What’s for dinner? Hamburger or Steak?
President Biden recently stated that “prices are still too high.” Perhaps he was referring to the price of gas, in which case that statement is always true. Or was he referring to the collective prices of goods and services as reflected in the CPI, implying that they would someday come down?
Possible, but extremely unlikely. Because that would suggest that the Federal Reserve completely failed its primary mission, and we have found ourselves in an extremely deflationary environment, aka the Great Depression.
Sorry, while prices may always be too high, they probably will never come down.
The much more likely outcome is that prices will continue to increase, as they have for the last century or so. The following graph is the CPI over the last 40+ years, note that it is steadily climbing:
Time for a little math wizardry! OK, not that complicated. We compute the annual change for each month, as a percent, and make a new graph! As long as this value is above zero, prices increased from a year ago. Other than the brief fun period known as the “2008 Housing Market Crash”, prices have always increased in this time frame.
Why should you care?
Consider this abbreviated version of the 2022 IRS income tax bracket:
The more you earn, the more taxes you pay, as a percentage of your income. This is known as a “progressive tax.”
For now, let’s make the crazy assumption that the CPI is constant, that the prices of goods and services do not change, that the value of the dollar is stable.
For the first few years (the first third of the graph), your incoming wealth (your salary, less income taxes), matches your outgoing wealth (your expenses). Meaning that your net worth does not change, as measured in wealth.
(If you have learned anything at all from me, you know that we do not make such measurements in dollars!)
In the future you receive two salary increases, reflected by the two salary step upticks. Will assume that your expenses remain constant (i.e., you do not upgrade from hamburger to steak), meaning that the area of the green sections reflects your accumulated wealth over the next two thirds of the graph.
That steak sandwich is starting to smell good!
Hold on! We need to account for taxes…
Will assume that your initial salary was $30,000, putting you in the 12% tax bracket.
Your first raise increased your salary to $40,000, still taxed at 12%.
That last raise, your promotion to “Assistant to the Regional Manager”, increased your salary to a hefty $60,000, meaning that some of your salary was taxed at the much higher 22%!
Sorry, need to remove some of that green using my magic white-out. (I know, my graphics editing is lame).
The good news is that you still accumulated wealth, just less than before. Steak is still a possibility!
Next consider the case where the CPI is more realistically gradually increasing over time, but your company says ahead of the curve, and increases your salary before the higher prices cause you too much financial pain.
The red areas indicate when you are losing wealth, green still means that you are gaining wealth.
It appears that the red and green areas are more or less equal, meaning that your net worth is constant over the years.
Better stick to the hamburger.
Hold on! Still need to correct for the higher tax rate in the upper income bracket. It would look something like this:
Ouch. Less green and more red in that upper income section. Sadly, you have experienced a net loss of wealth over the years.
Finally, consider the more realistic case, where prices go up first, and your salary increases later.
Yes, the situation is much worse.
Then we pour salt on the wound and correct for the higher tax bracket, adding even more red.
While my hand drawn graphs are lame, the point is nevertheless valid. To stay ahead of the wealth curve, your income needs to increase at least at the rate of inflation, without a significant time lag.
Failure to do so means that instead of upgrading to steak, you might have to downgrade from hamburger. Whatever food product that may be.
If you lost wealth, where did it go? It was not consumed; it was just redistributed to others. Opaquely transferred thanks to the devaluation of the dollar, the time lag in salary adjustments, and progressively scaled income tax brackets.