Discussions about income inequality, taxation and economics often center around the “top 1%” vs. the remaining 99%. Are you a member of the 1% Club? And what does it take to get into the Club? And is membership based on what you make in earnings or salary? Or does it have to do with the value of your assets or your net worth?
To answer this question, we need to know the difference between earnings and net worth. Generally, there are two ways to define “wealth” – how much someone makes from income (earnings) or how much someone actual owns (their net worth).
Let’s use a couple of examples.
“Judy” is retired and is still fairly active at 71 years old. She has a taxable income of $18,000 per year, mostly interest and dividends from her retirement and savings accounts (see Note 1). This amount of income places Judy in the bottom 35% of all income earners in the U.S.
However, let’s assume Judy also owns certain assets, like a home and has no debt. Judy has lived in the same home in Mill Valley, California for over 30 years. The current value of Judy’s home is now estimated to be $1.8 million. This is not an unreasonable assumption, given the current value of real estate on the West Coast.
Judy’s property taxes were frozen many years ago, so the property taxes Judy pays are not reflective of the current market value of the home (see Note 2). Judy also has additional assets of a car, furniture, a retirement & savings account and an RV which all total $500,000. Since Judy has no debt, her personal net worth is $2.3 million (the home of $1.8 million plus the other assets of $500,000).
- Net Worth is generally defined as the current value of all of your assets minus your debts.
With a net worth of $2.3 million, Judy is in the top 5% of all Americans in terms of personal wealth. So in this example, Judy is in the bottom 35% of income earners, but rises to the top 5% in personal wealth compared to others in the U.S.
Now let’s look at our other example.
John is a Millennial who is 26 years old. He graduated with a software engineering degree and has landed a job in Silicon Valley making $130,000 per year. Not an unreasonable salary for this type of degree in Silicon Valley. Congratulations John, you are now considered to be in the top 5% of all earners in the U.S.!
However, John probably doesn’t feel like he is in the top 5%. He owns almost nothing and has a great deal of debt. John’s car is new, but financed with a car loan. He also rents an apartment, so he doesn’t own a home or much in the way of furniture.
With assets of only $30,000 and liabilities of $80,000 (a car loan of $20,000 and student loan debt of $60,000), John’s net worth is actually a negative $50,000. This places John in the bottom 2% of all Americans in terms of net worth.
So in this example, John is in the top 5% of income earners, but drops to the bottom 2% of personal wealth of all the people in the United States.
Here is a summary of our two examples;
So a question;
Who is the “richest” of the two, John or Judy? And how should they be taxed?
You might consider Judy to be the “richest” – but the U.S. Government considers John to be the richer of the two. Here are two points to ponder:
U.S. Taxation is Based on Earnings not Wealth
The U.S. income tax system is based on an individual’s yearly earnings, not their net worth.
A Wealth Tax (the Taxation of Net Worth) is Unconstitutional.
Though other countries may have a wealth tax, the United States Constitution prohibits any federal direct tax on asset holdings (as opposed to an income tax on earnings or a capital gains tax when assets are sold).
Since the U.S. taxation system is based on taxing an individual’s earnings, such as wages, salaries, interest, dividends, business income, etc., there does not exist a system of taxing net worth or assets on the federal level.
So when you hear the comment, “…let’s tax the 1% Millionaires and Billionaires!” Consider that the comment is directed to that person’s net worth, not their earnings. And net worth is not taxable. (See Note 4)
Their earnings, however, are taxable. However, more than likely, some or all of those earnings might be protected from taxation because of tax shelters – which is the next post topic of this Amateur Economist.
Note 1 – Judy may also receive Social Security benefits, though not included here. Social Security benefits are generally not considered “taxable” as they are considered a return from the years of deductions from earnings. However, Social Security benefits are taxed on a tiered basis if the person receiving them earns over a certain amount (2017 – $25,000).
Note 2 – Property taxes are, technically, supposed to reflect the “fair market” value of the home. This value is usually adjusted on a yearly basis. However, most states have instituted a system which may freeze the property taxes of certain persons, usually homeowners of a certain age or because of disability or other reason. Additionally, some states, like California, have caps on property tax increases, regardless of what the current value of the home may be.
Note 3 – To be in the top 1% of earnings, an individual needs to make over $305,000 per year. The top 1% for net worth would require over $10.5 million in assets.
Note 4 – Interestingly, most news articles refer to the “Richest Americans” by net worth, not by the income they may earn. Most of the wealth of Millionaires and Billionaires is in the form of stock, business or real estate holdings.
Ironically however, most Americans in day-to-day discussion with others, judge whether a person is rich or well off not by their net worth, but by what they make in salary or earnings.