In the 1980 Berkshire Shareholder letter, Buffett refers to inflation as a tax on capital that is just as real as the explicit income tax. We are not anywhere near the inflation levels that persisted in the environment around this time, but it’s important to remember why inflation is important for every investor.
As Buffett writes, “For only gains in purchasing power represent real earnings on investment.”
What does this mean?
It means real earnings on investment occur when the investor has become richer. Again this is not richer in dollar terms per se, but purchasing power. The investor is richer when he or she is able to buy more. Here’s an example using hamburgers that Buffett uses that illustrates this:
Here is another example from Buffett from the 1980 shareholders letter, paraphrased in our own words:
Imagine inflation is running at 12% and you own a company that is earning 20% on equity. Assume that you are in the 50% tax bracket and receive all of the earnings of the business as a distributed dividend. So half of your 20% will go to income tax, leaving you with 10%. However, if inflation is 12%, your purchasing power will be eaten up, negating the remaining 10% earned from the business and decreasing your purchasing power by 2% (10% minus 12%) to 98%.
It’s amazing how powerfully (destructive) inflation can be to investor wealth. Most companies do not come close to earning 20% ROE but inflation rates have approached double digit levels multiple times throughout the past 50 years. Note in the chart below, CPI in 1980 of 14.59%.