison), had already drastically undermined the dollar, before the idiotic profligacy of the last eight years; nothing before September, 2008, offered anything quite comparable to the fiat money shower, seen in American dollars, over the past four months. Therefore, the coming depreciation of the dollar may be expected to be far steeper, far more dramatic than that over the past 75 years. However, let us see what a long-term, annual 4.18% dollar depreciation, actually means to the productive American, seeking to provide for future family needs and interests:

A hard working young husband, aged 30, has saved $5,000 from his after tax earnings since college, which he invests in the stock of a healthy company. He holds that stock for the next 36 years, collects dividends, on which he pays taxes, and considers the retained investment a "nest egg" against future need. When he is 66, he decides to sell the stock to help send his granddaughter to college. If the stock has merely kept pace with monetary inflation--or just enough over to pay the brokerage, he will receive $23,237.88 for the sale. In real terms, he has merely broken even on the capital transaction. But under the Keynesian socio/economic theories governing the U. S. Tax code, he has a long term capital gain of $18,237.88! At a 15% tax rate on long term capital gains, he will owe an additional $2,735.68 to the Government. Over 11.77% of his original capital has been effectively confiscated!

Say, instead, that at the moment our now 66 year old grandfather sells, he has a 20% growth, in real terms, on the stock, and receives $27,885.46 for the sale. Only $4,647.58 of that amount reflects actual capital growth, even in deflated dollars, but he suffers a taxable "gain" of $22,885.46! The tax on that amount, even at 15%, confiscates ($3,432.82) most of the relatively small actual gain. But what would happen, if the now more "Liberal" Congress were to raise the long term Capital Gains tax back to 28%? Then the tax on the small real gain becomes $6,407.93--far more than the actual gain!

Of course, in the present, with many shares selling at multi-year lows, our theoretical husband and grandfather, might actually be taking a long term capital loss, in real terms. What if his sale for the granddaughter's college only nets $15,000. In real terms he has lost $8,237.88 in today's dollars. But under Keynesian inflationary policy and related tax codes, even at 15%, he will owe a Government that has betrayed his heritage, $1,500! Yet things could be worse. He might have gone on saving until he was 36, purchased a long term bond for $10,000.00, and cashed it in when due, 30 year later, for face value, which at the 4.18% per year dollar depreciation would result in a payment equal to only 2,777.70 of his original purchase dollars. But one need not ask whether he could claim a loss against current income on his taxes. The reader knows the answer. (And please note, those lost 7,222.30, 30 year older dollars, would be worth over 3 1/2 times that in today's dollars, given the 4.36% compounded annual appreciation, discussed above.) [N.B. We have taken the smoothed 75 year effect, as the basis for these calculations. We realize that over any particular subset of that period, the actual gains and losses would have come in differing proportions.]

Finally let us look at what a now quite possible future dollar depreciation in excess of 6%, per year, would do to an investor today, considering the purchase of a 30 year bond, or a life insurance policy, payable in a sum certain in dollars, after 30 years? At a 6% depreciation rate over 30 years, the asset would retain only 15.6% of the current actual exchange value. At such a rate, a 10,000 stock purchase would have to be priced at $92,767.80, after 36 years, to even hold its value, in our previous family purpose example. Would the tax man be likely to treat such a sale for $92,767.80 as only "break even?" Again, the reader knows the answer! Sad to say, we believe that these calculations are based upon a hopelessly optimistic prognosis. The men in Washington, who every day show their contempt for the Constitution as the law of the land, have shown no greater respect or understanding for the laws of economics. We face a grim tomorrow.

Is The Above Described Confiscation Of Capital, Constitutional?

We are aware that some folk have challenged the propriety, indeed the efficacy, of the procedures by which the XVIth Amendment, which legalized an income tax, was ratified. We have never ascribed to such theories. However, it should be noted that the XVIth Amendment to the United States Constitution contains no language that would authorize the confiscation of Capital discussed above! The XVIth Amendment provides:

The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

The reason for the final clause, is that prior to the Amendment, the Constitutional language with respect to direct taxation of the people was that in Article I, Section 9, of the Constitution:

No capitation, or other direct Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken.

A direct tax, in proportion to the Census or Enumeration of the population would, of course, be one falling equally on every person, so enumerated. Taken in the context of other provisions, such as that in Article I, Section 10, which prohibited the States from making "any Thing but gold and silver Coin a Tender in Payment of Debts," it is clear that an unequal tax burden premised upon the wealth or income of the citizens was never intended. To the extent that was modified by the XVIth Amendment, Congress may tax us. But the Amendment only modified the earlier prohibition as it related to a tax on income. What we describe above, goes well beyond a mere tax on income. It involves confiscation of Capital, based upon a Congressionally caused accounting glitch: An accounting glitch that would have been avoided, had Congress fulfilled another duty, imposed by Article I, Section 8 of the Constitution:

To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures;

That provision does not provide for printing fiat money so as to destroy the value of that coined money, while abandoning any standard of measurement which might protect the integrity of that money. The ability to confiscate capital, as discussed above, is simply outside anything authorized either by the XVIth Amendment or the original Constitution. If Congress can call the pricing results of such contrived inflation, "income," there are no practical limitations on its authority to do anything it will, simply by calling actions or phenomena something they were never understood to be. To those who revere human liberty and/or the concept of rule of law, this procedure can never be acceptable.

William Flax
February 1, 2009

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