Don't Confuse Income With Wealth

Published in Investing on 13 March 2012

Many high earners' spending commitments match their income.

Many people confuse income with wealth. They are not the same thing, and failing to appreciate the difference will put you at a disadvantage.

Wealth is acquired by spending less than you earn and then saving and/or investing the difference. Even if you acquire wealth through inheritance or marriage, it still will have come from someone else having spent less than they earned at some stage.

In contrast, income is produced by labour and wealth that has been invested in income-producing assets such as bank accounts, property and shares.

Some high-earners are not wealthy

Many people claim that raising income tax rates is a good way to target the wealthy, and they use this to justify the 50% rate of income tax.

Aside from the fact that many people react to higher tax rates by arranging their affairs so as to reduce or eliminate their additional liability when taxes are raised, the correlation between income and wealth isn't quite as strong as you might believe.

Just because a person has a high income, it doesn't necessarily mean that they are wealthy. That's because many high earners have a lifestyle that makes it hard for them to turn their income into wealth. They have acquired a set of spending commitments which ensures that pretty much everything they earn is spent, leaving little or nothing at the end of the month.

Wealthy people don't necessarily have a high income

A surprisingly large number of wealthy people have fairly low incomes; most notably those who bought houses in the 1960s and 1970s before prices took off. They are the "asset rich, cash poor", and if a genuine wealth tax is introduced, such as a tax on house prices above a certain threshold, many of them won't have the income to spare to pay it.

We saw a good example of this last week when the journalist Joan Bakewell wrote in the Daily Telegraph about how she would probably have to sell her house if a 'mansion tax' was introduced because she didn't currently earn enough to pay it.

Now, while an asset like an expensive house can be turned into cash either by selling it or using it as security for a loan, I'm sure that the supporters of a mansion tax aren't doing so because they want to deliberately force some people out of their homes.

Convert income into wealth

Income can easily be turned into wealth. All you have to do is spend less than you earn, then save and invest the difference. It really isn't any more complicated than that and, if you spend a lot less than you earn, it can accumulate surprisingly quickly.

Charlie Munger, vice-chairman of Berkshire Hathaway (NYSE: BRK-B.US), advises people to underspend their income, especially when they are young. It's a good habit to develop and, as Berkshire's chairman Warren Buffett likes to reminds us, "Chains of habit are too light to be felt until they are too heavy to be broken."

When I worked in the City of London for a few years it wasn't difficult for me to save 40% of my income after tax, mostly because I acquired the habit of saving at least 10% when I first started work. And on the rare occasions when I was paid a bonus, all of it went into the stock market instead of being spent on consumption.

For people who spend everything by the end of the month, the only way they can save and thus acquire wealth is by committing to a regular savings plan. The most common ways of doing this are by taking out a repayment mortgage and putting money into a pension fund and/or a stock market-linked savings plan. Doing this means that this part of their income is no longer available for spending upon consumer goods.

Ultra-high income bankruptcies

A surprisingly large number of highly paid professional sportsmen and women are not wealthy. The best example comes from American football, where roughly three-quarters of National Football League (NFL) players are declared bankrupt within two years of retiring from the game -- even though the average annual salary in the NFL is £1.2 million a year!

There are several reasons for this. There's a culture within the NFL that seems to cause players to make very bad investment decisions, most notably overinvesting in highly speculative property deals that go wrong. It's also very common for players to hire advisors who rip them off.

The high income that an NFL player earns makes it very easy to acquire expensive spending habits that will be hard to support when their income falls in retirement. Combine this with their limited work skills outside of the game, a divorce rate close to 75% (another huge cost), and their high bankruptcy rate isn't such a surprise.

A wealthy NFL retiree will have accumulated a substantial pool of assets to generate a decent income after their playing career is over. Furthermore, by seriously underspending their income during their playing career, as Munger suggests, then they won't acquire too many expensive habits that could otherwise torpedo their finances in retirement.

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Comments

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alarmbells 13 Mar 2012 , 8:41am

Interesting.

What I find, is that at a certain level of income you effecctively have no inflation rate (at moderate rates.)

For example, the relatively wealthy can go to France for 2 weeks instead of Malaysia, shop at Tesco not Waitrose, buy chicken not pheasant etc.

Now i know the real way of measuring inflation is to compare like with like but that's not "real".

Similarly for someone on the breadline shopping at Aldi, taking no holday and spending a high proportion of income on fuel, inflation is real and menacing and unavoidable.

Also pay rises are often given in % terms. 3% of £100K is £3K. 3% on £20K is £600. A huge difference when the higher paid have an "element" of control over their personal inflation rate.

OIMO 13 Mar 2012 , 11:09am

alarmbells makes a very good point when he says "...pay rises are often given in % terms."

We have just experienced this at the large UK Plc I work for. As part of their austerity measures they capped pay rises at 3%, having previously frozen pay for 2 years. This has meant some staff are now seriously under-paid and little can be done about it*, while others although 'only' getting 3% are still getting large pay rises as they were already very well paid. Ironically they have also had a plans to extend performance related pay to more staff on hold for 2 years which I believe has been a couterproductive in terms of employee motivation and statisfaction - but the market like that they have keep the wage bill under tight control so that MUST be good!

* Actually the talented ones are doing something about it, they are moving to other employers who are now offering better packages resulting in something of a brain drain.

potato1066 13 Mar 2012 , 12:22pm

> I'm sure that the supporters of a mansion tax aren't doing so because they want to deliberately force some people out of their homes.

Wrong - politicians see this as a way to increase availability of larger homes by turfing out one or two owner/residents.

Basia02 13 Mar 2012 , 1:08pm

In the company I used to work for people earnt large sales commissions, and there were two sets of people:
1. Those who raised their standard of living to their temporary income with porsches, ferraris, mansions. They had to earn the big bonuses to survive, otherwise their debts overwhelmed them.
2. Those who only increased their standard of living slightly, if at all. The chap I worked with in the early 90s, a Northerner, made I reckon around £350,000 over two years - top salesman. The he packed in the stressful job which was killing him and became the lecturerer he had always want to be.
This article highlights a very interesting difference. There is no way of targetting taxes on the rich, without there being a group who suffer. I am just glad it is not my decision.

kenprice 13 Mar 2012 , 1:16pm

I was always taught that income is a flow of value and wealth a store of value.

Once you've grasped this all the other issues fall into some sort of logical position

GrahamMiller0 13 Mar 2012 , 1:40pm

I see a wealth tax as yet another way to kick Pensioners in the nuts.

They work hard to pay for their home, then retire on a pittance. Then they get clobbered by a Mansion Tax.

GoldenSoldier 13 Mar 2012 , 2:01pm

We have had unfair taxation for such a long time that people have now come to accept it and have forgotten that anything apart from a flat rate of tax on income is theft by the State. I am not biased. I pay only basic rate tax and it is very unlikely that I would be liable for a tax on my house.

millwall11 13 Mar 2012 , 2:53pm

I everyone tried to sell their 'mansions' (more like a terraced house in Wandsworth) at the same time; they would be worth less than 1/2 the taxable rate. How does that work?

hcidata 13 Mar 2012 , 4:46pm

millwall11 has highlighted the fundemental problem with wealth taxes - how much is something worth. Rember the person who know the cost of everything and the value of nothing? Homes - in the UK - serve two purposes; an investment and a place to live and sleep. So how do you split the value of a house/mansion into its investment value and it warmth/dry/dormotory value?

I have always been against wealth taxes and the value of any object differs from person to person. As others have said, just because you are wealthy does not translate to the ability to pay a tax if you income is low.

Tax income, tax spending but do not tax wealth.

duffmanchon 13 Mar 2012 , 10:11pm

Nope tax wealth. The wealthy need the state to protect their assets otherwise I would just go and rob them. You don't have a right to keep your home indefinitely, it was probably built before you were born and will outlast you, better to downsize and have a good retirement than rattle around in an empty home that could be put to better use.

jaizan 13 Mar 2012 , 10:33pm

Don't tax wealth & make income taxes as low as possible. Pay for it by cutting subsidies on indolence. That's what messes up our economy & society.

goodlifer 13 Mar 2012 , 10:59pm

"Joan Bakewell wrote in the Daily Telegraph about how she would probably have to sell her house if a 'mansion tax' was introduced because she didn't currently earn enough to pay it."

If an ordinary person is "asset rich, cash poor" the likes of Age Concern are able and willing to help by what they call Equity Release.

Does nobody offer the same sort of deals to millionaires?

Other ordinary people prefer to finance their pensions by moving into a smaller property.
Isn't this option also available to millionaires?

ANuvver 14 Mar 2012 , 12:09am

Nobody's done the Micawber reference yet... Mind you, I don't recall him having much to say about asset liquidity.

I find the current mood music against "unearned income", ie income generated from wealth, cack-handed and distasteful. Okay, beyond a tipping point, millions beget millions while the wealth-holder sleeps on sheets washed in the tears of the poor or prats around in dayglo pyjamas in Gstaad. But why should your average third little piggy get slammed for years of, oh what's that word I'm looking for... tschhhh... err, oh yeah got it, prudence?

With wealth comes responsibility. How many little pigs 1 and 2 see a Lottery (TM - thumbs up with crossed fingers logo) win of a couple of million as a chance to move into a flashy old pile in the sticks and regress to childhood? For a while, then flog the story to the tabs - "Loadsalotto, blotto then notto!!!" - before burning that as well?

Time for my pill...

tinamacmillan 23 Mar 2012 , 10:31pm

Some sections of society persist in telling others that "you don't have a right to keep your home indefinitely" etc. Who gave them the "right" to decide what "rights" another person has anyway?
Whether I have been on the dole, in low paid jobs or high paid jobs, I have always saved at least half of my income, now I am told (by those who have nothing but debts and the memory of the high life) that I have no "right" to keep my property, that I "should downsize", they tell me that I'm "lucky" that I might end up comfortable but I shouldn't expect to because others (who have lived the life of Riley with no thought for their future) may be worse off!
This country is already communist and its getting worse - if this was the middle ages duffmanchon would have lazed about all summer and then pillaged his neighbours stores in the winter and then justified him/her actions by bleating about how badly done to he was and how his "wealthy" neighbour deserved to starve because they didn't share their food.

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