Chris Baus

Income is not wealth

The New York Times posted an article this week titled: Why So Many Rich People Don’t Feel Very Rich. I find it odd that the concepts of income and wealth, especially when related to tax policy, are used interchangeably, and, often, incorrectly.

** A large annual income does not make a person wealthy. And wealth does not require a large annual income. **

I think wealth and income are confused because salaries are viewed as an annuity that will continue paying indefinitely. This may have been the case when the economy was ruled by large unionized companies who offered life long employment and a trustworthy pension, but more than ever, income is less often derived from a constant salary. For instance many people now own their own businesses, work on a commission basis, or are equity holders in the firms they work for.

Who is richer: a person who makes $50k each year for 10 years, or a person who makes $20k for 9 years and then makes $320k in 1 year? By current tax standards earning $320k in a single calendar year makes one “wealthy,” and subject to higher taxes then the person who earned a consistent amount. It is better to earn a consistent amount sooner as it is possible to earn interest on the savings.

There is some psychology of risk that causes many of us to prefer constant returns and earnings, over variable returns, even if variable returns offer greater overall wealth. Standard deviation of historical returns, which is a measure of return variability, is one of the bedrocks of modern portfolio theory, so even the pros value stability.

But stability nor income is a measure of wealth. Wealth is a function of savings, assets, and debt. It is possible for someone to earn a high salary, while spending more than they make, or paying a high mortgage on a devaluating property to be far less wealthy than someone earning a lesser amount.

A higher income does provide the opportunity for more savings, but many of us, myself included, often fall prey to increasing spending as our earnings increase. The key to wealth is spending less than one earns, and keeping debt in check.

Updates:

@uuilly provides a link to Thomas Sowell’s article Income confusion.