Thursday, October 30, 2008

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.

16 comments:

  1. Kevin R.C. O'Brien10/30/2008 2:35 PM

    This is a good catch. Of course, since the government has some means of controlling inflation, inflation can also be seen as a sub rosa tax.

    Unfortunately, Republican profligacy over the last eight years, and the mind-boggling corruption throughout Congress, seems likely to yield only to Democratic profligacy.

    No matter who you vote for, the Government always gets in.

    ReplyDelete
  2. No matter who you vote for, the Government always gets in.

    LOL! But, unfortunately, that thought just ruined my day.

    ReplyDelete
  3. There's also the issue of the higer marginal tax rates that welfare programs place on the poor.

    If a person is receivng housing, food, or child care assistance, things which are very expensive when you pay for them yourself... they face the cost of losing those assistance programs as their salaries rise PLUS the spectre of tax payments to support those programs they no longer use because they've been means-teasted out of them.

    Ouch! More incentive not to work.

    ReplyDelete
  4. I would like to point out (and I sent Prf Mankiw an e-mail about this) including the corporate tax rate in the calulation skews the numbers.

    It doesn't change the basic fact that McCain's plan is less punative than Obama's. However, it does reduce the projected returns substantially.

    ReplyDelete
  5. tax brackets are indexed


    are you GDMFGs that stupid?

    ReplyDelete
  6. "tax brackets are indexed" - nick

    Maybe, maybe not.

    Take AMT. Please.

    AMF.

    Stop being an arrogant jerk. Everyone may like you.

    ReplyDelete
  7. Perhaps the 10% return that he assumed is adjusted for expected inflation.

    -Ryan

    ReplyDelete
  8. "tax brackets are indexed" - nick

    Maybe, maybe not.

    Take AMT. Please.


    AMT, certainly. Also long-term capital gains, which are much of what is involved in investment returns. The difference between what you paid and what you sold it for is currently taxed at 15%, regardless of how much of any increase is due to inflation. Even if the tax law isn't changed, that 15% will increase to 20% on January 1, 2011. My guess is that it will be at 25% before the end of 2009 if we have a Democrat President and a Democrat majority in both houses of Congress.

    ReplyDelete
  9. i said TAX brackets, income tax brackets!

    ReplyDelete
  10. Republicans always earn more money than Democrats. In fact, once a person's income rises above a certain level, as a group, they will inevitably become appalled by Democrats.

    Hell, Republican women are much hotter than Democrat women, too.

    ReplyDelete
  11. For the liberals its a feature, not a bug. If investing your money gets you nothing then relying on the government to pay your way is more and more attractive, and you will tend to vote more along the way of the politicians who want to "take care of you."

    Its not even a slippery slope: its free falling.

    ReplyDelete
  12. maxwellthedog10/30/2008 4:21 PM

    One problem with this analysis is that it leaves the rate of compounding (rate of return on corporate assets) static while inflation is raised. A more realistic assumption is that as inflation rises, so do returns on corporate assets. This makes sense from an macro viewpoint as well-- if inflation increases because money is readily available, then returns demanded by investors (corporate or otherwise) will rise as well (or you just put your money in risk-free UST's).

    This fact mitigates some of the effect of this analysis, but does not negate the underlying truth that Obama's tax are a significant deterrent to both working and saving.

    ReplyDelete
  13. In general terms, assume a real rate of say 2% and a perfect-foresight nominal of 2+inflation.

    Then instead of trial & error, we just have to make sure our net after-tax return is at LEAST the inflation.

    If inflation is 4%, nominal is 6%. IF the total tax take exceeds 33%, then we are not netting 4% and thus losing to inflation.

    Compounding this one year view merely exaggerates the effect.

    ReplyDelete
  14. An analytical history of Stock Market bottoms.

    Is Obama's brand of socialism being discounted by the market?

    ReplyDelete
  15. ann coulter looks like a horse

    dont tel lme GOP women are pretty on the average

    ReplyDelete
  16. "dont tel lme GOP women are pretty on the average"

    er.. they are. Plus, you were only able to find flaw with 1 of the 15 women on that list.

    Ann Coulter is better looking than, say, Rosie O'Donnell or Janet Reno. Any heterosexual man would agree.

    Then again, you are not a heterosexual. So how are you qualified to judge the relative beauty of women?

    ReplyDelete

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