The Difference between Income and Wealth

Years ago, while comparing various economic systems, I learned that one indication of the economic values in a culture is the reaction of a person seeing someone else driving a Mercedes sedan. An American wonders how he can afford one someday. The Soviet wonders how he can take it away. The Englishman wonders how to tax it. Today, as I listen to the pundits ruminate about the 1% of the U.S. population controlling most of the wealth in the U.S., it strikes me that we need to clarify what kind of culture we want to create.

I asked Fareed Zakaria, host of CNN's international affair program, why he and his guests frequently confuse individuals earning income and societies distributing wealth. He acknowledged that a distinction should be made. So, I am offering a simple distinction. Earning income occurs when someone works, provides a service or product and is paid by an employer, customer or borrower. Distributing wealth occurs when the government takes someone's earned income either through taxes or usage fees and gives it to another person. Using the terms "income" and "wealth" interchangeably obfuscates the logic for assessing how the economy really works.

Definitions

A sociology professor offers broader definitions:

Generally speaking, wealth is the value of everything a person or family owns, minus any debts. However, for purposes of studying the wealth distribution, economists define wealth in terms of marketable assets, such as real estate, stocks and bonds, leaving aside consumer durables like cars and household items. Income is what people earn from work, but also from dividends, interest, and any rents or royalties that are paid to them on properties they own. In theory, those who own a great deal of wealth may or may not have high incomes, depending on the returns they receive from their wealth, but in reality those at the very top of the wealth distribution usually have the most income.

While the debate about income and wealth can be confused, intentionally or unintentionally, governments are the only entities that can impose taxes. Obviously, taxes have a long history in human society; the forms of taxation might change, but formal governments have a constant need to tax. Modern society needs some funds for basic public services. However, the idea of wealth redistribution is less about raising adequate funds to perform government services and more about pursuing some subjective conception of social justice.

Countries that have tried to impose economic egalitarianism have generally not prospered; a sinking pond lowers all boats. Today the United States primarily taxes income. Conversely, Italy has imposed a wealth tax for years and in September tried to increase the rates. With the new focus on the wealth tax, the Financial Times (FT) reported Italians' anger "directed at the country's top-earning footballers, who were exempted from the wealth tax."

Some of you may think it is a good idea to tax wealth, but to make exemptions for some people. I do not. In fact, we can learn from the case of Italy. Economist Nouriel Roubini, addressing the high debt in Italy that must be funded, recently observed in the FT:

"Influential figures in Italy have suggested a wealth tax could achieve the same reduction in public debt. But a debt restructuring is superior. To reduce the debt ratio to 90% of GDP, a wealth tax would need to raise €450 billion, or 30% of GDP. Even if payment of such a capital levy were spread over a decade, that would imply an increase in taxes equivalent to 3% of GDP for 10 years running; the resulting drop in disposable income and consumption would make Italy's recession a depression.

Restructuring the Debt or the Culture

When you read that a country or a company is restructuring debt, recognize that the losers will be the people or entities that lent or invested capital in the situation. After a restructure, investors wisely are hesitant to lose more capital and to invest in the same entity. Even the recent bankruptcy of American Airlines reveals that the shareholders lost their wealth over one year when each share valued at $8.90 dropped to $0.40 in November. Bankruptcy laws allow for contracts to be re-written and debts to be forgiven.

The important point is that trust, risk tolerance and the culture of investing changes when someone dictates reduced economic terms and attaches your wealth. America's Poet Laureate Philip Levine, when asked about his hostility for the upper class and how he fantasized about firing a gun at every Cadillac he saw, recently told the New York Times Magazine, "If we started making radical changes in the way wealth is distributed in this country, it would be a hell of a lot better."

I am not sure which country's economic system Levine would prefer. If he supports a Robin Hood paradigm, that's still thievery. If he wants to live off others' wealth, that will kill the Golden Goose for this generation and future ones as well.

Blythe McGarvie is the founder and CEO of LIF Group, a firm offering a global perspective for clients seeking profitable growth and providing customized seminars for corporate and academic groups. A former CFO of BIC Group, McGarvie serves on several boards, including Accenture, Pepsi Bottling Group, The Travelers Companies and Viacom. Her latest book, Shaking the Globe: Courageous Decision-Making in a Changing World (published by John Wiley & Sons), is available HERE.