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The silent tax collector: Inflation

Published on 08/07/2021

Taxes are what everyone loves to hate. Apart from taking a chunk of our hard-earned cash, we all dislike something we don’t fully understand. It’s heavy, complex and can be less than fun to figure out the intricacies... and inflation is effectively a hidden tax.

Some economists, such as Milton Friedman suggested that, under certain circumstances, inflation can become an effective form of tax as it has eroded the real value of people’s wealth. He is once famously quoted as saying “Inflation is taxation without legislation”.

In many countries, we have limited experience of inflation over the past three decades and therefore many of us can not fully grasp what may happen to our daily lives, as well as our assets if inflation does surge. There have been concerns about inflationary rises in the west over the last 30-years due to an unprecedented global money supply, which in turn has brought fear about the uncertainty of inflation risk to many people, investors and consumers alike.

As we can reduce our tax bills by understanding more about the tax allowance and tax system, we can save hidden costs and protect our wealth from the invisible tax caused by inflation by knowing what asset classes and investment strategies have historically tended to do well or poorly in environments of high and rising inflation.

A group of quantitative researchers recently identified statistical evidence about the impact of inflation over the last (almost) 100 years. Whilst some of the analysis reaffirms what we already know or can intuitively guess, the findings showed that the ways to protect from the inflation risk are quite similar to those of tax saving.

First, as tax rates and allowances are different depending on the taxpayer's situation, different asset classes perform differently. Traditional assets such as equities and bonds do not perform well in real terms during inflationary periods.

On the other hand, hard assets such as commodities, residential real estate, and collectables like art and wine are more robust in general. Out of the hard assets, commodities have historically performed best during high and rising inflation. All commodities have generated positive real returns during the eight U.S. inflationary periods. Foodstuffs like agriculture and softs (such as coffee and sugar) fare the worst, whereas energies outperformed by a significant margin. Residential real estate and collectables such as fine art, wine and stamps could be assets for an inflation hedge but some caution should be taken due to liquidity constraints - if you can’t sell it, then does it have value?

Secondly, equities benefit from rising inflation if the starting level is low, but significantly hurt by rising inflation when this starting inflation rate is more than 2.6%. This is similar to the complexities of the tax system. For example, higher income tax can enable redistribution of income within society, but at the same time, it may have an impact on reducing the incentives to work and supply labour.

Finally, like the old saying “no pain, no gain”, in order to save our tax bill legitimately, we need to pay more attention to it and make an effort to understand tax rules and allowances. Likewise, when it comes to the selection of investment strategies between passive and active approaches, inflation favours the strategies that need more effort.

Trend-following strategies in literally all asset classes including equities, bonds, foreign exchange, and commodities have strong hit rates during the eight inflation episodes and provide an impressive level of protection.

We don’t know if inflation will surge or not in the near future and don’t have insights to forecast when or how it may appear, however, like any tax saving efforts we aim to make, thinking about what may happen to the performance of a wide range of asset classes as well as investment strategies could save us from the hidden tax caused by inflation.

There’s an art to being prepared and a science to being right.

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