Why the rich get richer…

Continuing the financial theme from the last post (I promise the next post will be different!), I thought this graph would be a good illustration of why the rich get richer while the poor and middle class just kinda flounder where they are.

After Tax Income in Different Scenarios (Ontario)

The graph shows how after tax income in Ontario varies with gross income. First focus your attention on the blue and green lines. The blue line is the ideal and has a slope of 1 – i.e. you get to keep every dollar that you earn.

The green line is what happens if your gross income just consists of a paycheque from work, plus maybe some interest from GICs, Canada savings bonds, ING savings accounts, etc. In short, the primary sources of gross income for the low to lower-middle class.

This is fine at the low end of the scale because the slope of the green line is pretty close to 1. However, notice that as you move up the scale, the slope of the line decreases, meaning you earn more, but more gets taken away. In the highest tax bracket, the slope is almost 0.5, meaning you lose $0.50 of every additional dollar you earn. Not good. i.e. You’d probably have to work your butt off to go from a salary of $80,000 to $100,000, but your net income only increases from $60,000 to $70,000. Arguably not worth the effort. This is the area where the middle to upper-middle class flounders. They work harder and pull their purse strings tighter, but it doesn’t actually amount to much in absolute terms.

Ideally you want some way to push the line up, which brings our attention to the red line. Capital gains are what happens when you sell an asset (e.g. a stock) for more than you paid for it. Those gains are counted as gross income, but are taxed at a much lower rate. The important thing to notice is that not only has the red line moved up compared to the green one, but its slope is also more positive. You win twice. Plus, the more your gross income comes from capital gains, the closer the line gets to the blue one both in terms of distance and in slope.

So the red line represents half of gross income coming from capital gains, which might be kind of mind boggling. Imagine earning as much buying/selling stocks as you make at your day job. Not as difficult as it sounds if you have a high savings rate. My theory is that the rich tend to have higher savings rates because the cost of living doesn’t increase linearly with net income. A higher savings rate translates into more money available for investment, which makes it easier to obtain large capital gains that rival what you earn from your paycheque.

Like Skeletor and her lover in the last post, if you’re able to increase your savings rate far above the average, that extra money should be going towards attempts at capital gains. That way you move along the red line (or even better). If you instead put the extra money in GICs, ING, money market funds, etc., you’re moving along the green line, which is really much more work than it’s worth.

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