The Law of Zero Return

In the Glossary, I have an entry called The Law of Zero Return which is defined simply by a formula: Return on Investment = Inflation + Taxes. I left little explanation except that more info can be found in the book 200% of Nothing by A. K. Dewdney. So, just in time for tax season, I am finally getting around to explain.

In the book, Dewdney uses a real world example sent to him by an anonymous retiree. In 1987, the retiree put $10,000 in a CD paying 8.75%. Inflation for that year was 4.4%, so his original investment is devalued by $440. Then the form 1099 arrives from the bank, and the taxes on the $875 dollar return on investment comes to $269.50. So, the real return on the CD is $875 - $440 - 269.50 = $165.50. Had inflation been a percent and a half higher, the return would have been 0. Of course, return on investment is not always exactly inflation + taxes, but it is a way of understanding why it is difficult to get rich off investing. Like gambling, investing favors the house, the house being the tax collectors.

The formula has been around for a while and is not original to Dewdney. It should be thought of as a formula of investment. According to Dewdney, one strong advocate is financial advisor Vernon K. Jacobs, who operates a website on legal ways to avoid taxes at http://www.rpifs.com/. According to Dewdney's book:

Blaming the government for inflation, Jacobs labels as an additional confiscatory tax. Jacobs has documented the twin tax ravages by applying a comprehensive analysis for the years 1940 to 1986. He calls the law of zero return the "100% tax theory." (op. cit. pg. 84)

I decided to do a little simplistic "back of the envelope" example to show how this works. I used this years tax tables from form 1040A, and did a little comparison to the tax tables from the 1996 tables for 1040A. What I did is take the adjusted gross income figures of multiples of 5000 and looked them up in both tables for a "single" filer. Column 2 and 3 show these figures. Notice that below 25,000, these numbers are identical. Above 25,000 the taxes have come down slightly. In column 4, I adjusted the 1996 salary to inflation. I used the calculator at http://www.westegg.com/inflation/ to come up with the inflation rate of 6.42% over 3 years (this is quite low). Then in column 5, I looked up the income taxes on the inflated salaries and guess what. Everyone's taxes have increased an average of 6% over 3 years.

Some may say that taxes are just keeping up with inflation since you are paying tax with deflated dollars. But, it is more ugly than that. Think of it in spending power terms. In 1996, your adjusted gross income was $15,000. You get annual cost of living salary increases so your spending power does not decline, so now your adjusted gross income is $15,963. While your income is just barely keeping up with inflation, your tax burden is now $142 higher even though your adjusted salary is the same old $15,000.

Inflation affects your income in three ways: First, your dollars are worth less over time, even though you may have more of them. Second, the money you gain just to keep up with inflation is subjected to additional taxes. Third, because income tax is progressive -- the more money you earn the higher your tax burden -- inflation is pushing people into higher tax brackets they cannot afford. Tax rates are not adjusted by inflation. That 39.6% top tax rate that the middle class did not care about in 1993 because it was only for "rich", will eventually become the tax rate of the middle class as inflation raises the cost of living. How do you think the US Budget can go from deficit (where it still sits now), to a projected surplus of trillions in 10 years even after adjusting to inflation? Because, inflation works in favor of the government.

What is even more amazing is how few people even realize what is going on. Even the staunchest conservatives in Congress have little to say on this dirty little secret. If we are ever to get around the Law of Zero Return, tax rates will have to be adjusted to inflation, (the technical term is "indexing"). Better yet, create a flat tax with a higher standard deduction that grows with inflation. Otherwise, the tax burden will keep getting higher.

Update (May 2000): A few questioned whether or not the standard deduction goes up with inflation. Based on the data I have, the standard deduction has remained the same since 1993. So has the wage that pushes you into the next tax bracket. If one, or better both, were adjusted to inflation each year, then inflation would not increase taxes.

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