With the democratic presidential primary elections starting to take shape, financial inequality is one of the biggest issues, if not the biggest issue, being debated. I remember similar arguments during the run up to the 2016 election, which were essentially the entire impetus for Bernie running for president. I also remember a specific conversation I had during that time, where an acquaintance of mine was making the case that wealth and the estate tax are the wrong way to target inequality – they argued that the source of wealth is income, so the best solution would be increasing income taxes.
This was long before I had done my dive into personal finance, so I hadn’t spent much time thinking about wealth vs. income, and didn’t argue against this view. If someone made the same argument to me today however, I would be more inclined to push back. With a very simple idea (which I was very familiar with at that point, but apparently hadn’t thought about in any substantial way), we can see that wealth and income are essentially interchangeable. That idea is interest.
We’re all familiar with interest. The most common scenarios where it comes up are receiving interest on a bank account or paying interest on a loan. But what you might not have realized, at least not explicitly, is that interest is a way of transforming wealth into income or vice versa. When you take out a loan, you are giving up some of your income for access to wealth. And when you invest or lend money, you are receiving income in exchange for giving someone else access to your wealth.
Of course, while interest provides some mechanisms to convert between income and wealth, it does not make them identically equivalent. There are a few important differences from a more explicitly personal finance perspective, but I’ll save those issues for another post.
The important difference I’ll cover today comes from how the government (at least in the USA) sees and taxes income vs. wealth. For the great majority of people in the US, the main way they are taxed is via their earned income. When they perform labor that earns them money, a percentage of it goes to the government. The percentage depends on different factors, but the most important one is how much you earn. Someone earning a modest salary might be taxed between 10-20%, while someone earning millions of dollar annually would be taxed at almost 40% (at least in theory – in practice there are tricks for them to pay less).
However, if you are very rich or part of a very rich family, there are two other taxes that will apply to you: capital gains tax and the estate tax. The capital gains tax applies to income that you make from your money (i.e., investments) rather than your labor, and the estate tax applies to wealth transferred to heirs after a rich person dies. These taxes work in a similar way to income tax, where higher “earners” pay higher rates.
I won’t go into detail about the estate tax here, since it is harder to compare to the income tax, but for capital gains it is fairly apples to apples. In both cases, you are taxed on money received, it’s just the source of the money that differs: the income tax affects money you received for performing work, while the capital gains tax affects money you received for having money and investing it.
So how does the government see wealth and income differently? The income tax rates are roughly double the capital gains tax rates. In terms of how much you owe Uncle Sam, it’s much better to “earn” your money through having wealth than to earn it by working. This is one piece of the puzzle of why wealth accumulates and inequality grows, and why inequality is now such a central issue in American politics.
There are a few high profile tax proposals on the Democratic side at present aimed to address inequality:
- Raising the top marginal income tax rate (publicly championed by Alexandria Ocasio-Cortez)
- Raising the estate tax (publicly championed by Bernie Sanders)
- Introducing a wealth tax (that is, a tax on net worth above a certain threshold – publicly championed by Elizabeth Warren)
I think all of these would be beneficial for the country, but of the three I’m most enthusiastic about the wealth tax. It addresses the reality that wealth is more powerful that income, and cuts directly to the problem of wealth inequality most directly.
I’m a bit surprised no one is championing an increase in the capital gains tax (at least, no one that I’m aware of). That would be another more direct route to addressing wealth inequality, and wouldn’t add any tax burden to the majority of Americans.