Inflation is the most clever, pervasive and destructive of all the sneaky methods governments have put in place to steal from their citizens. Unless you understand what it is, your investment success will be hamstrung. I will now explain to you, in as simple language as possible, what inflation is and what to do about it.
Investment is fundamentally the art of buying assets that increase in value faster than inflation, rather than decrease in value. Robert Kiyosaki’s book “Rich Dad, Poor Dad” is dedicated to this concept. It is a great book, but could have been written in 30 pages! It is amazing how many people don’t understand this most basic of concepts. They spend their lives accumulating depreciating cars, boats, jet skis, furniture, clothing, high-rise apartments and so forth. They should be accumulating quality stocks, commodities, land, homes and businesses, all of which have a much higher potential for appreciation. What Kiyosaki does not tell you is the underlying cause of this phenomenon of rising prices. In a word it is inflation. The job of all investors is to create a return greater than the real rate of inflation, period.
Unless you can achieve this fundamental goal of beating inflation you will be constantly going backwards financially, and need an ever increasing income to stay still. I recently spoke to a man who retired 15 years ago with a $300,000 nest egg. He lived comfortably for a few years but now he is desperate. When he first started his retirement he could have bought two homes with money to spare. Now he cannot even buy one house and is desperately searching for ways to grow his capital again. Inflation has crippled him because he didn’t know what it was and how to beat it. Everyone who sold their house just before the Australian real estate boom years of 2000-2006 knows the ruthlessness of monetary inflation. Pensioners are also trapped because of their fixed incomes. Retirees living on the interest from bonds are likewise suffering as interest rates reach historic lows while the true cost of living rises much faster.
The official inflation rate is measured through a mechanism called the Consumer Price Index, or CPI for short. Wage earners listen up: Don’t think for one minute that if your rising salary is indexed to the CPI increases it will help you keep up with monetary inflation. Wage rises average about 2-4% a year in the better industries and professions. This is roughly the same as the official monetary inflation rate as calculated by the CPI. However, to trust the CPI figures is like trusting self-regulation in the used car industry. This is because since the 1990’s, western governments have started to exclude from the official CPI all items that increase in price quickly. If you think that’s bad, they are also subtracting; yes, you heard correctly, SUBTRACTING from the inflation rate any item that rapidly increases its technological level, such as computers. “Hedonic adjustment” is the term for this deceitful practice. In 2013 a new weapon was introduced by the USA government to keep the official figures lower than what they should be. It is called “substitution” and it goes something like this: If a shopper can elect to buy spam instead of a steak, or watch TV rather than go to a game or listen to a radio if TV prices are rising, then the costs of the former are no longer going to be considered inflationary. This is the theory of substitution and is really being considered for social security inflation benefits and you know the CPI in time.
The bottom line is that it is no longer safe to trust a government when it publishes an inflation figure of 2-3%. A current official CPI inflation rate of 3% is equivalent to a rate of CPI inflation rate of 7% as measured using methods used as recently as the mid 1990’s! If you want to know what the real inflation rate is then I suggest you go the leading experts on inflation, housewives! They can speak for hours on the price increases they endure at the supermarket and retail shops. If you want to check out the real inflation rate in the USA look up this site www.shadowstats.com . It will show you what the inflation and unemployment rate is in America using methodology used by the government as recently as the Clinton Administration. Also look at house prices, as these are a brilliant long term indicator of inflation. The Reserve Bank of Australia says house prices have averaged 7.25% annual price gains from 1985 to 2015. Another good indicator of the inflation rate is the price of gold, the one currency governments cannot print. It has averaged 10% across all major currencies since the year 2000. Now can you see the bigger picture?
THE CAUSE OF INFLATION
So what really causes inflation? Understand this secret and you are well on the way to beating the banks and government at their own game. In the modern world there are two types of inflation. The first type, which is of minor importance, is caused by short term scarcity such as higher food prices in a drought or the availability of land in the centre of a growing city. The second type of inflation is monetary inflation. Contrary to popular myth, monetary inflation is not the slow and relentless increase in prices. This is simply the effect of inflation. To say monetary inflation is an increase in prices is to suggest that the weather is caused by the rain. Rain is the product of the weather while the sun is the cause. Monetary inflation is caused by the creation of extra units of currency, and this is done through the banking system. It is condoned and encouraged by all governments because of the hidden benefits it gives them, which are listed a little further into this essay.
The actual nuts and bolts process of currency creation occurs when people take on new debt. The money you borrow from the bank is a fiat creation, that is, it is created out of thin air and issued to you. I wish I could do that but the privilege is given to banks only. When you make repayments on your loan the bank extinguishes the fiat money you borrowed, while the interest you pay from your income is real money taken from someone else’s debt! So, if there was only ever one loan made in the history of Australia there would be a net drain on the money supply from the community into the hands of the lender as you paid back the interest.
Let me explain how the scourge of modern inflation began. In renaissance Europe, trade was conducted primarily in gold and silver coins. Coins were durable and had value in themselves because of their scarcity, but they were hard to transport in bulk and could be stolen if not kept under lock and key. Many people therefore deposited their coins with the goldsmiths, who had the strongest safes in town. The goldsmiths in turn issued convenient paper receipts to the depositors that could be traded in place of the bulkier coins they represented.
The mischief began when the goldsmiths noticed that people began trading the receipts instead of the gold and only a fraction of their receipts came back to be redeemed in gold at any one time. They could therefore get away with printing extra certificates over and above the gold they held in storage and “lend” them to people who needed money, then charge interest on the loan! As long as they kept a certain percent of the value of their outstanding loans in gold to meet the demand their fraud was initially undetected. They could thus create “paper money”. They typically issued notes and made loans in amounts that were four to five times their actual supply of gold. If 20% of the gold was used to back these loans, a gold single coin could be loaned out in paper cash five times over.
All this was based gold the goldsmiths did not actually own and could not legally lend at all! If they were careful not to overextend this “credit,” the goldsmiths could thus become quite wealthy without producing anything of value themselves. However, since the money supply was now multiplying rapidly, after several decades more money was eventually owed back in principal and interest to the goldsmith than people as a whole possessed originally. They then had to continually take out loans of new paper money to cover the shortfall, causing the wealth of the given town and eventually perhaps the whole country to be siphoned into the vaults of the goldsmiths-turned-bankers, while the people and governments fell progressively into their debt.
The goldsmiths eventually became bankers. The word bank comes from the Italian word bench which is where the goldsmiths conducted their business out the front of their shops. The practice eventually allowed kings to finance wars they never dreamed possible before. The Medici families of Florence were best of the bankers and their wealth allowed them to dominate Southern European political, cultural and religious life from the15th to the17th centuries. The entire fraudulent process had gained such momentum in Europe that by the 1600’s it was considered normal practice and central banks run by governments were starting to be set up to regulate it.
Over in the new world, America inherited this banking culture that allowed private banks to issue their own banknotes in sums up to ten times their actual reserves in gold. This was called now called “fractional reserve” banking, meaning that only a fraction of the total deposits managed by a bank were kept in “reserve” to meet the demands of depositors. But periodic financial panics led to runs on the banks when the customers all got suspicious and demanded their gold at the same time this caused banks to go bankrupt, which simply means ruptured bank, caused the entire monetary system to become unstable.
In 1913, the private banknote system was therefore consolidated into a national banknote system under the Federal Reserve, a privately-owned central bank which was given the sole right to issue Federal Reserve Notes and lend them to the U.S. government and to banks. These notes, which were issued by the Fed basically for the minimal cost of printing them, formed the basis of the national money supply. The whole world eventually followed. Because of the inherently fraudulent nature of the system, all nations now have fractional reserve banking, a central bank and an inflation problem.
Each country’s central bank is the system’s dubious umpire. As it manipulates interest rates it can control the speed at which total debt levels grow. This controlled growth in debt ideally fixes the pace of inflation at somewhere around five percent. The central banks of the western world would never dream of having an inflation target of zero, which would be a wonderful benefit to the whole society. But you will never read on the internet that inflation is five percent as that would cause people, especially government workers to demand much higher wages.
According to a report by AMP, Australian average household debt is now four times what it was 27 years ago, rising from $60,000 to $245,000, reflecting an annual growth rate of 5.3 per cent above inflation and leaving our income growth rate of 1.3 per cent trailing in its wake. The Reserve Bank of Australia’s own inflation calculator shows that a basket of goods bought in 1950 has suffered an annual inflation rate of 5.13% since that time. Since 2000 it shows Australians have suffered a 51% decrease in the purchasing power of every dollar we own. Even with the recent low official inflation figures (due to a reduction in the speed of private borrowing), the cost of education is consistently doubling the official inflation rate and private health insurance premiums are currently rising by 5.5% per year. I rest my case.
What I have told you in the paragraphs above should have shown you why the low-ball figures of one to three percent that you hear about in the media and on the news are fictitious. This is all very deliberate and criminal, but still it is universal the world over now due to; the monopoly control over currencies by governments, the final ditching of the gold standard in the early 1970’s, the insatiable desire for politicians to spend more than they collect in tax, and universal government reluctance to pay for spending through increased taxation.
Inflation also enables politicians to pay down their old debts with lower value units of currency in the future. This system works also well for home owners, but retirees, renters and businesses hate it. Thus constant inflation has been the norm for the western world since the 1970’s. It suffered a near mortal blow in the Global Financial Crisis of 2008-9. People stopped borrowing so governments stepped in and took their place. However, the process of private debt creation is now speeding up again as memories fade, new highs are reached in housing prices and stock market corporate buybacks reach record highs. This new private debt spiral, sitting on top of record global government debt, is the due to the lowest interest rates in all recorded history. These ridiculous interest rates, which are sometimes negative (!!!!!), are a last ditched effort by the central banks to keep the debt bubble rising.
At this stage your head is probably spinning with all sorts of questions and outrage, so let me anticipate a few of them for you by making a quick summary:
1. So, every time you take out a loan you are contributing to the Australian inflation rate because of the extra money you just put into circulation. On top of this, all advanced economies need a constantly growing debt level to pay back previous loans. The system is simply a giant Ponzi scheme. Please Google that term now so you understand it.
2. The inflation rate really is about five to ten percent as you have always suspected after checking your health, education energy and food bills. Most western central banks allow their local currencies units to increase in quantity by about five to eight percent a year. In fact all central banks are playing a game at the moment called “competitive dilution”. They all have to keep inflating their money supply at roughly the same rate as the American Federal Reserve or risk a spike in the value of their currency against the US$ and others who peg to the US$. If this happens their export industries decimated. In fact this is what is happening in Australia as I write. This is why real stuff, like copper, oil, gold and houses keep getting more expensive.
3. Inflation means that every dollar in existence is someone else’s debt. Take out the cash in your wallet and look at it. Even though they are printed bank notes, they symbolise someone else’s bank borrowings that found its way into your pocket.
4. The need for continued inflation is why our tax laws are set up to encourage debt and discourage savings. Heaven forbid the thought that a nation’s citizens would actually begin paying off their loans, all the money in the entire banking system would disappear down a giant drain. If this happened it would be called deflation and it is the one fear that gives the bankers and politicians of the world their worst nightmares. They will fight it with every bone in their body. So while the fiat financial system exists there will always be inflation.
5. Continued inflation requires debt levels to increase forever if we are to generate the money to pay off the loans of the past, which is clearly not going to happen. Inflation is a game of financial musical chairs and when there is a recession or depression those holding the debt lose their financial chair.
6. If the private sector stops borrowing, the government must step in and load up on debt. If they succeed in reflating the system it is called a recession. If they ever fail, and they probably will between 2010 and 2020, then we will have a full blown depression on our hands as all the debt built up in the system from the 1970’s begins to default. The last time this happened in the Great Depression it was the catalyst for World War II.
7. A spike in debt levels due to a prolonged lull in interest rates caused the housing boom of 2000-2006. It didn’t come from increasing wealth in the pockets of consumers. It came from increased access to debt caused by extra low central bank interest rates in Japan and America. Extra money in circulation was chasing a relatively static supply of houses. Bingo, house price inflation! The same process is happening again some 10 years later. Human memory is very short.
8. To counter inflation you had better get you assets out of fixed interest securities that earn between two and five percent.
9. The system stinks, but while your house price is “going up” you love bragging about it and keep voting for the incumbent government. The middle class has come to love asset inflation as it makes them feel wealthy without thinking smarter.
10. Inflation is nothing but subtle and legalised theft. It is the theft of the value of your money right from under your nose without it even leaving your bank account or your wallet.
11. Inflation is a tax too. It pushes you into ever-higher tax brackets and the government pretends to be your saviour by adjusting them up a little just before an election. In the 1960’s the top tax bracket in Australia cut in at about 15 times the average wage. Now it cuts in at 1.5 times average earnings. How clever is that?
Now consider the following paragraph taken from an excellent essay on the cause of inflation by Ellen Brown (posted on July 3rd, 2007) where she reflects on the stranglehold of the private banking system on the US economy.
“Price inflation is only one problem with this system of private money creation. Another is that banks create only the principal but not the interest necessary to pay back their loans. Since virtually the entire money supply is created by banks themselves, new money must continually be borrowed into existence just to pay the interest owed to the bankers. A dollar lent at five percent interest becomes two dollars owed in 14 years. That means the money supply has to double every 14 years just to cover the interest owed on the money existing at the beginning of this 14 year cycle. The Federal Reserve’s own figures confirm that M3 has doubled or more every 14 years since 1959, when the Fed began reporting it. That means that every 14 years, banks siphon off as much money in interest as there was in the entire economy 14 years earlier. This tribute is paid for lending something the banks never actually had to lend, making it perhaps the greatest scam ever perpetrated, since it now affects the entire global economy. The privatisation of money is the underlying cause of poverty, economic slavery, underfunded government, and a financial ruling class that thwarts every attempt to shake it loose from the reins of power.”
Now if you think through the implication of the need for ever-climbing debt levels you will quickly realize that the entire system is doomed to face an ultimate collapse. It is the worlds biggest ever pyramid, or ponzi scheme. These are scams where the later borrowers create the money for the earlier borrowers to pay down their debts. The process is unsustainable and will result in a two stage collapse. Stage one: Debt levels in reach saturation levels where consumers are tapped out and government attempts to take up the slack in creating debt are also tapped out, leading to a deflationary pause in inflation. Stage Two: There will then be what economists from the Austrian school of economics call a “crack up boom” in inflation. Inflation will become rampant as governments attempt to create enough extra currency to be able to pay down the old debt with diluted money. Think QE1, QE2, QE3, operation twist, negative interest rates eventually giving way to what is popularly called “helicopter money”.
This trick is as old as time itself and a great book to delve further into this history of inflation is This Time Is Different: Eight Hundred Years of Financial Folly by Rogoff and Reinhart. Inflationary dilution it is already in play in the USA and Japan. I believe the second and third decade of the new century will witness this crack up boom.
During the 1970’s inflation raised its ugly head in consumer prices. From 1980 until the turn of the century it raised its ugly head in asset prices. During the first decade of the twenty first century inflation was clearly visible in rising commodity and house prices. During the second decade it has largely been seen in the stock markets and more recently housing. This process will continue during the crack up boom. When this last ditched attempt to keep the banking ponzi scheme going through inflation has run its course we will see a total collapse of the economies of all the world’s debt-laden economies.
This collapse will be the defining event of the first half century for those countries. It will herald an unimaginable level of heartache and financial misery for the people of the western and developed world. The inherent fraud and deception of fractional reserve banking will be laid bare. In the meantime, pay down your debts and build up ownership of quality assets that will withstand an inflationary spiral and a debt collapse. The one investment area that will reign supreme during this time will be precious metals, as they have done through many previous episodes of financial manipulation and collapse over the last 4,000 years. The only way for central banks to restore equilibrium and trust in their balance sheets will be to revalue gold at a level so much higher than today’s prices so it squares their books and wipes their debts. To do this gold will have to be revalued at well over $10,000 an ounce.
Let us now come back to the present and have a look at house prices to see how this inflation gene works in the real world, right now. It is no accident that houses have increased in value at about 7% a year for the last 100 years. They are simply tracking the true inflation rate. I recently owned a 100 year investment house in Toowong, Brisbane. The owner before us bought it for $100,000 five years earlier. We paid $156,000 for it in 2000. We sold it in 2003 for $330,000 and it is currently worth somewhere in the $600,000’s. This inner-city house price inflation rate is well over the 10% a year.
This tells me two things. One; it will probably not increase in price much in the next few years. Two, the amount of asset inflation in my country in recent years has been horrendous. Remember this is just an old house. The value of the house has not changed much over the 100 years. When you sell a house and buy in the same market all you have made in terms of profit is the value of one house. Measured in dollar terms though everyone thinks you are rich! Has the house increased in value? Not really. The money you have made in the sale can still only buy one house. Has it decreased in value? You bet, the house needs constant repair.
By the way, with the increases in the value of our investment house there came increasing land taxes from local, state and federal governments. These have gone through the roof in recent years and now comprise a significant part of new housing and land prices in Australia. Inflation once again comes to the rescue of the tax base. Governments lose elections when they overtly increase taxes or introduce new ones. However, inflation gives politicians extra money to increase their spending without having to increase taxes. People hate extra taxes. On the other hand, people hardly notice ongoing inflation and very few understand its cause. With a fiat currency, a government or its central bank can create as much monetary inflation as their people can tolerate.
PROFITING FROM INFLATION
Let’s wrap up this topic of inflation by giving some practical advice. You now have a working knowledge of inflation its causes. Housing is a great inflation-fighting investment and a good barometer of the true inflation rate. People instinctively understand its position as the chief weapon in the average investor’s fight against inflation. As a market it is over three times the size of most local stock markets, and much more familiar to the average citizen. Housing’s chief advantage, especially in large cities is its limited supply. To obtain a return significantly better than inflation you must find an asset that has a limited supply and a growing demand. In a growing city the best place to buy real estate is as close to the city as possible where land increases in value the fastest. Always remember that with real estate you are speculating on the future value of the land. The building will not rise in value. In fact it will drop in value over time as it ages.
Currency and financial assets such as bank accounts and fixed interest bonds are not recommended because the system has an unlimited supply of them. Bill Goss founded the world’s biggest bond Fund called PIMCO, and his January 2013 newsletter is instructive. In it he said “The future price tag of printing six trillion dollars’ worth of checks comes in the form of inflation and devaluation of currencies either relative to each other, or to commodities in less limitless supply such as oil or gold.” Commodities have been a great inflation fighter in the past and again especially since 2000 due to the increased demand from China and other developing countries, the limited supply from new mines and monetary inflation.
The ultimate inflation fighter through the centuries however deserves its own few paragraphs. Gold is the arch enemy of the central bankers and governments the world over. This is especially so of the American government which is the custodian of the world’s reserve currency. It has done everything in its power over the last 45 years to suppress the price of gold so as to make its currency look stronger than it really is. Gold has been regarded as a monetary commodity since history was first recorded, and always will be. It is the only currency without a central bank, an enforced government monopoly, or attached debt obligation. Remember what I said earlier, every dollar you own is someone else’s debt. But gold is free to rise in value at the real market rate of inflation.
It is no accident that a Roman denarius is still as valuable today, some 2000 years after it was minted. Will the five dollar note in your pocket hold its value for as long? In 1900 a 1 ounce gold coin could buy you a good suit. An ounce of gold, at today’s value, will still buy you a good suit. This is one of the reasons why I have a large exposure to precious metals mining companies. I even have an American one ounce gold coin minted in 1899. In those days you could carry paper money or gold and silver and exchange them at a bank when you wished. My one ounce gold coin could be swapped for a $US 20 paper note!!! This shows you the level of inflation in the world’s reserve currency in a little over 110 years. For the record, gold has increased at an average of 10% against the worlds currencies sine he year 2000, and that includes a major bear market that has now finished.
The good news for investors is that gold is slowly migrating back toward the centre stage of world banking. Central banks are now net purchasers of gold for the first time in 20 years. China is producing 400 tonnes a year and importing an extra 600-1000 tonnes a year. This is one third of global supply. Gold is now being bought by wealthy Muslims and Asians by the tonne and secure storage capacity is expanding rapidly in Singapore and Hong Kong. A new era is dawning and it is characterised by gold leaving the west and arriving in the east. You can almost hear the whooshing sound overhead! Go with history and join them.
A note of warning: Like most other investment vehicles in this world, the value of gold and other commodities tends to go through 15-20 year cycles and you must be on the right side of the cycle to profit. Smart investors who sniff the wind early will preserve their wealth. Those that don’t think, like the middle class, will be fleeced when the value of their electronic and paper savings goes down the toilet. Gold was the best performing financial asset of the first decade of the century. It then went through a four year bear market. In 2016 it emerged from hibernation and is now embarking on the second multi-year leg of its 20 year bull market.
The bottom line is that anything that is hard to find or duplicate like resources or housing, will be a good hedge in an inflationary era. However, since housing is so closely linked to debt financing then it may perform differently to commodities if there is a truly huge economic disaster such as a run on your currency or a debt crisis. I knew a man who lived through the Argentinean foreign debt crisis of 2000. He told me that banks were shut for 6 months and house prices plunged 90%, but the price of commodities never changed because they were attached to a global market.
As we move through the second decade of the new century the amount of debt has picked up rapidly due to government bailout packages in the trillions of dollars. This will foster a whole new wave of inflation in the crack up boom. When gold starts making headlines around the world by setting new record prices, it is always the sure sign that debt-fuelled inflation has worked its curse once again.
Below are listed some good websites and resources to keep you informed about inflation and related economic issues from an American perspective:
- Goldseek: www.goldseek.com
- The global debt clock: http://www.economist.com/content/global_debt_clock
- Shadow Government Statistics www.shadowstats.com
- Inflation Data www.inflationdata.com
- Financial Sense www.financialsense.com Catch their MP3 broadcasts.
- Korelin Economics Report www.kereport.com , also broadcasts in MP3.
- Grandfather Economic reports http://mwhodges.home.att.net/summary.htm
- Foundation for Economic Education www.fee.org
- Business Spectator (Australian) http://www.businessspectator.com.au
- Reserve Bank of Australia Inflation Calculator http://www.rba.gov.au/calculator/annualDecimal.html
There are other great sites as well but these are good for starters. The wealth of data and informed commentary at these sites will be very worthwhile. The coming years will be treacherous for our financial well-being and making informed decisions will not be a luxury; they will be a necessity. This is why you need to fully understand what inflation is, how it is deliberately manufactured and how you can protect you assets against it.
Taxation is the legalised theft of private wealth for the purpose of carrying out the mandated and discretionary spending of those who rule over a population. The opening page of my Australian Securities Institute course on tax simply said the following “There is neither logic nor morality when it comes to taxation. There is only the law”. This statement has never left my mind as it is so true. Taxation goes to the core of the issue of sovereignty, or who rules the land and its people. It is accepted to the degree that citizens believe there is some benefit in the system for themselves, their families and their local communities. This is especially true if they are receiving some form of government handout via wages, welfare or contract.
Taxation does not have to be fair, ethical or logical. It is just a set of rules for the confiscation of wealth. For the individual investor, the task of creating wealth is made very much harder by the taxation rules under which you operate. Some readers may question the morality of not wishing to pay a fair share of the taxation burden. My reply would be to ask you to define the word “fair”. In many ancient civilizations any taxation above a flat rate of 10% of yearly increases was considered abuse of government power. However these days Australians, and citizens in most other western countries with large welfare budgets, pay an average of 50% of income in all taxes of some form by the end of each year. We work till June for the three levels of government and then we start working for ourselves. Is this fair?
Unfortunately the democratic system works well while many work and few are on welfare. But when the masses find out they can vote themselves into getting other people’s money via the government democracies collapse. The demographics of the western developed world is now squarely in the latter camp. We are now in this era of abuse and it is onerous enough to have to pay the minimum tax legally required. In the western capitalist nations things have now progressed to the point where over half the population is on some form of government benefit while less than 50% provide the taxes to pay those benefits. Barak Obama’s eight year administration will go down in history as the emblem of this crossover period. Europe was there some time ago, America is there now and most western countries are close behind. This marks the beginning of a new era, one that will not end well. Standards of living will drop significantly.
For the individual investor, taxation is also a game you can play to win. It has rules and rewards. There are winners and losers. Abide by the rules of the game at all times, but play hard within the rules and you will get to keep a lot more of your hard earned wealth than the majority of citizens who do not take the time to search out how the game operates. I will explain below some of the general rules of the tax game and show you how to operate fairly but shrewdly.
There are two main types of tax, direct tax and indirect tax. Direct tax is the confiscation of part of your income or profits by the government. Taxes on wages, dividends, capital gains and company profits form most of the direct tax base. Direct taxes are themselves broken down into two subgroups, lower taxes on financial risk takers, and higher taxes on financial risk avoiders. Indirect taxation consists of those taxes added, often invisibly, to the goods and services you purchase as part of your daily living. This list includes import duties, departure/arrival taxes, GST, fuel exercise, vehicle registration, stamp duty, land taxes, levies, registrations and the like. These taxes are a great way to take money out of the pockets of those who are consumers of their wealth, which today means most households. The only way you can reduce your indirect tax bill is to reduce your consumption and begin to save something from what you earn. This is also the first and most important and most powerful way to begin the transformation from financial dependence to financial independence. Pay less tax, save more, invest more, simple!
Taxation, in all its forms, also dramatically slows down the process of wealth creation for individuals and increases it for governments. Savers pay less tax and consumers pay more. Risk takers pay less tax while risk avoiders pay more. Got the picture? It is no coincidence that he tax rate in all the worlds fastest growing economies is always low. To illustrate, Singapore began its independence in abject poverty, with the dire threat of Communist insurgency and no natural resources. Under Lee Quan Yew’s leadership, it wisely adopted a low tax culture, encouraged savings, attracted investment and began to grow. Singapore overtook Australia many years ago and is now the second richest country in the world. The same story can be retold many times for many countries. If you, as an individual, begin saving your capital for investment, as Singapore did, you too will overtake your peers in wealth as the time goes on.
When it comes to taxation, governments deliberately try to confuse taxpayers. The government makes the rules so they make them so complicated that no one can understand them. Control by confusion is their favourite tactic. They have written 13,000 pages of taxation rules so far in Australia and are adding more all the time. Can any single human understand this much information? The annual tax update with a quick, easy to read summary of the laws amounts to over 2,000 pages. Governments also deliberately intimidate taxpayers. The rules of taxation say that you have to prove your innocence in an audit, you are assumed guilty. The threat of fines, sanctions and criminal proceedings hangs over any one who is put through an audit. This threat is enough to make most people comply to the point where they do not go near the grey areas of the game.
Governments also deliberately milk wage earners, or risk avoiders. As a wage earner, you earn money for your time, are forced by law to hand over part of your earnings up front, and take the rest home to spend. The average person cannot create wealth on a wage alone. The reason for this is the regressive structure of the income tax system in most western nations. The more you earn the higher percentage of your income you must hand over to the government. The government is brilliant at knowing how to tax just enough to keep the people from voting against them. Until 1915 there was no income tax in Australia. It was brought in as a temporary means to help the war effort. I guess that is a new definition of the word “temporary”. The tax brackets were static for nearly two decades between 1960 and 1980 until the average worker’s wage approached the top bracket. Inflation was doing the job of pushing wages up, while the tax rules were doing their job of fleecing more and more money from our hip pocket nerve. Tax brackets are now a political football as they are used by government to buy middle class votes. Add to this the army of indirect taxes that you pay daily and you quickly ramp up to the 50% level. You must become more than a wage earner if you are to create financial independence.
On the other hand, a risk taker, otherwise called an entrepreneur, investor, businessman or capitalist, earns money from their capital and investment skills. They can spend some of this money on legitimate business building activities before tax, claim all sorts of costs of running their business or investment, before tax, and then pay tax on the residual profit. It is easy to see the advantages these people have over wage earners in the tax game. Governments know that the source of all wealth that trickles down to the rest of society is the genius and risk taking of investors and business people. this is why they favour them over other people who refuse to take these risks.
However, there are two types of risk the intrepid business person or investor faces, and this is why they are taxed at a lower level. The first is the risk that the capital may not come back at all. Think of it like the rental apartment burning down. I personally have suffered this type of loss more than once. Most countries allow tax breaks for you to off-set these losses against future income. The other danger is the risk of little or no income from the business or investment. Think of it like tenants not paying their rent.
If you can join the ranks of the risk takers you get to enjoy these special tax rules that are designed to cushion the risks you take. Basically there are only two ways of joining the ranks of the risk takers. You can either go into business or become an investor, or become both. If your business grows then it usually turns into a company. Then if it needs to raise substantial capital to expand further it will list on a stock exchange and give others a share of its business in exchange for their investment capital. After it has listed people can then buy and sell these securities.
Back in the 1750’s the risk of loss to a wealthy person who financed a trading voyage was huge. Most such ventures were therefore financed by a group of individuals in partnership. From this process there developed the concept of the company or corporation where ownership became separated from individuals and liability was limited to the capital injected. People had to have legal security and protection over their personal assets or they would hesitate to fund high risk ventures in far off lands. Venture capital and world trade blossomed under these legal structures. This in turn helped spark the industrial revolution in England and elsewhere in Europe. Without the development of the company, the modern form of western capitalism that we know and enjoy would look much more like the extended family business empires of Asia and the Middle East.
Companies are therefore completely separate legal entities to humans. Remember the joke about death and taxes, well the creation of a company does away the first of these realities, because companies do not die. This immediately eliminates capital gains taxes that people have to pay when assets are distributed via a will. Companies have directors, a secretary and stockholders. Because they are not humans they are taxed differently to humans. The tax rate for companies ranges from 15% to 35%, depending on the country. It is no surprise that the faster growing economies, such as Singapore and Hong Kong tend to have the lower corporate tax rates. But like citizens, companies still have to pay the full rate of capital gains tax if their assets rise in value. They also have to pay income tax at 30% from the first dollar of profit and they have stricter auditing requirements.
Governments generally treat capital gains on assets and personal income very differently. In Australia the dividing line between these two categories is the magic 12 month time frame. Any asset bought and sold in less than that time is assessed with your income. Anything held beyond 12 months is assessed under capital gains/loss legislation. Note what was said earlier, the rules are set up to encourage capital investment, so the tax rates for investments held longer than 12 months are much lower than those held for less than 12 months.
Whether or not you should set up your business and/or investing legal structure to minimise tax is a decision you must not take lightly. You should speak to you accountant in depth, but be always aware that accountants get paid to set up these legal structures so their advice could sound very rosy. Make sure you get plenty of independent advice from people who have been down the track before you. Friends you trust and individuals who have created wealth and who have set up their own tax efficient legal structures are the best source of information.
Oh, and never invest just to avoid paying tax.