Grim implications of Inflation & Taxation
In this article, I intend to discuss the devastation that inflation & taxation causes to our income & savings. Merely understanding implications of these, will break delusions (& hearts) about money.
Precursor on Inflation
Inflation is the rise in prices of goods & services over the years.
In my previous blog, ‘Why one must “save” & “invest” “early” ’(read here), part of the blog dealt with ravages of inflation. Here is a short demonstration of the impact of inflation. Suppose you had 100K INR in 2006 & you stashed it under your bed & forgot about it for a decade. One decade later, in 2015, you suddenly recall that stash. What is the value of 100K? It’s 41,264. YES!!! It’s dropped by 59% over 1 decade! Here is the graph showing how consistently this occurs:
Value of 100K consistently drops by <more than> half over a decade due to inflation.
Oh, & this was with official Indian government reported statistics. Reported inflation is much lower than inflation readers would practically come across since it doesn’t include any premium service that we use. Inflation on premium services is difficult to measure, so I will stick with government statistics. As we will see further, the implications of govt. reported inflation is disheartening enough.
Using official Indian government data, 15 year average of inflation is about 7% per annum.
Above stat is useful for further analysis.
Salary Growth — Consequences of inflation & taxation
Incremental Rupee earned is taxed at 31.2%
The highest income tax bracket in India is 31.2% (30% income tax + 4% cess on that). In this bracket, every INCREMENTAL rupee, earned over 10L* (per year) is taxed at 31.2%!
31.2% tax combined with (5%/20%) tax slabs has interesting consequences on IN HAND salary growth.
Let me take an example, suppose someone earns 10L & get’s an increment of 10% (10% for simplicity of calculations). This is how approximately the IN HAND cash varies before & after increment.
Assuming 10% pre-tax growth leads to only 7.8% In-hand cash growth!!!
The calculations are approximate. There would be a lot of factor such as growth in EPF, current level of salary etc.
The message should be clear.
PRE TAX Salary growth must be 9–10% for IN HAND CASH to play catchup with inflation (7%)!
Taxation plus inflation is a double whammy on salary growth.
Practically, the long-term implication of Inflation & Taxation is nuts! Even 9–10% salary growth won’t suffice! One rough patch. Perhaps you are unemployed for a few months. (Recession/Health concern/Sabbatical/Anything) & BOOM! Your income took a drastic hit one year. Now, your salary must grow by much higher than 10% just to catchup now.
Personally, I would have mixed emotions (both happy & sad) if my salary JUST matches with long term inflation (after taxation). Obviously, I would dream of higher income growth. But. I don’t burden myself with high income growth expectations.
Expenses — Consequences of inflation & taxation
We spend money on a post-tax income. But the income we associate ourselves with is often pre-tax(CTC!!) This creates a fundamental disconnect in our thinking.
Suppose you want to spend 100K more next year. Maybe you have an exotic foreign trip planned. Maybe you want to buy some electronic device. Or perhaps something else.
You must spend 100K from your post-tax income. What do you need to be able to afford this spend? You need an incremental pre-tax income of 145K (100K/(100–31.2%)) to really just cover up for this large scale spending.
Spending that 100K is quite easy. Earning that 145K just to afford to spend that extra 100K is hard.
When you think of your next large spend. Just take this 1.45x factor in consideration.
I know. Some readers are rolling their eyes over this mathematical trick, arguing that there is no need to earn an extra 145K as 100K can be adjusted with current income. Well, yes. This isn’t required for regular expenses. But rare & over the top luxury spends? For that you need to think wisely.
Implications of inflation & taxation on LUXURY Expenses:
There are two caveats on luxury expenses:
- Luxury expenses command a much higher inflation.
- Luxury expenses are addictive — Let’s take an example. An exotic foreign vacation. You want to go there once. Just once. And you manage to make it happen. But you wouldn’t be satisfied with just ONCE! After the first one, you want another one. Then another. Then another. There is no end to it. You will be ADDICTED to the luxury expense. This is going to happen with ALL luxuries expenses! (A common luxury product that’s difficult to afford long-term: Petrol/Diesel. Yes. Even Petrol/Diesel is likely difficult to afford long-term. More on that some other time!)
You can’t sustain the subscription cost of a luxury expense!
Let’s take a simple example to understand why luxury expenses are extremely difficult to sustain. Consider someone earning 100K per month. For simplicity assume he spends it all & manages some luxuries on that. Next year, he is able to grow his income by inflation. Most of his expenses have also grown by inflation. But his luxury expenses will grow faster than inflation. So, he can’t really plunge into the luxury this year! But, let’s for once say, he manages it somehow this year. What about the year after that? What about 5/10 years after that? He will likely not be able to afford it. He is going to be disappointed that he can’t afford the luxury anymore!
In a more practical scenario, for young adults, financial goals will increase over time: that will require more savings. One of the following will happen with luxury expenses over the long term:
1. Lower savings over the years, to sustain luxury expenses. OR.
2. Savings is preserved. But Luxury expenses are stopped. Luxury expenses are phased out.
Pick your choice. With either choice, long-term disappointment is almost guaranteed. Remember. Humans think in path dependent way. Not outcome dependent.
Investments — Consequences of inflation & taxation
I will keep this brief. It was already covered in detail in my previous blog, ‘Mutual Funds- Compounding & Inflation’. (read here). I had investigated long-term rolling returns of benchmark Nifty 50 & adjusted it’s return for inflation & taxation. Assuming 60% exposure to equity led to the about 3–4% returns on total portfolio. Even the BEST case of portfolio was mere 6%!
Total Portfolio returns are going to be in low single digit range after accounting for inflation & taxation!!
To be clear, I am NOT discouraging saving & investing, infact, WHY save & WHY invest was covered in detail in my previous blog (read here).
Quick question
Let me ask a DUMB question:
Person A: Grows his investment portfolio after inflation & taxation by 10% for 10 years.
Person B: Grows his investment portfolio after inflation & taxation by 5% for 10 years.
Obviously, Person A ended up with a larger corpus right?
NOOOOOOOOOOOOOOOOO! WRONNNNGGGG!
It was a trick question. It depends on who saved more money. Person B CAN have a larger corpus if he saved more than Person A.
High Savings- Panacea for ALL things money
There are just too many advantages in personal finance with high savings. It’s difficult to list them all down. But let me try. High Savings as a habit ensures you are better prepared for any emergency. It brings a habit of utilizing money judiciously.
High Saving ensures low luxury/lifestyle expenses. This itself has HUGE advantages:
- Lower Luxury expenses implies inflation experienced personally is low. Hence pressure on growing your salary is lower.
- The saved corpus, when liquidated, will last longer. Since it will be used on low inflation needs & due to habit, it will be used judiciously.
Having high savings really takes care of all the financial worries.
Parent’s Generation — Mismanagement of Money?
There is a general belief amongst my generation about our parent’s money management. Parents invested in terrible instruments & hence destroyed their hard-earned money over the long term. I was under that delusion too. However, now I realize something much deeper:
1. Parents hit home on the most important financial metric. They had HIGH SAVINGS!!!
2. Financial education & awareness: Their generation did NOT have any tools to learn about money & educate themselves. Hence, they did what everyone else was doing. BUT our generation do have these resources available! YET. So many continue to mismanage money. Parents put a lot of efforts on savings. ARE YOU TAKING THE SAME EFFORTS ON YOUR FINANCIAL EDUCATION?
Conclusion
Let your EXPENSES CRAWL & SAVINGS LEAP! That’s the only way you get RICH.
(Above line is an altered quote from Nassim Nicholas Taleb: ‘History doesn’t crawl, it leaps.’)
I sincerely hope I have broken some preconceptions about money for a few readers. If not, some Parting Horrors:
- Under-estimated Inflation: All this with simply government reported inflation. Imagine all this, with a more practical real-life inflation?
- Tax Rate seems to be rising! Some trends:
a) Cess applicable on income tax was assumed as 4% for my article. Let’s track it’s history. Cess was introduced at 2% in 2004. Increased to 3% in 2008. Increased again to 4% (current rate) in 2018
b) Long term equity taxation introduced at 10% in 2019
c) Long term debt taxation increased to 20% from 10% in 2014
d) EPF taxation introduced in 2020 (Applicable above a certain limit)
e) Stamp duty on mutual funds introduced in 2020 (Currently feels insignificant at 0.015%. Future of this is a mystery.)
Life is a race. Race Against Inflation & Taxation.
*- 31.2% incremental tax is applicable for >10L income for the old income tax system, whereas 15L for the new income tax system. Tax rate greater than >31.2% for >50L income due to surcharges.
