How the Rich Can Pay Only 3 % of Their Actual Income in Taxes – Without Tricks

Disclaimer:  I am now retired, and am therefore no longer an expert on anything.  This blog post presents only my opinions, and anything in it should not be relied on.

No, it’s not from hiding the money overseas, or tax-saving tricks that skirt the outer edges of US legality.  It’s from the peculiarities of the way the tax code handles capital gains taxes.  And a recent change to the estate laws to allow a “step-up in basis” is a big part of it.  Can you, the average reader, take full advantage of it?  Only if (a) much of your net worth is in stocks (preferably low-expense index funds), and (b) 9% times your total stock value is much greater than your yearly expenses.

What follows is an explanation using a “typical case” approximating the real-world experience of someone I know.

The Idle Rich

Let us suppose that you have net worth of $10 million, entirely invested in a Vanguard or Fidelity S & P 500 index fund (expense ratio 0.1 %), with little or no work income and expenses of about $250,000 per year.  You reinvest dividends immediately back into the index fund.  Studies suggest that over the long term such an investment increases by 10.85 % per year.  If we subtract the expense ratio from that, you may expect actual income from this investment to increase by 10.75 % every year, or $1,075,000.  Presto, you are a millionaire this year, without working a day for it.

Now you need to pay income taxes – and here’s where things get complicated.   The money comes to you in two forms:  (1) dividends, which you reinvest, and (2) “capital gains” (all the rest).  My comparison of the S & P 500 total return index (which includes dividend reinvestment) to the S & P 500 index we all see on the financial pages suggests that in the long run, dividends increase your investment by 2.25 % per year ($225,000), leaving 8.5 % ($850,000) from capital gains.  The tax code handles these two cases differently.

Dividends

Your Federal tax bite from dividends is pretty straightforward:  15 % (let’s assume you live in a state without dividend and capital gains taxes of its own; note also that at about $25 million in investment wealth it kicks up to 20%).  So on the order of 2.25 % of your income tax for this year is at this 15 % rate, or about 2.25 % of your actual income (about $27,000).

Capital Gains

Capital gains are defined as the amount your stocks in that index fund have appreciated since you first bought them.  To maximize the yearly gain in net worth (for reasons too complicated to explain here), you are going to pay your expenses of $250,000 by selling stocks from your index fund. 

Let’s assume, for the sake of simplicity, that all your stocks are effectively just over 1 year old – as in the case where this is a new inheritance (explained later).  You typically have three choices of what you’re going to tell your index manager to sell: “first in, first out [FIFO]”, “average cost [basis]”, or “modified last in, first out [LIFO]” (you won’t necessarily see FIFO and LIFO presented that way).  FIFO, which really means “first bought, first sold”, is a no-brainer:  that means the oldest stocks with the biggest capital gains get sold first, so you typically don’t want to do that.  “Average cost” is, as it seems, halfway between worst and best in most cases.  LIFO means “first bought, first sold”, and modified LIFO means that you actively go in when you sell from your portfolio of stocks or index fund and arrange to not sell stocks bought less than a year ago – because otherwise your capital gains tax just about doubles.  In our simple case, all three selling approaches get the same result.

Your capital gain on your $250,000 of yearly expenses is about 9 % (0.1075/1.1075).  A Federal tax rate of 15 % therefore leaves you taxed about an additional 0.14%, on top of the 2.25 % from dividend income.

Finally, index funds steadily buy and sell stocks throughout the years on their own hook, in order to reflect stocks entering and leaving the index.  In the case of the S & P 500, a typical year might see 10 stocks “turn over” like this, usually the ones least capitalized, for a rough guesstimate of 1 % of the index’s total value.  That’s a straightforward additional 0.15 %.

Total

Your total tax bite from your actual total income, therefore, is about 2.55 % of $1,075,000, or about $27,400.  However, this now flows into gross income, which is then “adjusted” for various tax breaks and then converted to “taxable income” via the usual standard or itemized deductions.  The typical rich household (married filing jointly) has at least $12,700 from these sources – so the net is at or below $14,700 (more like 1.45 of actual income %!).  Over the long term, this will creep up as the average stock gets “older”, but I will anticipate that discussion below and state that it effectively stays below 5 % for quite a long time.

[Note:  Here I don’t discuss the recently-added Net Investment Income Tax of 3.8 %, which appears to apply only to much richer individuals]

Thomas Piketty in his book Capitalism in the Twenty-First Century points out that the top 0.1 % of the US income distribution (which roughly corresponds, I believe, to $10 million and up in net worth) has the bulk of their net worth not in land or other assets, but in investments, mainly in stocks.  I conclude that, therefore, we may expect the savvy rich person to pay perhaps 4 % of his or her actual income – not the income declared in tax returns, but with the additional income from untaxed capital gains added back in – in income taxes this year.

In the Long Run, The Rich Are Dead, But They Still Don’t Pay Much Income Tax

There are two caveats that do apply to my scenario, which indeed drive the income tax rate of the rich higher.  However, on closer examination, they don’t really increase the tax rates of the rich that much.  These two caveats are:

1.       The rich don’t really behave like that; and

2.       In the long run, capital gains should approach 100 % of the stock’s value.

The Rich Don’t Really Behave Like That

 The first objection to my scenario under this heading is that the rich don’t invest the way I’ve described:   they invest more in (corporate and state) bonds.  One may also include property, but, again, Piketty notes that this is typically less than 10 % of the holdings of the rich and particularly the very rich.

The answer to this objection is that bonds simply don’t provide anywhere near the long-term return of stocks (more like 1-3 % percent after inflation), so that a 60-40 stock/bond split works out in practice to more like an 83-17 income split, and an 80-20 stock/bond split works out to more like a 92/8 income split, for a likely maximum of 1.6 % in additional taxes (on much less income!).  Moreover, most investors tend to prefer “tax-free” bonds, which pay no Federal tax at all – if the investor does this exclusively, the overall tax rate actually decreases, so a better guess of the effect is more like a 0.5 % tax rate increase.

Next up is the idea that the rich typically don’t instruct their funds to do modified LIFO (“last bought, first sold”), for other reasons that may or may not be valid (e.g., complicating tax preparation, tax consequences when the market is going steadily down).  In fact, the real-world case I draw on uses “average cost basis” for precisely those reasons. 

When most stocks in the portfolio of the rich person are pretty new, say, in their first two years of ownership (the “short run”), the answer to this objection is that the tax effect of average costing is pretty minimal:  about 1.6 average years of total increase works out to about a 17 % average increase in stock value and a 15/85 gains/no gains split.  With adjustments for the fact that some of these stocks would be sold anyway by the index fund, it works out to about a 40 % increase in capital gains taxes, from about a 0.30 % tax bite to a 0.42 % one – significant, but still leaving us well below 3 %.  Over the long run, this case involves capital gains approaching 100 % of the stock’s value, so I’ll discuss that part of the answer to this particular objection below.

The third objection to my scenario is that most rich people spend more per year on expenses than $250,000.  This is true; and yet the key figure here is actually the ratio of expenses to income.  As long as the ratio of expenses to income (about 0.2) in my scenario is the same as that of the average rich person, our analysis doesn’t alter in the slightest.

And the evidence appears to be, if anything, that as you consider richer and richer people, the ratio of expenses to income goes down.  By the time you reach $100 million, it would take buying a $10-million-dollar house every five years to approximate an 80/20 split.  By the time you reach $1 billion, nothing short of a $50-million political investment every two years would do.  And as that ratio dips, the percentage of income that must be paid in capital gains taxes goes downwards.  Assuming, for example, a $100 million fortune and $1.25 million per year in expenses, we are talking about capital gains taxes cut in half compared to our scenario.  Of course, at that point the deductions have much less effect, but the net effect is still to cut our “real-world” tax bite so far to well below 2 %.

In the Long Run, Capital Gains Should Approach the Stock’s Value

It would seem reasonable, given my scenario, that as the average stock in the rich person’s portfolio far surpasses its original value, the average ratio of original value to value now would approach zero.  Certainly, I have heard of cases in estates where “generation pass-through trust” stocks when sold had a cost basis of 1 or 2 % of the total, and therefore 98 or 99 % of the value of the stock was taxable as capital gains.

Let’s be more concrete.  To a first approximation, the person newly coming into a $10 million fortune in investment stocks is in his or her mid-40s, and has maybe 30 years to live.  What does the capital gains situation look like in the tax returns for his or her 75^th and last year, and what therefore is the tax rate?

Under average costing, if we assumed no stocks have been sold in the meantime, the average stock has been in the portfolio for 30 years, with an average gain of about 1327 % (1.09 to the 30^th power).  So 93 % of the portfolio would seem now to be capital gains. 

But, in fact, we know that stocks have been sold in the meantime, for expenses and (by the index fund manager) to keep up with the underlying index – about 21-22 % of income, meaning about 3.5 % of total stocks, year after year.  So, after 30 years, every stock in the portfolio has been sold an average of 1.17 times, and the actual age is more like 12.8 years, with an average gain of 300 %, so the actual percentage of the portfolio which is capital gains is now 75 %.  In turn, that means that the tax bite for capital gains is about 11% of total income and therefore the overall total tax rate has now climbed to 13.25 %.  

But wait, there’s more.  Our rich person is paying this rate in year 30.  Remember, his or her underlying goal is not to minimize tax rates at one period in time, but overall taxes throughout the 30-year time period.  And that means that we should consider the fact that in the 30^th year, he is paying taxes on his capital gains an average of 15 years late.  To put it in terms of purchasing power, if we assume inflation of 1.5 % per year over that time period (typical of the last 10 years), he or she may be paying 11% of capital gains in tomorrow’s dollars, but that’s the same thing as paying less than 9 % in today’s dollars.  If we assume a more historical 3 % rate of inflation, it’s more like 6.5 % (although, for the rich person, the higher inflation is, the less the “real” income both before and after taxes).  And thus, the “real” overall tax rate is back down to about 8.75 %!    

What About When You Die?

Now, it would seem that when the rich person in my scenario died, the chickens come home to roost, or, to put it another way, most of the capital gains of the rich person are finally paid out in taxes, one way or another.  After 30 years, the final estate has grown to around $133 million (1.09 to the 30^th power).  40 % of $122 million of that ($48.8 million), where a husband and wife are involved, would need to be sold to pay those taxes, plus enough to cover the 11 % capital gains tax rate on the sold stocks (about $5 million) and miscellaneous fees ($0.5 to 1 million).  So we have net taxes of about $54.5 million, or 41 % of the estate.  Add to this the previous 30 years of average 6% tax rates for stock income averaging about $6 million (0.3 times 30 times 6, or $5.4 million), and the total tax on capital gains would seem to be more like 45%.

Except for two things:  Factor 1, the “step-up in basis”, and Factor 2, the effects of inflation.

Factor 1:  Because of the recent law allowing stocks to be reset to show zero capital gains at the point of our rich person’s death, their heir(s) no longer need to pay that extra $5 million in taxes to cover capital gains taxes from selling stocks.  So now we’re back down to about 41 %. 

Factor 2:  We are paying that $55 million in tomorrow’s dollars – dollars 30 years on, to be precise.  Assuming a historical inflation of 3 % per year, those dollars are worth 41 cents in today’s terms.  And that, in turn, means that we are really down to an annual capital gains rate on actual income of 16.9 %.

In other words, after these two considerations, the rich person has really paid the government only 12 % more than the Federal capital gains tax rate.  And the clock is now reset to our original scenario, as the heirs pay less than 3 % of actual income on their next income tax bill on the remaining stocks. 

Contrast this, by the way, to the schmoes who earn between the median wage of about $60,000 and $200,000 per year.  Yes, they don’t have estate taxes, but indications are that they pay more than 20 % of real total income in income taxes – and then, if they save a fair amount for their old age, get taxed another few percentage points on their savings from any stock investments they have, which typically yield much less than 9 % per year anyway!

Advice and Horror

To close out, let’s return to the question of whether the average reader can approximate this.  As I see it, to pull this off a reader should do three things:

1.       Start off with sufficient net worth in investments in diversified and low-expense-ratio stocks (at a guesstimate, a minimum of $3-5 million) so that your yearly expenses can be about 2.5 % of that net worth.

2.       If you want to milk the last drop of profit from this scheme, arrange it, if possible, so that modified LIFO is your strategy for all stocks sold.

3.       Make sure that between 1 % and 4 % of your stocks are “churned” – sold and bought – each year while preserving diversification and a low expense ratio.  An index fund like a good S & P 500 one plus paying most of your expenses out of stocks are excellent ways to accomplish this.

At this point, I should remind the reader that the most important thing for him or her is not minimizing taxes, but maximizing net worth after taxes.  Things like low-cost index funds and reinvesting dividends are valuable because they help maximize net worth before taxes, and hence (because they have few or no tax effects per se) net worth after taxes.  As I said in my unpublished book on personal finance, the strategy that aims to maximize income is almost always better than the alternative strategy that tries to minimize taxes.

And finally, I just want to express my personal feeling of horror at the implications of this analysis.  It should take no reminding for readers to contrast this situation with income from wage work, which can be taxed at a typical rate of 5 to 10 times the rate for investments when your wage is between the median of $60,000 a year and, say, $200,000 a year.   And for what?  The rich don’t work harder on average, they spend much less of their income to contribute to an economy, thereby lowering the income of the rest of us, and if they’re top-level managers they also excessively squeeze wage income for the rest of us, as Piketty documents extensively. And in the long run, as Piketty also notes, by using some of their spare money to change politically the rules of the economic game in their favor, they raise the likelihood of serious recessions and depressions that harm all of us.

And there’s another apparent effect that really bothers me.  In my scenario, the government sees most capital gains income for the first time, not when the income is gained, but in the reporting for the estate, 30 years from now.  That means that, on average, in real terms, we see the real investment income of the rich 15 years after it occurs, when it has perhaps two-thirds of its actual value.  If this is so, we are seriously, seriously underestimating today’s income of the rich, the degree of income and wealth inequality in this society, and the degree to which this tax code is causing that inequality.

Caveat homo medianus!  Let the average person beware! 

How Software Makes Nonsense of Ayn Rand

It amazes me, nowadays, just how many political and business figures – from Rand Paul in the U.S. Congress to Alan Greenspan, the former Fed chairman – cite Ayn Rand as an inspiration.  I first read The Fountainhead more than 50 years ago, and was interested until the climactic trial, in which the prosecution gave a speech unlike any real-life prosecutorial speech I have ever heard.  I have later heard excerpts from the climactic speech in Atlas Shrugged, which suggest that Ayn Rand’s themes in the two books are part of an overall effort to define “libertarianism” as an attempt to distinguish the “makers” from the “takers” in a typical society. 

Thus, for example, in The Fountainhead the “maker” is an architect who is put on trial because he destroys the corrupted version the contractor (apparently, local or state government) has made of his quality work.  In Atlas Shrugged, apparently, similar indignities drive Dagny Taggart and like-minded individuals to remove from the “takers” and their governments the “makers’” technical ability, needed to use modern machinery such as a radio, and to withdraw from society until it realizes its need for them.

Out of such writings, it seems, are political and economic philosophies made.  Let us also note that at the time Ayn Rand wrote, it was barely possible to see the work world and national economies much as Rand saw them:  inventors and hands-on builders who were also heads of larger enterprises, like Henry Ford and Thomas Edison.  Even in the post-war period, with the advent of the veteran CEO who knew how to get things done from executive training in the hands-on Army or Navy, there were possible examples of “makers” to cite as the ones who really made the world work, and made the world a better place.

Today, however, more and more of our products, our solutions, our processes, and our lives are infused with computer software.  And as a result, it is impossible to make Ayn Rand’s vision a reality.  In fact, today, computer software makes what Ayn Rand wrote complete nonsense.

Joining the Few Who Are Far Too Many

 An old British comedy routine spoofs WWII newsreels by intoning, “People flocked to join the few.”

“Please, sir, I want to join the few.”

“I’m sorry, there are far too many.”

That is the first bit of nonsense in Ayn Rand’s philosophy:  that relatively few “makers”, like Atlas lifting the world on his shoulders, run businesses, make things work, and keep progress moving forward.  No:  take any product, from a smartphone to an oil rig, and very few people actually build or design the new hardware.  On the other hand, many programmers over the years have built the software that connects the smartphone to the Web and to others (just like radio!) or monitors the performance of the oil rig, reporting that performance to remote sites looking for promising well sites and prepared for reaction in the case of disaster.  We need hardly add that a vanishingly small percentage of this software was made by executives. 

In other words, over the last fifty years, programmers (and make no mistake, programmers are creative and do their own thing) that are more and more prevalent have taken over more and more of what makes the world run and “progress.”  Take a vacation from making the world run?  How would you contact all those programmers, all over the world, much less get them to agree?  And where would they go to take a vacation until the world needs them?

That leads on to the second bit of nonsense from Ayn Rand:  That “makers” work harder, while “takers” seek to parasitically feed for their own benefit off “makers’” work.  Hedge fund executives work hard, and think creatively about investments; but do they work harder than anyone else?  Heck, no.  Programmers work just as long hours (as do, say, some police or construction workers, to cite a few examples), are just as creative, and their creativity has far more to do with how well the world runs than the creativity of the private equity firm. 

The key point is that if anyone is parasitically feeding off anyone, it’s the CEO or the program-trading hedge fund manager feeding off the programmer.  Moreover, if we remove the manager from the equation, it is relatively easy to substitute other wannabe rich folk for them, while if we remove all programmers, things would indeed slow down quite a bit.  And yet, in Ayn Rand’s definition, programmers are not “makers”, because they don’t know how the underlying hardware works, nor how to run a business.  Summary:  if programmers aren’t “makers”, then all those execs she was glorifying (a) don’t work harder (and aren’t more creative or more impactful on moving the world forward) than programmer “takers”; and if programmers are “makers” and execs are also (according to Rand) “makers”, then the main people feeding off programmers to the tune of billions in cash are other “makers” (i.e., execs).

That leads to the third bit of nonsense:  that government of all stripes is on the side of the “takers.”  We have seen plenty of examples of “maker” programmers inside and outside of government – or, for that matter, hackers.  We should also note the “open source” movement, that seeks to ensure the free availability of software outside of both business and government, and which both government and business are now “parasiting.”  We could cite further examples ad nauseam; but this Randism, today, just doesn’t come close to being true. 

It’s Okay, Honey, You Fulfill a Vital Function

So why don’t the Alan Greenspans and Rand Pauls of the world recognize how completely Ayn Rand fails to fit today’s software world?  My dark suspicion is that they want to believe that somehow they are doing something that makes the world run better, and “the gummint” (due credit to Walt Kelley’s Pogo) is the faceless entity that represents those who want to take well-earned money gained from hard, creative work away. 

I like the way Douglas Adams puts it in one of the Hitchhiker books.  One of his characters, on the run, bumps into a prostitute in a back alley.  Only she isn’t selling sex; she’s selling making businessmen feel better about themselves.  “It’s OK, honey,” she croons to a possible depressed-businessman John , “You’re really needed; you fulfill a vital function; our economy wouldn’t work without you.”

However, because of software, CEOs and investment firms are less and less vital to the functioning of an economy.   Yes, as we’ve seen, their “creativity” can screw things up; but it is less and less important to moving the technology forward.  Yes, they work hard and can be creative; but they simply don’t have the positive impact that they used to.  And so, I wonder if much of the buzz, past and present, about really earning outsized salaries and stock options, sweetheart deals after you leave the political arena with lobbyists, paeans to the “free market” and “laissez-faire” (according to economic theory, these don’t exist in the real world, by definition, because real-world markets don’t have perfect information equally shared), and the like are the output just as much of the prostitute seeking some share of the billionaire’s billions as of the income-unequal CEO himself or herself.

And so, thanks to software, Ayn Rand’s philosophical justification has become real-world nonsense.  In fact, I wonder if what’s going on isn’t the ultimate irony: to see Rand used to justify “taking” by non-governmental CEOs and the like?

But then, I still haven’t forgiven her for that prosecutorial speech.   I hope she’s being forced to code in FORTRAN down in the nether regions.

Why the Rich Get Richer – and Why Even Most Economists Don’t Seem to Get It

I was recently pleased to note that a Frontline program from last year (“The Retirement Gamble”) had finally begun to note the virtues of low-expense-ratio large-market-index index funds.  This year, we have Piketty and Saez, who have finally noticed the importance of wealth rather than merely income in creating and maintaining the ranks of the rich.  They echo what I wrote in an (unpublished) book on money management for the rest of us 15 years ago:  that while over the long term (20 years or more) stocks are the best bet, there are two sets of people who will guarantee that your stock investments will under-perform:  other people (most advisers and fund managers) and yourself.  Index funds are on auto-pilot; they avoid both sins.

However, what I really had not thought deeply about 15 years ago was that simply putting half of your money available to invest in a reasonably diversified stock portfolio (the rest, say, in bonds), above a certain level of investment “wealth”, will effectively guarantee that you will get richer and richer relative to everyone else.  In other words, unless you manage to spend so outrageously that you go below that minimum amount (despite what you think, it’s not easy), your net worth will over any 20-year period grow at such a rate, on average, that it will double every 8-15 years.  $5 million today?  If you go for an S&P 500 index fund from Vanguard with a 0.1% expense ratio, it will be $10 million in 2022, $20 million in 2030, and $40 million in 2038, or about when you’re ready to pack it in if you’re 60 now – and that’s after inflation. 

And those who don’t invest in stocks (reasonably diversified) and are lucky enough to avoid a shark like Bernie Madoff (as the late Robin Williams remarked, “Was the name not a clue?”) – i.e., those who aren’t rich – will find it much harder to get rich, at the least.  Bonds?  1-2% above inflation, often less than enough to cover living expenses. Houses?  2% above inflation at best, because all those fancy sales figures don’t show the large amount you must spend on upkeep to keep them usable.  Anything else?  Historically, either worse, or the equivalent of hoping to “win the lottery”. 

Rich Person’s Game

So here’s how it works, for a particular rich person – one, say, starting with $3 million in the Vanguard index fund referenced above, and with a net wage income of, say, $57,000.  That index fund, on average (actually, something called the geometric mean), generates about 10.85% per year before inflation, about 8.6% after.  About 2.25% of this comes from dividends, or $67,500, on which you pay 15% tax, or about $10,000, leaving you with $57,000 (net return about 8.3%).  Now let’s assume that you live on your income for the first year.  The next year, you have about $3.25 million.  What about capital gains?  The S& P fund is superb for avoiding most of those – the smallest stocks in the index are the ones that get bought and sold (enter or leave the S&P 500). And you’re still paying only 15-20% in taxes on those.

8 years from when you start (when you’ve doubled your money), your take from your dividends has reached $114,000.  However, you’re still getting a net of about 8.3% from your investment, year after year.  Over time, the amount of capital gains gets slightly larger, but – here’s the shocking kicker – after you die, the “cost basis” from which capital gains get computed goes to the stocks’ current value, which means that capital gains of anything that gets sold after that goes back to about $0 again.  How could Mitt Romney pay 10% of his income in taxes?  1/3 of the income was dividends, and 2/3 was sale of stocks with effectively 0% capital gains tax. I don’t know if that’s what happened, but that’s how it could be done.

The most amazing thing about this is that you can up the taxes, assume that the rich person is sub-optimally investing by a large amount, and still, the net worth will keep marching on up – by less, but still by enough to handle a lot of wasted spending.  At $6 million, you can spend money on four $100,000 cars per year and your net worth will still march on upwards.  At $12 million, you can afford an $800,000 second house, cash up front, and you will still be gaining.  You can give away 3% to an active manager of a fund in a 401(k), and still be doing well.  You could be taxed on your wage income at 90%, or your dividends and capital gains at 50%, and you’re still doing excellently, increasing your net worth more and more. 

In fact, many rich people do invest poorly.  They go for active funds, investment advisors, hedge funds (performs less well than index funds over time, latest figures show, and the fund is taking perhaps 80% of the profit), far too much in the way of bonds (by some figures, about 50%), and plenty of fads.  Piketty’s figures seem to suggest that they’re no better than the few non-rich who have to use 401(k)s with their rigid menu of non-index funds and high fees up and down the line (estimates are it costs us 2-4 %).  The difference is, the not rich are trying to reach that magic $3 million, and using some of the investments for living expenses, because they have to.  Even at $500,000 in investment wealth, you’re still in real danger of getting poorer.  But the rich get richer.

And the higher you go, the less job income matters.  Don’t like the CEO’s $10-million-per-year package, 400 times the corporate median wage?  If that CEO is a billionaire, he or she is earning $80 million a year just from investments (if it’s our index fund example), or $40 million if he or she is the typical lousy investor.

And so, what the CEO earns (most of the rich are CEOs, including CEOs of financial firms) is not a case of the rich getting richer; it’s a case of the head of the firm finding a way to enter the charmed circle of the rich, quickly.  Controlling inequality is not a matter of controlling income from work; it’s primarily a matter of controlling the amount the invested rich reap from their stock investments compared to the non-rich.

Why Even the Best Don’t Seem to Fully Get It

Most commentary about today’s increasing imbalances in income and wealth seems to fall into three categories.  The first category is those who justify these imbalances as somehow reflecting the value of the individual who is becoming richer and richer.  Of what added value to society is an individual who simply sits on an investment and watches it grow (remember, that’s how today’s rich are increasing their wealth)?  Anyone can do that.  No, to me those who justify the imbalances are the equivalents of the prostitute in one of Douglas Adams’ Hitchhiker books, whose sole source of income is assuring the rich that they really do deserve all that money, and those who criticize them are just meanies.

The second class of commentators are aware that there’s a problem, but seem to think that income taxes are the solution.  Rather, high income taxes slow the flow of new rich into the charmed circle, but have very little effect on those who have already joined – they get most of their money through dividends and stock appreciation. 

The third set of commentators – I would include Paul Krugman and Piketty and Saez in this class – realize that there’s a problem, and that it’s connected to wealth.  However, the same sophistication in economics and understanding of data collected about the aggregate within a nation that allows them to see the results of the rich getting richer right now, seems to fail them when they actually consider the connection between national trends and the individual case.

In the case of Piketty and his better critics, the question focused on is whether “r-g” will continue – at a guess, whether the rich can continue to gain a larger piece of the pie indefinitely.  But that’s a question with an easy answer:  as long as stock markets continue to deliver outsized returns over the long term, as they have done for at least the last 95 years, and taxes and very severe depressions do not shrink wealth to the point where many fall out of the charmed circle (as seems to have happened in the forty years during and after the Great Depression), then the rich will indeed get richer.  And yet, looking at things from the perspective of national economies, the idea that the rich can have a bigger slice of the pie for a very long time seems counterintuitive.  And so, the idea of higher income taxes and estate taxes is the focus, while a wealth tax such as the one in France is barely mentioned and assumed not to be an effective path to reversing wealth and hence income inequality.

To my mind, one of the main reasons for this “difficulty in getting it” is the fact that we don’t see most of the appreciation of stock in the data – it shows up only as capital gains when the stock is sold, and even those are far less than the real income appreciation.  Remember, you first pay out of dividends, and then take a little capital gains when the index fund has to rebalance, and when you die the cost basis is reset and when your inheritor sells it seems as if there has been little increase in the stock.  So, over 30 years your wealth may multiply by 8 times and yet, going by dividend and capital gains figures, it has not yet doubled.

There is, by the way, one really strange way that we also underestimate the wealth underlying capital gains reporting.  Let us suppose that we arbitrarily decide to sell 0.8% of our stocks every year.  Remember, each year the value of the stocks goes up by 8+ %, so for the first ten years, we are paying capital gains on our first year’s gain in stocks, and by the end of the 20^th year, we are still paying capital gains on the second year’s gain.  However, during the 20 years, we have seen inflation that has effectively reduced the value of the money we are paying.  So, at about 3.5% inflation, that payment in the 20^th year, in real terms, is about ½ of what it would have been if we had paid at the end of the first year.  This, by the way, is another way that the rich reduce their taxes in real terms.

Now, if at the time of your death you had to sell all your stocks, all those capital gains savings on delayed capital gains tax payment would be reversed.  But you don’t – you will probably have to sell relatively little of the stock.  And so, the real cost of the capital gains to your heir keeps getting smaller, and smaller, and the amount of actual wealth relative to the amount of capital gains reported keeps getting larger and larger …   

The Personal and Global Bottom Line

I see two take-aways from this analysis of the investment rich getting richer.  The first is personal:  whoever you are, if you aren’t rich by my definition, get somehow to a net worth of at least $1.5-$3 million that includes at least $1.5-$3 million in diversified stocks.  Then, by the method I’ve outlined, you should be set for life.  Note that this doesn’t include expenses from your support for other people, such as a spouse and children – ideally, they too at some point in their lives should reach equivalent wealth, so they are set no matter what happens to you.  Yes, I realize that for most this is very hard to do, and that the kind of fees we see out there when you do a 401(k) or an actively-managed fund or get investment advice or try to do stock investing yourself make it much, much harder.  All of this discussion of how to optimize your investments is in my unpublished book of 15 years ago.

My second take-away applies in the area of global economic policy.  Piketty and Saez have masterfully shown how, with the exception of the period after the Great Depression, income and wealth inequality have grown steadily over at least the last 150 years.  Unless policy deals with the underlying reason, as I’ve laid it out, that the rich can indeed get richer in relation to the rest of the world, then policy is very likely to be ineffective.  That means serious consideration of a wealth tax such as the 2% one in France, as long as it applies to stock investments.  Personally, I’d make it a 3% tax targeted at the rich – those who are smart enough to weight their investments heavily in index funds will continue to grow in wealth, but the majority, whose yield is much less, should see an almost flat net worth trend.

Of course, you still have to deal with the problem of making such a tax global, else the rich will just domicile elsewhere.  Still, as with other taxes, there are ways of dealing with this to some extent.  If we wish to get a handle on a problem that makes the global and US economy underperform and also has very bad effects on the non-rich, we need to target just exactly why the rich are getting richer, and target our solutions to that understanding.  Here’s hoping we won’t take decades to do this.

The Insights of the New Inequality Reports Relevant to Personal Finance

Those of you who have skimmed my bio will have noted that a good while ago I wrote a (unpublished) book on personal finance.  In the book, I came to certain counterintuitive conclusions about the best way to manage your money; in the last few years, I have conjectured that my take on personal finance can be used to analyze wealth management and investment patterns at the macro level, i.e., at the country or global level.  However, up to now, the only evidence I had for the correctness of my views was anecdotal.

In recent publications, the acknowledged experts on income inequality – Piketty and Saez – turn their attention (and that of their co-authors) – to wealth.  In the process, they derive some insights which place on a solid statistical foundation most of my conjectures.  In this post, I summarize some of the insights of the reports that may seem counter-intuitive to many readers, but together form a picture that places wealth – not income – squarely at the forefront of personal finance and many aspects of today’s economics.

In no particular order, here are the insights, in grossly generalized form:

1.        Over the last 200 years, except for a period around the Great Depression, “capital” (really, stocks and bonds) has consistently performed better in terms of growth of wealth than income from “labor” (ranging from salaries to CEO “incentive pay”).

2.       As a result, again consistently, there is a line somewhere around $2-$4 million in invested (stocks and bonds, not real estate or venture capital-type investments) wealth below which the wealth of the individual does not grow significantly over time, and above which his or her wealth grows at about a 7% (in real terms) rate per year.

3.       Again consistently, 50% of the population has zero or negative wealth, 40% has minimal investment wealth, and for 8-9% much of the investment wealth comes from a pension or 401(k) whose yield income is typically less than that person’s labor income.  Only the top 1-2 percent have investment income greater than labor income.

4.       The very rich (top 1-0.1%, $20 million to $100 million in wealth, plus the top 0.1%, $100 million and above in wealth) are no better investors than the other 99% (actually, the other 49%, since 50% have zero or negative wealth) – despite sometimes having certain advantages in the treatment of capital income, and in connections to investment “opportunities”.  

5.       It appears that high estate taxes, fairly high income-tax rates, fairly high capital-gains rates, and fairly high dividend-taxation rates have had little effect on this “shift to capital income”, while the main reversal of trend (the Great Depression) may have occurred because the loss of stock value was so severe (perhaps 70% from peak to trough) that many of the 1% found themselves below $2-4 million in invested wealth, with habits of high spending that were difficult to break.  Also, the Great Depression effect may have lasted for 40-odd years because high marginal income tax rates and smaller markets and pay norms did not prevent those with more than $4 million from growing at 7% per year, but did prevent most would-be entrants (typically CEOs) from reaching the magic level over the course of a career.  Reductions in tax rates, globalization of markets that allowed more scope for high CEO salaries, and new norms of compensation that piled direct-to-investment stock options on top of large increases in salaries in the 1979-1990 time period probably broke the Great Depression mold.

Here are the initial conclusions I draw – or, more properly, move from “anecdotal evidence” to “firmly based in statistics”:

1.        The aim of personal finance should be to achieve $2-3 million in low-expense-ratio S&P 500 (or Russell 2000) index funds.   Note that Vanguard typically has a 0.1-0.2% expense ratio over time.  The tendency of the rich to invest instead in high-expense-ratio actively-managed funds, in bonds, in derivatives, in hedge funds, in real estate, in venture capital firms (assuming that the aim isn’t philanthropic), in listening to con men, in conspicuous consumption, and in political maneuvering to protect labor income from miniscule threats, explains why the average rich person is no better at investing than the less-well-off 401(k) owner who is forced to deal with lack of available index funds and 2% fees in the 401(k), as well as less opportunity to use capital-gains, dividend, and interest tax advantages.

2.       Overall, these wrong investing decisions cost the top 50% about 1.5% per year (based on a study that showed that in real terms, a Vanguard S&P 500 index fund or the like grows about 8.5% per year).  They also suggest that unless there is less than 15 years to go until retirement or one’s employer is also contributing significantly, investing directly in such an index fund may be better than putting that money in a high-expense-ratio 401(k) or IRA.

3.       It also follows that once one reaches the “safe rich” category as defined above, there is far less urgency about piling up more and more than is assumed.  What the rich buy in terms of power to protect their money with the extra cash is unneeded in the first place.  Economics, as many have said, is not a morality play; but if one reaches the “safe rich” category, it is perfectly reasonable to do the moral thing and not stretch desperately after more and more and more, and the person who does so will typically not suffer any real penalty.

4.       The first macro implication of these insights is that income tax and estate tax tweaking is strictly limited in its effect on this “investment rich get richer” trend.  It now appears unlikely that we can reverse the trend by limiting entry into the “$4 million and up” investment club – although we can prevent its spread to many of today’s CEO wannabes.  No, by far the most powerful tactic for preventing rapid wealth/income rich-share expansion (and, by the way, the top 1% now have 40% of the wealth and the top 0.1% 20-22% of it) is an investment-wealth tax.  France, I note, has a general-wealth tax of 2%, which has helped somewhat – one might consider putting it at 3.5%, to counter the effects of 2.5% inflation.  Note that this will simply take the rich’s yield down to 3.5%, still enough to ensure some wealth increase, but one-half the increase of the 49%.  I limit it to investment wealth, because the data suggest that if the super-rich shift to other forms of investment, not only will their own income suffer (stock options), but their own investment yields as well.  However, other distortionary economic effects may mean that one should echo France.

5.       The second macro implication, I believe, is that inequality and its follow-on economic effects is not primarily a problem of income inequality, or as Krugman conjectures in recent blog posts, a matter of inherited wealth – the Rockefellers and Vanderbilts are still doing quite well through stringent estate taxes and loosened ones.  It is, rather, a matter of regulating both entry into the “safe wealthy” category and the amount of wealth growth once one has reached that stage.  To have a hope of long-term success, in other words, inequality policy must deal with investment wealth above a certain level.

Oh, Those Statistical Nits!

Recently, I read a Paul Krugman NY Times column on income inequality, which referenced a NY Times article on income inequality, which referenced a Pew Research Center study on income mobility over generations. The NY Times article stated flatly that the Pew study found that 81% of Americans have more income than their parents. I read the first part of the study carefully, and it did indeed state that most sons of parents in the study, whether white or African-American, bottom or middle or top third of parental income, earned more than their parents did. And then I read even more carefully, and realized that the data absolutely did not support a conclusion that today’s American sons earn more than their parents did.

What went wrong? Well the study took a longitudinal study of families whose sons were between 0-18 years of age in 1967-1971, and compared the family income of the parents in 1967-1971 to the family income of the sons in 1995-2002 (omitting a couple of years). There were three basic problems with the analysis. First, government data shows that for the bottom third of family incomes, family income grew from 1967 to 1979, decreased slightly until 1994, grew again until 2001, and decreased to below the 1979 level by 2010. For the middle third, there was a similar trend, except that family incomes are now about the same or slightly below the 1979 level. For the upper third (and especially for the upper 1%), family income has grown consistently and, by 2010, substantially over 1967-1971. So the choice of the two “snapshot” time periods maximized the growth of income between parents and sons in all three income strata. Thus, it is likely that had the period been, say, 1980-1984 vs. 2006-2010, far fewer sons would have increased their family income compared to their parents.

The second problem with the study was the interval of the two “snapshots”. We know from demographic data that people were having kids, on average, earlier, in the 1950s and 1960s, and so it is reasonable to suppose that those sons who were 0-18 in 1967-1971 typically had parents that were 21–49, and most frequently about 35, while the sons in turn during 1995-2002 would be 24-55, and most frequently around 40. The reason this matters is that government data shows that families’ earnings trend steadily upwards from 20 onwards, and reach their peak from 45-55. In other words, the time period chosen exaggerated the income earned by the sons by pushing more of them into a peak earnings period.

The third problem with the study’s statistical approach is that it took “family income” as equivalent to “personal income.” Back in 1967-1971, across all three strata, less than one-third of women worked. According to the latest Census data, perhaps 80% as many women as men work, and that was pretty much true in the 1995-2002 period. These, in turn, have been earning perhaps 80% as much as men. So, especially in the bottom and middle thirds, women contributed less than 10% of average “family income” in the 1967-1971 period, and about 40% of “family income” in the 1995-2002 period. If we are really comparing apples to apples, we have to say that if we compare fathers to sons, it is clear that any upward trend in income is far less frequent. Now, the study notes that the “family income” is converted to personal income by being “family-size adjusted in all analyses”; but all this does is exaggerate things even further, because family sizes were slightly smaller in 1995-2002 (and now) than in 1967-1971.

One caveat: I was unable to access the Appendix to the study, which explained Pew’s methodology in greater detail. It is always possible that they dealt with these problems to some extent by further statistical tweaks. However, I view that as pretty unlikely, since these considerations are so important that they should have been noted in some way in the main paper.

Now, it is important to keep in mind that I am not a statistics “rocket scientist.” All it took me to figure this one out was a little ongoing digging on the topic of income inequality, and a careful lay-person reading of the methodology section of the Pew paper. The problem here is not that Pew was “lying with statistics”, because the facts were right there in the front of their study report. The real problem is that the so-called journalist of the NY Times apparently didn’t even bother to read that section carefully, much less do a little additional research which would have called the Times’ “81% of Americans” into further question.

So, as that fellow in the insurance commercials would say, what have we learned here? Well, first of all, statistical nits matter. I suspect that when the dust settles, we will find that less than half of all American males are presently earning as much, in real terms, as their fathers did (and the women aren’t a slam dunk either, since much of the surge in their employment and wages happened by the late 1980s). Even if that isn’t true, there’s no way the figure is anywhere near 81%. You need to consider statistical nits like the ones I have cited to convert a statistical study into a realistic picture of what’s going on in the real world.

Second, and equally important, you can’t trust any old reporter to do it for you, no matter how prestigious the name of their institution. You at least have to make a stab at the statistical nits yourself – or you’ll wind up believing what just isn’t so. Thank heavens for the Web, so that we can begin to check those statistical nits. Thank heavens for the Web, which gives us pointers to data that put those statistical nits in context. If we fail to do so, then by all means blame the knucklehead at the NY Times – but also blame ourselves.