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How Inflation erodes tax relief.

What is tax relief if it is already lost?

The income of an Individual or household is a reflection of the control they have over goods and services. One of the common effects during an inflationary period is that this control is diminished through a reduction in purchasing power. Suddenly the same amount of money buys less than before.

Whilst an increase in tax relief is welcome the crux of the matter is that, this increased tax relief relative to the increase in cost of living as a result of inflation, means that the tax rebates and relief are often wiped out. Tax relief should be considered in conjunction with the adjusted cost of living for the consumer.

Many taxpayers get excited by the new tax rebates announced each year, but don't be fooled, inflation and the cost of living has in all likelihood risen by more.

10 Common effects of inflation:

  1) Erodes Purchasing Power

Purchasing power is reduced by increases in prices over time. A fixed salary or amount of money will afford less consumption.

2) Disproportionately affects lower income households

Lower income households spend most of their income on the necessities and thus have less of a cushion against inflation compared to higher income households who spend a lower proportion of income on necessities.

  3) Keeps Deflation at Bay

Deflation represents a reduction in spending, there is also wide spread loan defaults and this can lead to a banking crisis and major lay-offs. Thus relative inflation vs high inflation is favoured as opposed to deflation.

   4) When high, inflation feeds on itself

When inflation is high the pressure mounts on other stakeholders in the economy to raise prices to cover their costs. One of these stakeholders are Employees, wage increases during a time of inflation can lead to a wage cost spiral.

   5) Raises interest rates

Interest rates are a good way of dampening spending and therefore economic activity. Dampening economic activity with higher borrowing costs leads a constrained money supply.

   6) Lowers Finance costs

Those with fixed rate mortgages will enjoy servicing a lower level of debt with a higher valued rand. A fixed rate mortgage will help offset the effects of inflation.

   7) Lifts short term growth and employment

In the short term inflation inspires growth and employment. This is coupled with increased spending, leading to more inflation. One of the first things that happens in this scenario is that the market eventually resets and after a period of hign inflation there has to be a downturn that resets all expectations.

   8) Can cause recessions

Inflation and a prolonged period of lack of employment and diminishing spending power leads to a depressed economy and a resulting recession.

   9) Affects Bonds and Growth stocks

Bonds and Growth stocks are discounted at a higher rate and their present value is thus lower leading to lower cash flows.

  10) Boosts Real Estate

Landlords can raise rents and this helps to mitigate the erosion of the real cost of fixed rate mortgages.

What to do in a period of inflation?

1.     Set up a budget

2.     Pay off existing variable debt

3.     Maintain a rainy day fund

4.     Explore the bond market

5.     Invest in your home

During periods of inflation consumers are urged to pull back from riskier opportunities and to return to tried and true practices for protecting wealth.

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