The tax code is signalling how to build wealth
Not all income is built equal and it's important to understand the difference sooner rather than later.
Passive income is an attractive goal. It is especially attractive when it starts replacing your salary.
Many people dream of having passive income because it gives them financial freedom. It is to receive income without having to “work” for it. It also allows you the financial freedom to stop work, pursue a passion, and live comfortably without relying on government support.
To replace your salary, intuitively, you need income producing assets.
There are several major asset classes or avenues that offer income producing assets.
Not all income is built equal
Not all income is built equal. There are different levels of effort, tax treatments, and risks.
I recently read a book on tax - Rebellion, Rascals, and Revenue: Tax Follies and Wisdom through the Ages by Michael Keen and Joel Slemrod. It is better than it sounds. It went through the differentiated tax treatments of income from different sources.
The author’s opinion is that ‘permanent income’ (income from capital such as land, dividends from equities and interest on debt) should be taxed more heavily than ‘precarious’ income (labour earnings and income from trade and professions). The book argued that the greater stability of the former implied a lesser sacrifice.
The author points out that there is no deduction for the depreciation of human capital which encompasses skills, your physical ability to perform labour, knowledge and experience. The example given quotes Chancellor Herbert Asquith, a former Prime Minister of the United Kingdom.
You might derive an income each year from a perfectly safe investment in government bonds, perhaps accumulated as inheritance, and another “making the same nominal sum by personal labour in the pursuit of some arduous and perhaps precarious profession. To be taxed in the same way is, to my mind, flying in the face of justice and common sense.’
Regardless of whether it flies in the face of justice, it reinforces that not all income is built equal. In the pursuit of passive income, the less sacrifice required from you – whether time, expense or labour, or tax, the more passive it becomes and the more ‘permanent’ it becomes. The concessions given to some forms of passive income can be the foundation of building wealth.
As passive as income can be, there is no free lunch. All of these assets require maintaining and monitoring.
The depreciation of labour
When Chancellor Asquith was speaking about precarious income he was referring to a world that was predominantly blue collar. The connection is easy to make how labour depreciates.
With ‘white collar’ services, our capacity and labour depreciate due to reduction in time horizon and the plateau of income earning.
I have spent most of my life building up my human capital. I built my human capital through a strong education and took on debt to achieve this.
After graduating from university, I was wealthy with human capital – I had time. I had negative financial capital, with a net position of around -$40,000.
As time moves on, human capital depreciates. To balance the scales financial capital must correspondingly increase. So how to balance the scales?
You create permanent capital. $1 of permanent capital is worth more than $1 of precarious income. It is not equal.
$1 of permanent capital is worth more because it is supported by favourable tax treatment. There are negative gearing deductions. There are franking credit deductions. When you’re looking to sell your capital, you get a tax discount on any appreciation. There’s effort that is put into initially investing and maintaining your portfolio, but you will earn income while you are working, while you are sleeping, while you are dining.
There is also a reason why it is called permanent capital. It will continue to provide you with income regardless of effort. However, there is depreciation with inflation. If you leave your capital as cash it will be worth less tomorrow.
The importance of investing
It is up to you whether you find it unfair that workers have little to no tax concessions while those who build or inherit permanent capital enjoy tax advantages.
You can guess my stance by the fact that I decided to write this article. Ultimately, it does not matter. We must make the best of the system that we have. Use it to better our quality of life and our progress towards our life goals.
For many people this goal is passive income. Income that replaces the ‘precarious’ income that depreciates over time, and sometimes just ceases due to medical conditions, redundancies or becoming a carer. Whether voluntary or involuntarily the money to survive from labour is finite.
Investing serves twin purposes, the fact that precarious income is finite and that financial capital depreciates from inflation. Capital is just capital, until you take the steps to make it ‘permanent’ by generating income from it.
The importance of time
Many investors think that speculative investments should be made when you are young and there is time to make up for loses. This is where you are putting the most permanent capital on the line.
One of the keys to successful outcomes is time in the market – the duration of time spent with your money invested. After all, to draw a healthy income you have to have a healthy base of capital. One of the best illustrations I have seen that show the power of time combined with compounding is the following:
The green on the second graph shows capital, and the orange shows growth. The scenario goes through the monthly savings needed to accumulate $1 million by 65. I would much rather have a consistent $855 going into the market, building to a strong capital base than smatterings of success stories and failures, with all the transaction costs in between. The earlier you start, the more of the hard work that is taken off your plate.
How do I build permanent capital?
I don’t want this article to be purely academic. It is a perspective that I hope will encourage you to either start, continue or more fervently invest.
Here are a few resources to assist.
This Investing Compass episode goes through how Mark has structures his portfolio for income. His portfolio goal is to earn and grow his passive income from his portfolio to fund goals such as travel.
This article on how to build an income portfolio is a step-by-step guide to building a portfolio that reaps passive income.
Passive income is a goal for many, but especially those in retirement. This article walks through the steps to calculating the amount of capital you need to retire.