David R. Henderson  

Income Variability

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In a post two months ago, I pointed out the important distinction between being high-income and being rich. I gave an example of a friend, and a couple of the commenters suggested that my friend guest blog about his situation. He didn't want to identify himself but he gave me permission to tell his story. Here is my story of Mr. X. I add that in my original post, I exaggerated his numbers in both directions. What follows are the accurate numbers, which I checked with him this morning.

Mr. X, like me, earned a Ph.D. in economics. In 1985, at age 36, he decided to leave academia and set up a full-time business with his wife. They ran the business out of their house in a major American city. Here are their income ranges for the last 25 years:

. In 15 of the 25 years, their income was < $100K.
. In 10 of those 15 years in which their income was <$100K, it was also < $50K
. In 2 of those 10 years, their income was $0.
. In 5 or 6 of those years, their income was > $500K.
. In 1 of those 5 or 6 years, their income was just over $900K.

All of their 5 or 6 high-income years were years in which their marginal tax rate was 39.6% or 35%. In other words, in none of their high-income years were they in the Reagan 28% or the Bush I 31% top tax bracket. And, of course, in those years, various of their deductions didn't count because they are phased out as income rises.

To make this income, they work 6 to 7 days a week for 10 to 12 hours a day. When I visit X, which I do once a year, he takes a few hours out of his day to go for walks or go out on his boat. He leaves his phone on and often deals with employees or clients.

Because they work so hard, some of the things the rest of us do and don't hire people for, like gardening, minor repairs to the house, etc., are things they hire people for. These payments are largely non-deductible from their taxable income.

Because they own their own business, their business's payments for their own family health insurance count as taxable income to them.

They still expect much upside on income because the business has finally become successful, but a huge percent of this upside will be taxed at 39.6% or more from 2011 on. The idea that the government is taking it from those "who did so well in the 1980s and 1990s" does not apply to them.

Because their high-income years came mainly in the last half of this decade and their two daughters are roughly halfway through college, they didn't qualify for any financial aid. For each daughter, they are paying over $50K a year in tuition, books, and room and board.

I asked him his net worth. It's about $2 million.


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CATEGORIES: Taxation



COMMENTS (17 to date)
kebko writes:

I have always been self-employed, and my earnings are similar to theirs (except for dividing theirs by about 10) :-(

Anyway, as with them, the gini number you would get just from the individual annual data points in my earning history would be much higher than it is for the nation.

Considering how much wages typically increase over a lifetime, I wonder if this might frequently be the case - that an individual's lifetime gini number would tend to be higher than the nation's is at any point in time.

GU writes:

Does the net $2MM include his house? That would make it even more of a reality check for the income taxers.

kevin writes:

Does any country tax based on net wealth instead of income? It would seem to be a more fair way of generating government revenue.

Patrick writes:

@kevin

I think Sweden has a wealth tax of 1%.

David R. Henderson writes:

GU,
Yes, the $2 million includes his house. His equity in his house is only about 10% of his net worth.

mulp writes:

Unless the incomes were adjusted to constant dollars, the numbers are misleading; from MeasuringWorth.com

In 1985, $100.00 from 2009 is worth:
$50.20 using the Consumer Price Index
$56.10 using the GDP deflator
$49.50 using the unskilled wage
$47.80 using the Production Worker Compensation
$38.10 using the nominal GDP per capita
$29.60 using the relative share of GDP

Bob Murphy writes:

David,

Can you clarify a little more what the overall moral is here? I think some people might look at those numbers and say, "Huh?! In six of those years they made a total of about $4 million. And now they're only worth $2 million? It's not the government's fault if your buddy goes to Vegas when he has a good year."

I think part of your story is that in the high income years, he had to pay off business loans or something, right? Or are the above numbers what they reported on their personal income taxes?

Mike writes:

Can't they defer income? Also, as a self-employed persons, they can contribute more money to IRAs than average. Isn't it up to $49,000 for each person? Thus, that income would be tax deferred.

Losses can be taken up to 3 years back, right?

Seems like they (and you) are leaving out quite a bit of information....

mulp writes:

All of their 5 or 6 high-income years were years in which their marginal tax rate was 39.6% or 35%.

Clearly these people do not understand basic economic public policy theory and failed to work less when taxes were highest, and work more when taxes were lowest.

So, they get a D- or F in economics??

jeppen writes:

Sweden has abolished the wealth tax after economists concluded it's a net loss to the government. However, the socialists are promising to re-introduce it after their probable election win in the fall. That, of course, has stopped the wealthy from taking home their hidden wealth from accounts abroad.

The socialists aren't concerned that the tax hurts the state's revenues, or that their threats about taxes does. Their priority is upholding the impression that the rich pays for everybody elses benefits. This is how they get the middle class to actually vote for them.

NoWay writes:

[Comment removed pending confirmation of email address. Email the webmaster@econlib.org to request restoring this comment. A valid email address is required to post comments on EconLog.--Econlib Ed.]

Peter writes:

Your numbers don't add up on the back of my napkin; I am showing a four year gap. I can account for twenty-one of twenty-five years which works out to about 4 million using best case scenarios (see below). But even with that let us run with four million in twenty one years which really isn't all that great a deal nor a good example of high income or wealth given it's neither but solid upper middle class.

1) You have dual income so that's really two million over twenty-one years per person or about ninety-five thousand a year which is reasonable even for folk without a college degree, not self-employed, and working forty hours a week (which works out to around $45 an hour).

2) Now your friend is working six or seven days a week over that time period so for the sake of math lets run with he is averaging sixty hours a week which works out to roughly $30 an hour or sixty-two thousand a year if your normalize it for a standard work week which is well below what he would have maid had he stayed in academia with a PhD.

In my view your friend sacrificed a lot of his life and quality time with his kids and hobbies for a hard life with little to show throwing away the money spent initially on his education.

I am going to call BS on your friend's numbers. No way he has two million in net worth outside some serious luck in the housing market or jack potted a stock (luck is poor measuring stick) unless he seriously hunkered down simply living off one income completely investing the other (which is doable, plenty of guys making less than that with housewives and more kids) which I have a hard time believing given they were hiring maids, handymen, gardeners, et al on top of a half mil for their daughters college.

-- Bad Napkin Math --

392,000 = 10 years (8*49K, 2*0)
495,000 = 5 years (99K*5)
2,495,000 = 5 years (899K*5)
901,000 = 1 year (901K*1)

caveat bettor writes:

If your friend and his wife contributed $20k per year to 401k, IRA, 529 plans from 1975-85, I can see how they might have been able to grow a million dollars of tax-advantaged savings with under a 6% average annual return (not adjusted for inflation).

I think your friend should take a heavy haircut on his retirement accounts; how will Congress be able to resist taxing them more in a decade or two?

David R. Henderson writes:

@Bob Murphy,
You're right. I thought it was obvious but I can see from the comments that it's not. When they were growing their business and earning under $50K or under $100K, they were going into heavy debt. At one point in the mid-90s, they had over $400K in debt, much of it on credit cards. I think some of the commenters are so used to a world in which you earn x amount per year and put some fraction of x into retirement savings that they have trouble imagining a world in which you earn x in a year but go into x of debt that year to keep a business going.

fundamentalist writes:

Dr. Thomas Stanley (his most famous book is "Millionaire Next Door") estimates that 85% of wealthy people (net worth > $1 million) got their wealth by growing a business over 30 years. They tend to work many hours and live frugally. Naturally, all people see is the wealth they have accumulated after 30 years, not the 30 years of hard work and deprivation to get there, so they want to punish them for being wealthy.

I have a friend who dropped out of college after one year and bought an old feed mill by borrowing from his parents, his in-laws and the seller. He raised a family and lived very modestly for the next 30 years while gradually improving his business and slowly paying off the debt. He recently sold it for a couple million. No he is one of the bad guys because he has money. And the state wants to take it all away in taxes.

Tom writes:

"The socialists aren't concerned that the tax hurts the state's revenues, or that their threats about taxes does. Their priority is upholding the impression that the rich pays for everybody elses benefits. This is how they get the middle class to actually vote for them."

Obama, answering a similar question in one of the debates, did say its about fairness, didn't he?

Peter:"about ninety-five thousand a year which is reasonable even for folk without a college degree, not self-employed, and working forty hours a week "

Would put you in the top 1% of your cohort, I believe.

RobbL writes:

David,

You focus on their "high" taxes and forget all the goodies. Since they work out of their house, the government subsidizes their expenses for their "home office". They get to expense their computer and internet and phone costs. They may be expensing some of their automobile and restaurant costs. If they want to go to a "seminar" in Hawaii, they may be able to expense that.

I am not blaming them for this, but the tax rate in a vacuum is misleading.

Another thing that I have personally discovered this past year is the cushioning effect of progressive tax rates when your income falls. If you drop from 100k to 60k the actual drop in income is much less than 40k. Just another government benefit!

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