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Making the best of inflation

Government taxes what it creates. Here are some strategies for making the best of it

Making capital gains is the essence of investing. Yet many gains are nothing of the sort. They are only the illusory repricing of goods and incomes. Government drives inflation, then taxes stocks and bonds, incomes, house prices and even farms that are part of the repricing. If you think that this is unjust, you’re right. There are ways to cope with inflation-driven asset price changes and resulting taxes. Read on.

If inflation is, say, three per cent a year, then, in theory, a product’s retail price or a crop’s price should rise by a similar amount, a company’s products should go up that amount or something similar, and bottom line profits should rise by three per cent. If you buy a share of stock and hold it for 10 years and if inflation runs at three per cent for that decade, then the first 30 per cent rise in the stock price is just inflation.

There would be nothing unfair if all assets rose at the rate of inflation. Sadly, it does not work that way. There are really two markets for goods. First, the ordinary markets where land sells for $1,000 an acre in year one and then, if inflation is running at three per cent a year, sells for $1,340 including compounding 10 years later. Second, there is the special market in which inflation-driven price gains are not taxed. The most common market for this special treatment is a principal residence, the gain of which is not subject to capital gains tax. Second is the special market for farm land though the $800,000 farm land tax credit for qualified farms. That eliminates the tax on gains, some of which are driven by inflation.

Farms and principal residences and certain qualifying small Canadian-controlled private corporations have exemptions from capital gains taxation. Yet the great majority of other investments do not. Let’s look at what inflation means for the investments that have full exposure to inflation-driven gains.

Bonds and inflation

Bonds are a worst case in this context. In mid-December 2014, the highest return you could get on a 30-year Government of Canada bond was 2.32. Yet the Consumer Price Index has risen at an average of three per cent since 1960. The 2.32 per cent yield to maturity on the government bond will be taxed at the holder’s bracket rate, say 30 per cent, so that the after-tax yield will be 1.62 per cent. That is hardly a winning investment. The bondholder gets lots of risk and all the inflation erosion. The government, with no risk, gets the tax revenue.

The bond may appreciate for other reasons, as, indeed, long bonds have done for several years. Government of Canada bonds with terms of 10 to 30 years have generated average annual returns of about 7.5 per cent for the last decade. The gains have been driven by demand for long bonds by insurance companies that use them to match liabilities, pension funds that buy them for their future obligations, and investors who assume they can continue to capitalize on the trend. But this is a risky investment, for long term interest rates could rise, forcing down the appeal and value of existing long bonds. The problem comes down to the simple fact that bond price appreciation over the rate of inflation is very slight and that all of this gain will be taxed unless the bond is held in an RRSP, which merely defers tax, or a Tax-Free Savings Account, where the gains on assets are not subject to taxation.

Stocks and inflation

Stocks appreciate if their companies make more money and if shareholders expect rising earnings to persist or grow further. Dividends are subject to tax as well (outside of RRSPs, which defer tax, or TFSAs which eliminate it). Dividends, when taxed, are straight income if from companies based outside of Canada or are, if Canadian, given a tax break through the dividend tax credit (a mixed blessing if it triggers the Old Age Security clawback tax).

If dividends rise because company earnings, driven by inflation, rise by 30 per cent in period of a few year, then tax is paid progressively. Sale of shares driven upward by inflation are also taxed on sale with no reduction or adjustment for inflation. Some of the capital gain on shares or other property is inflation repricing, but there is no tax break for that process.

It’s invest, gain and be taxed on the inflation adjustment.

That is the bad news, but there is good news too. Investors can make inflation adjustments by collecting a premium while they own a stock. Writing covered calls, in which the investor can charge a premium for the risk that a stock will rise above a certain price, can also generate inflation-pacing gains. If the stock goes nowhere or falls, the investor keeps the stock, any dividend it pays, and the call premium. If the stock rises above the call price, he keeps the premium but loses the stock. Clearly, this is a strategy of limited use unless the investor has an active options strategy and can beat the market. The risk of failure is evident.

Inflation compensation

There are other ways to buy inflation compensation. Canadian bonds with inflation protection are called Real Return Bonds and pay handsomely if inflation exceeds a given target. Right now, RRBs are priced for inflation expected for the next three decades at 1.89 per cent per year for 30 years.

U.S. inflation-linked bonds called Treasury Inflation Protected Securities, TIPS, are similar. They are mostly long bonds and, as such, are vulnerable to price drops if interest rates rise a good deal. However, if you buy these inflation-linked bonds, there is nominal protection and gain from inflation over the target rate. In reality, gains on these bonds, which are repriced continuously, are charged as ordinary income and taxed in full tax every year even though you may not cash out for years or until maturity. You are in essence prepaying taxes on future value. The only way out is to hold these inflation-linked bonds in RRSPs, which defer tax, or TFSAs which eliminate tax on gains. But there is a good deal of risk, for if inflation runs at a lower rate than the bonds are priced for, you lose what amounts to an insurance premium you pay to buy these low-yielding bonds. Much of the time, conventional bonds with fixed coupons pay better.

Commodities

The final and best bet for getting paid for inflation is to bet on a commodity that is driven by inflation. Retail food prices are good proxies for inflation, so buying shares in a large grocery company should work. Of course, grocers have their own corporate strategies, so this is anything but guaranteed.

In the end, government, which creates inflation and then taxes it, is to blame. Inflation becomes a tax base. It is democratic in that everybody pays but it is unjust in that three per cent or so of most capital gains and even of ordinary paycheques is just inflation compensation.

Without inflation, we can have deflation. Government won’t give tax refunds if your asset prices shrink. But real deflation causes companies to be unable to pay their bills, unemployment rises, bankruptcies soar. The only winners in deflation-driven markets are people who hold government bonds backed by the power to tax and even to print money if need be. If we do get a serious dose of deflation, those government bonds, which currently pay little, would be hugely profitable.

That’s the irony. Government creates inflation in which you lose. If it cannot beat deflation, then investors in the same government’s bonds would be winners. If you think life’s unfair, inflation economics is your proof.

About the author

Columnist

Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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