Tax-flation Going Broke Safely

by Jeffery A. Keill, CFP, CIM,FMA,FCSI, Portfolio Manager and Wealth Advisory Keill & Associates- Advisory Team

In 1973, Roberta Flak released her version of ‘Killing me softly with his song’ which reached Number 1 in Canada and The USA. In those same years both inflation and interest rates began to rise dramatically. Every time I hear this song I think about the slow erosion of wealth from tax and inflation. For those who do not know me will think this is strange. This Brief Discussion Paper is a discussion on the slow capital erosion that happens over time having devastating consequences to people’s financial security. Yet people, mostly due to fear, allow it to occur. The song Killing me Softly with His Song reminds me of this financial tragedy and I can’t help but change the lyrics to “Killing me Softly with his Tax’. The idea of ignoring the realities and the long term impact of tax and inflation by choosing to avoid all risk is simply a way to go broke safely. The irony is choosing safe is the consequence of also choosing failure when it comes to long term planning.

What is ‘safe investing’ and why do people seek guarantees?

I have never met anyone, while sane or sober, that has declared to me a desire for the lowest amount of investment return for the greatest amount of risk. The prudent man would seek out the opposite- maximum return for the least amount of risk. This is no different in many ways to only wanting the cost to be equal or less than the value received. I am not going to pay $2 for something worth $1 nor am I going to take on more risk and not expect higher return.

Risk is a 4-letter word. A dirty word for many; but it shouldn’t be. In truth, risk and return are absolutely connected and have an unbreakable bond. You can not have one without thinking of the other. Seeking low risk means acknowledging lower returns. Seeking higher investment returns means you will accept higher risk. Risk, for the sake of this paper meaning a variability of returns and investment values. Comparing financial risk between various assets, in the short term, can be viewed as the deviation of returns around a standard (sounds like Standard Deviation from stats class?)

The higher the variability the greater the fluctuations in returns and value. These investment returns as expressed by percentages or gains and losses when expressed by dollars. Over time, these short-term variations of outcome experiences have little impact on the longer term financial returns we are truly seeking to attract. When investors think of risk, people seem to think in short periods. Unfortunately this is where many go wrong. Wealth creation is measured over a lifetime whereas risk is viewed by many in terms of today and tomorrow.

When I ask people what they are most afraid of when it comes to investing, the answer is always- ‘I don’t want to lose my money!’. To the extreme, the answer is I don’t want to lose ANY of my money. When they make this statement, it seems pretty simple. I invest $100, I want to get back my $100. Who would argue this point and this will lead most people to search out the lowest risk investment that satisfies this need of a guarantee on their deposit. In the short term this will look wise but over the long term, this approach will lead to disaster almost 100% of the time. The longer the time horizon the greater the chance of failure. Looking at risk in these short-term periods creates the scenario where investors end up “ going broke safely”. Let’s look at this further.

Inflation:

At the same time Roberta Flack song was rising to number 1 position in the music charts, so was inflation on the rise. The rise of inflation during the 1970's and into the 1980's led to tightening of monetary policy, which in simple terms means the Bank of Canada started to raise interest rates to slow the economy and thereby lower inflation. By raising rates the central bank tapped on the brakes of the economy to try to slow it down. The higher the interest rates went the harder the Bank was pushing on the brakes. It is a delicate touch to tap the brakes just enough to slow the car but not enough to bring it to a complete stop and turn it off. Inflation in Canada went from 2.7% in 1971 to 7.49% in 1973. Sound familiar today? It is important to realize that inflation causes prices to rise. A basket of groceries last year that cost $100 just five years later would cost $125 if inflation was 5% per year. To think of it decrease or erosion of your purchasing power over time.

Now, slightly time lagged after the rise of inflation during these periods, interest rates on conventional mortgages rose from and average of 4% in the proceedings 10 years to over 10% by 1974. Sounds familiar today? Rates kept rising throughout the 1970's until they peaked in 1981 at 18%.

Of course the fact that interest rates on mortgages rose during the 1970's and most recently in 2020's also means that depositors are given a higher rate of return on their deposits in things like GIC’s and High Interest Savings Accounts. As matter of fact, in 1973 you could have earned 7.5% on a deposit at a bank. Today you could earn about 5% on a deposit. In the decades before the 1970's and the 2020's deposit rates were down around 3.5% and 2% respectively. On the surface, it would seem depositors are huge benefactors of these higher rates meant to kill inflationary period. In a moment we will review the effects of inflation on these higher deposit rates.

Income Tax:

Although our ‘temporary war measures’ tax act has been around since 1917, it was really in the 1970's the government tax policy started to get more aggressive in the collection of tax to fund deficits and spending on the ever increasing social programs. This has hardly changed up to today. The art of ‘ plucking the goose until is hisses”, as French Minister of Revenue said back in the 1600's has been a constant threat on the long term ability to build wealth for Canadians. Introduction of capital gains tax (which is not even technically income!), the introduction of the GST/HST, and the clawing back of benefits through income testing has a direct impact on our ability to build wealth.

Tax-flation:

When we look at these two detractors of personal wealth building together, we can see the impact on our ability to grow. This is something we like to call “Tax-flation”.

Not to long ago I was giving a presentation on the impact of tax-flation on investors at an event in Ottawa. Before I took the stage a gentlemen stopped me and asked, that I explain how investors were better off during high interest rate periods than during low interest rate period. I explained that was what I was going to talk about but he might not like what I had to say. Here is how it went.

In 1981 inflation peaked around 12.5% and deposit rates also peaked around 19%. Can you imagine a deposit return where you would make almost 20% per year?! Well, here is how it actually played out. If you had invested $10,000 at 19% that year you would have earned $1,900 in interest. Not bad. Of course, the pound of flesh must be paid by way of income tax. If your marginal tax rate is 35% you would have been left with a net amount after tax of $1,235 ($1,900  income- $655 tax).

To keep up to inflation you needed to earn at least $1,250(or 12.5%). You had $1,235 left after tax to spend but inflation eroded this by $1,250. This leaves a true negative gain in wealth of -$15. As expressed as the after tax and inflation (tax-flation) rate of return meant your wealth grew by -15%.

The result is no different for depositors in 2024 with deposit rates at 5.25%, inflation at 3.75% and tax at 35%. The result is a negative growth rate of -0.09%

Your true wealth does not increase when you consider tax-faltion. You are truly going broke slowly and truly going broke safely.

How to combat the evil effects of Tax-faltion?

Here is a short list of ways to increase your family’s chance of long-term wealth creation success:

• Educate yourself. Reading articles such as this will increase your understanding around the truth of risk and returns. One of the banks used to have a slogan that Knowledge is Power. I think this is cute but at the same time stupid. There is a difference between having knowledge and having wisdom. The key is to not only learn about tax-flation and investing but to gain the wisdom on how to implement successful strategies or work with someone who can.

• Invest in things that have a history of producing long term exceptional returns that consistently out perform the effects of inflation. Deposits do not achieve this. Investing in ‘loanership” investments (such as GIC’s, High Interest Savings Accounts, ect.) on their own will not achieve the outcome you desire. “Ownership’” type investments such as real estate and shares in quality companies do achieve this. History has proven this repeatedly.

• Learn about tax preferred incomes. Not all income is created equal. Passive income such as interest is fully taxable whereas other more active types such as dividends and capital gain are tax preferred. In other words- you pay less tax on some income. Learn the difference and tilt towards that which is preferred.

• Learn about sheltering and the ability to growth wealth while legally avoiding tax or deferring income to a later year when tax rates may be lower. By differing the tax, you also, in a strange way, let the affects of inflation work in your favor. Think about it... If you owed $10,000 in 1970 it was far greater real amount than $10,000 today.

• Speak to a professional Wealth Advisor. Yes, this is a shameful plug for our Team and other Wealth Advisors out there. Truly we spend most of our time helping clients achieve exactly what we have spent talking about here. The real cost is not the fee. The real cost is the lost value you would receive.

The next time you hear Roberta Flacks “Killing Me Softly” song, think of this topic. Think about how you are positioning your financial future to avoid the long-term wealth erosion of tax flation. Don’t set your self or your families financial future on the fallacy of safety when this will ultimately lead you down a road of going broke safely.

Disclaimer and Notice to Reader: This Discussion Paper should not be construed as legal or tax advice but rather only as a general statement and explanation of the topic matter. Professional tax and legal advice should be obtained for the readers own personal situation. For more information on this topic or how it applies to your family, please contact our Wealth Advisory team.

Last Edit Feb 7, 2025