Adding Inflation to Greg Mankiw's "Work Incentives" Post

When I first read Greg Mankiw's post on Personal Work Incentives I found it interesting enough to write a post of my own on it (Berman Post: The True Effects of the McCain and Obama Tax Plans). Mankiw had effectively shown the true dampening effect higher taxes has on work incentives. If I understand what he did however, he missed something which increases the dampening effect; inflation.

Brief recap: Mankiw calculated how much you would be able to leave for your child for every extra dollar you work. If we had no taxes that dollar would turn into $28 in 35 years. That same dollar in the same time frame would become $4.81 under McCain's plan and $1.85 under Obama's. As bad as those numbers sound, when viewed through the prism of inflation they get even worse.

Now for the calculations. I start with Mankiw's results and then adjust for the value of inflation over 35 years to give you the real dollar value.

Obama's $1.85 becomes:
With 2% inflation -> $0.91
With 3% inflation -> $0.64
With 4% inflation -> $0.44
With 5% inflation -> $0.31

McCain's $4.81 becomes:
With 2% inflation -> $2.37
With 3% inflation -> $1.66
With 4% inflation -> $1.15
With 5% inflation -> $0.80

Some quick takeaways. Even with the unlikely low inflation rate of 2%, the taxes under Obama's plan would mean losing value on your savings. In other words, the dollar saved today would be worth less then a dollar in value terms when your kid's spend it in 35 years. Even with the slightly high inflation rate of 4%, the taxes under McCain's plan would mean gaining value on your savings. In other words, the dollar saved today would be worth more then a dollar in value terms when your kid's spend it in 35 years. It goes without saying that no taxes would be better for you then either candidates plan.

To really understand the difference, the final calculations will determine the break even inflation rate number. The break even inflation rate number is the inflation rate at which the dollar invested today will equal in value a dollar in 35 years. At that rate their is no penalty in saving, nor is their any incentive to save. A higher inflation rate means the person saving is penalized by saving, while a lower inflation rate means the person has incentive to save.

Break even inflation rate number under Obama's tax plan = 1.75%
Break even inflation rate number under McCain's tax plan = 4.40%

Obama's plan ends up penalizing savings unless the inflation rate averages below 1.75% for the next 35 years, a very unlikely event. McCain's plan encourages working and saving unless inflation rates averages above 4.40% for the next 35 years, also an unlikely event. McCain's tax plan provides more incentive both to work and save then Obama's does.