Do You Hate Paying High Taxes? Me Too.  Here’s the REAL Problem…

Do You Hate Paying High Taxes? Me Too. Here’s the REAL Problem…

6 min read
Ben Leybovich Read More

My friend and colleague Mark Ferguson published an article a few weeks back in which he made the argument that high taxes are a good thing.  In his view, since paying more taxes is indicative of having earned more money and higher productivity, high tax bill should be viewed as a sort of a metric of success…

While I am not about to argue that money and earning high income is bad, I do happen to see things differently from Mark relative to taxation.

Related: I Like Paying My Taxes (You Might, Too, After Reading This!)

PROBLEM WITH PAYING HIGH TAXES

Let me preface this discussion by stating that while I am very fiscally conservative, I am not one of those conservatives who feel that government and taxes are inherently evil; some days I do, but not by and large 🙂  I do think that everyone should re-pay the society for the incredible opportunities which it offers us, and if taxes are a price to pay than so be it.  Furthermore, I have the view that as an entrepreneur I will always find ways to make more money if I need to.  Taxes are not likely to impact my ultimate success in a negative fashion.

Having said this, though, I am capitalist through and through.  I use other people’s money, time, and talents to advance my goals, and in this vein I do not believe in paying any more taxes than I absolutely have to and legally am obligated to.  I am, indeed, of the opinion that I can deploy capital much more efficiently than Uncle Sam…

With this in mind, I think that paying 40%-50%, and in some cases higher, effective tax rate is unproductive, unnecessary, and kinda stupid – yet many high income earners do just that.  Interestingly, the law certainly does not require anyone to pay this much – it’s a choice people make.  If you pay that much tax, it is indicative of something, but I am getting ahead of myself…

LOOK AROUND

I know many people who believe the way Mark believes – having to pay more taxes is the price of being more productive; it’s a function of having earned more money and is indicative of success.  But, how can this perspective be reconciled against the reality out in the economy?  Just take a look at the wealthiest members of our society – Mitt Romney, Donald Trump, Koch Brothers, and Warren Buffett have been in the news the past couple of years.  All make more money annually than a human being will ever know what to do with, and yet all pay a very low effective tax rate; likely in the neighborhood of not more than 15%.

Knowing this, how can it be reasonably argued that a high tax bill is necessary, desirable, or smart? Can it really be indicative of financial success?  In fact, a reasonable observer would have to extrapolate that these people’s prodigious financial success is specifically a function of having low exposure to tax for a prolonged period of time…

THE CRUX OF THE MATTER

The truth – earning high income is not at all the reason why someone pays high taxes.  Indeed, the reason people pay high taxes is not simply because their income is high, but because it’s the wrong kind of income generated in the wrong way.  Thus, I am not at all against high income – only against wrong high income…

3 Types of Income

The internal revenue service groups all income into 3 categories:

  1. Earned Income
  2. Passive Income
  3. Portfolio Income

1. Earned Income – W2 and 1099 income.  This type of income should be thought of as trading hours for dollars.  It can also be thought of as “personal service,” meaning that if you are not there to render service and put-in time, then there is no income.

Because of this, earned income presents challenges relative to financial security and stability, which is likely why you are here studying about real estate in the first place – you want to say good buy to your boss as much as the next guy and you figured out that real estate can be a good way to do just that.

But, aside from financial security and stability, which are inherently and by definition impossible in the world of earned income, earned income also presents big challenges relative to wealth accumulation in that of the three types of income it is by far the most highly taxed.  Not only is the 2014 tax bracket for highest income earners relative to Earned Income category sitting at 39.6%, which in and of itself renders earned income highly inefficient, but it is also subject to the Social Security and Medicare Taxes (also known as FICA taxes).

Indeed, it is not uncommon that someone earning $500,000 annually will have 50% effective tax exposure – or more!  This means that for 6 months out of the year this person/family works for nothing more than just to pay the tax bill!!!  Talk about inefficient…

2. Passive Income – Income resulting from passive cash flow from real estate and business ownership.

3. Portfolio Income – Income which results from paper investments.

Both Passive and Portfolio types of income are created through investment activities of one sort or the other, and both come with much lower tax basis, plentiful shelters, and no FICA exposure.

Related: The Truth About Active Income vs. Passive Income

PERSPECTIVE

Relative to money, how much you earn is much more 2consequential than how much you keep, and how much you keep is very much a function of controlling your tax exposure since tax is by far your biggest expense.  If, for example, you’ve established that in order to maintain your desired quality of life you need to Net Cash Flow $200,000/year, then presuming a 50% effective tax rate you would need to earn $400,000.  However, presuming a 10% effective tax rate you would only need to create $220,000.  See what I mean – how much you keep, not how much you earn…

And here’s the thing – pay attention to this:  Most people erroneously believe that a graduated taxation system means that the more you make, the more tax you pay.  But, this is only partially true and only as it relates to earned income.  Indeed, the level at which you are taxed is much more a function of HOW you earn rather than how much.  Thus, the very potent question to ask yourself is:

Question: The activities that I am involved in every day which earn me $300,000 – are they the type of activities that will ever bring me closer to converting the face value of my earnings from earned to passive and portfolio?  If I stopped working today – what adjustments to my life-style would I have to make…?

SO – WHAT EXACTLY IS THE PROBLEM THAT BEN HAS?

Well – my wife would likely tell you that I have many problems, and I never argue with Patrisha.  But, relative to high taxes, follow my logic:

  1. If your tax exposure is high, this is indicative of earning high earned income
  2. The reason you have to earn a high earned income is because 1) you enjoy a fly life-style, and 2) you are penalized so much via taxes.  This is a circular function of earning more and paying more taxes and spending more after-tax, which leads to lower and lower efficiency in your earning capacity.  Furthermore,
  3. In order for you to earn so much, you have to spend a lot of time at work…
  4. Ben doesn’t like to spend a lot of time at work, and more importantly…
  5. Because of the MS diagnosis, Ben does not have the luxury of relying on being able to continue to spend a lot of time working in perpetuity. Ben cannot get used to relying on paying for his life and retirement via earned income!
  6. Therefore, Ben chooses to focus on creating money, not earning money – that’s the difference of passive vs. earned…
  7. Because of this, Ben’s effective tax rate is quite low…
  8. Since Ben’s tax exposure is low, he therefore doesn’t have to earn nearly as much money as most to substantiate a life-style that a lot of people with much higher incomes lead…
  9. But, it is indeed hard to create substantive amounts of income which the IRS would classify as passive – it takes time and lots of knowledge…
  10. Therefore, Ben’s family leads a rather frugal life-style.  Ben could have a couple of beamers in the garage – Ben and his wife Patrisha choose not to!

TO WRAP IT UP

Financial Independence, in my opinion, is measured in units of free time more so than units of currency.  Financial independence is a function of creating income without needing to show up; it is a function of how little you have to work to sustain your life-style, not how much you made while being a slave to the system.

It makes sense to me, therefore, that if financial independence is what I want and need, focusing on passive income generation is vastly more important than earning high income of the wrong kind.  And the tax code, which was written by capitalists for capitalists, agrees with me and this is why I pay very little tax compared to most…

Does Ben’s thinking make sense to you? 🙂

My friend and colleague Mark Ferguson published an article a few weeks back in which he made the argument that high taxes are a good thing.  In his view, since […]