If I've made 5% on a CD, and inflation is 3%, my real earnings are 2%. As far as I know, income tax is calculated on the 5%. Why would we tax each other on false income, ie the 3% needed to maintain the same value of the money? Shouldn't an income tax apply to real earnings above inflation only?

Many companies give COLA raises. The average cost of living raise is 3.2%. If you don't get a cost of living raise at your job then you are usually among the group of people who are struggling to make ends meet with no disposable income left to invest. Your pay should be increasing in real terms to keep up with inflation. There are basic Tax brackets for everyone regardless of the cost of living. The IRS does not figure inflation into taxable income and has set standard tax brackets. Many times living expenses are rising yet a person's pay stays the same. This is why we have so many working poor.

More on cost of living

Any investment needs to be evaluated on it's earning potential and it's tax consequences. A CD is what it is, is taxed accordingly and therefore is not likely the best investment unless you are just trying to protect your money against inflation. There are much better investment opportunities out there but a CD is highly secure short term investing and not necessarily the way to make a high return. Essentially the CD is gaining value partially through inflation so it makes sense that the increase that you get through that would be taxed as income. There is no way around it... your value increased X and that is income to you just as my pay raise each year is taxed as income. Taxation is generally on a percentage so it doesn't get taxed at any higher rate than other earnings (on investments) and therefore it all pans out.

If you'd like an investment that would increase in value and you are not taxed on the profits then a Roth IRA is the best retirement savings you can do (you can also make withdrawals for first time home purchase without penalty). There are other IRA's out there but in general tax sheltered saving programs are in place for retirement or educational savings accounts and not for short term investments as a CD is.

Think of it this way. If you have $1000 spare cash and you don't put it in a CD then the value of that $1000 goes down due to inflation and you wouldn't even think about it. If you take action to protect that $1000 against inflation by putting it in a CD then that increased value is taxable at the same rate as other investments; you've earned more money. The only problem is that the margin is smaller in the case of a CD and if you'd chosen a stock you might have more to consider profit.

To expand on what aminator said about your cd value increasing partly through inflation:

Using the Fisher equation (really easy) or several that are more in depth, interest rates are calculated based on expected inflation.



Example:
Your bank expects inflation to be 3% (that is the mean for the last 50 yrs).

Therefore, they need to give you an interest rate high enough above that that you will get a CD from them - the other 2% you received.

However, if expectations change; say, they think inflation will be 0%, then your CD would have only paid 2%.



There are whole college level finance and economics courses that go into figuring out exactly what to charge.. and how to determine what to expect. But, in a nutshell... if you want tax free return, you need to get municiple bonds. Risk varies based on bond, but the interest is entirely tax free.