A Penny Saved is a Penny Earned– Tax Free

Benjamin Franklin is credited with the saying, “A penny saved is a penny earned.” While this was certainly true in Ben’s day, it is a gross understatement today. Let’s do some calculations. Examples will be based on economic conditions in the United States. The numbers can be adjusted for the country you live in.

Suppose you want to buy some widgets for $100. What will they really cost?

The Cost of Earning Money

First, you have to obtain some money. If you are a normally employed American (even self-employed), earning $100 is not going to be nearly enough. In the labor market, you create value for your customer, and your customer pays you for it. If you are self-employed, you know who your customer is. It is the person who comes to you asking to buy your product or service. If you are an employee, then your customer is typically the person who signs your paycheck. In either case, you cannot be paid the full value that your labor creates.

If you are self-employed, then you must pay a labor tax on yourself. Currently that is in the form of social security and medicare, totalling 15.3% of your income. So if you earn $1.00, you only get to keep $0.847. In order to keep $1.00, you must earn $1.18 by creating $1.18 of value for your customer. (The reciprocal of 0.847 is 1.18).

If you are an employee, the situation is often slightly worse. The tax agent will tell you that as an employee, you only pay half of your social security and medicare tax, and your employer pays the other half. Technically, yes, that is how the law is written. Economically, it makes no difference. Your employer simply lowers your nominal wage to compensate himself for his share of that tax. That isn’t because he is a jerk, it is because he is constrained by the same economic laws which affect all of us, regardless of how the tax code is worded. Supply and demand, and competition, require him to consider his total labor cost, not just the amount that finds its way into your pocket. So in sum, you must still create $1.18 of value in order to keep $1.00 in your hands. But it is slightly worse than that. In my state for instance, employers must pay for unemployment insurance in case the employee loses his job, worker’s compensation insurance in case the employee gets hurt, plus a federal unemployment insurance. With the rates quoted for my business when I had employees, the total payroll tax was 17.84% after accounting for taxes taken before gross and taxes taken after gross (I can share the math if anyone is interested). This meant I could not afford to pay my employees more than 82.16% of the value they created. The reciprocal of 0.8216 is 1.2171. In order to keep $1.00, you need to earn $1.22 by creating $1.22 of value for your customer (your employer). By the way, what if you didn’t earn the money? What if you won the lottery? The gambling tax, by a cursory glance through the literature on the Internet, is 28%. Now you have to win $1.39.

Income Tax

Now, suppose you are in a 10% income tax bracket. That’s 10% of gross. Factoring this in, your take-home pay is 73.26% of the value you created. You must now earn $1.37 in order to keep $1.00. What if you have that coveted job that pays $100,000 per year? Now you’re in a 28% tax bracket. After payroll taxes and income tax, you can only keep 57.25% of the value you create. You must earn $1.75 to keep $1.00. We won’t even consider state income taxes for this exercise.

The Cost of Spending Money

If you live in a state that assesses a sales tax on items purchased, it will cost you more to spend your money after you’ve already paid for earning it. Several states have sales taxes as high as 7%. That means your $1.00 will only buy $0.93 worth of goods or services. To buy $1.00 worth of goods, you need $1.07 of take-home pay. If you live in one of these states, and you are in that 28% income tax bracket, This translates to $1.87 of value created in order to save enough after payroll taxes, income taxes, and sales taxes, to buy $1.00.

The Cost of Borrowing Money

Suppose you have to borrow money to buy your widgets. If you use a credit card, maintain good credit, and make the minimum monthly payment on the card, you will triple or quadruple the price of your purchase in added interest. If you default, you will pay default interest rates up to 35%. Now you can double the price of your purchase in only 3 years. If you pay late fees and overlimit charges, you can double the price of your purchase in much less than a year. If at all possible, don’t even go there. There are very few items that are worth this risk of overcharge. Even the necessities of life should give pause. Find another way.

The Cost of Owning Widgets

Depending on what widgets you buy, you may pay for them many times over. If you buy something which must be licensed or registered yearly, such as an automobile, boat, or airplane, you’ll be paying every year just to own it and use it. If you buy expensive art or jewelry, you may pay a personal property tax on it. If you buy real estate, you may pay a real property tax. These taxes can be up to 5% per year. Over 20 years, and without adjusting for inflation, you’ve paid double for the things you purchased. Over those 20 years, you may pay $374 for your $100 purchase.

Summary

So you want to buy $100 worth of widgets? You will have to create between $146 and $187 worth of value for your customers (or employers), or win $149 in the lottery (or make $173 in capital gains). On and on it goes.

A Penny Saved

If you could save that $100, it would be as good as earning up to $187. You could save it by simply deciding not to buy the widgets in the first place. If you do buy them, you must decide whether you actually value them at $187. You could also save that money by making the widgets for yourself instead of buying them. Calculate your cost of making the widgets and compare it with your cost of earning and spending enough money to purchase them.

Alternatively, you could save money by bartering for the widgets. Bartered goods and services are theoretically taxable in various ways, but valuing those goods and services is tricky at best and very squishy at worst. Plus, if you are bartering within your own household (or tribe), it is not taxable (ask your tax accountant or lawyer about this, and correct me if I am wrong. I may be.) The economics textbooks state that work you do in your household is not taxable. A fourth way to save that $100 is to simply negotiate or find a better price for the widgets. I do not advocate taking real value away from someone who has created it, but you can often find someone else with a lower cost structure who can afford to sell you the same physical object or provide the same technical service at a lower price. Every penny you lower the price will save you up to 1.87 cents of hard work to earn that penny. Be careful though. The person selling the widget at a higher price may actually be providing a greater value than the discount store. Factor in extras such as free delivery, service warranty, satisfaction guarantee, speedy service, or just a friendly face when the discounter meets you with a scowl. You must weigh value against value, and not only price against price. If the prices are the same, go for the highest value. If the value is the same, go for the lowest price. But make sure you are getting the best value for the best price, and not simply choosing between value and price.

One way to avoid paying excessive personal and real property taxes is to only own old, ugly, stinky property. Build your own appliances and vehicles from scratch. They can be just as functional as high-priced commercial items, but they will be hard to value on the market. If you have land, start a junk yard or a smelly chicken farm. This will lower the value of the land, and lower the property taxes as well. If you must own a plane, boat, or automobile, build them by hand, or buy ones that are 25 years old, and dent them up a bit. Think outside the box.

This is a very empowering principle if you live in a place where there are high taxes on commercial activity. The preceding examples were based on United States economic conditions. Whatever country you live in, if you have the option to earn less and spend less, it is an option worth considering.

Should You Contribute?

The concept of avoiding spending is only one tool in the economist’s toolbox. There are many others. I believe the world will be greatly enriched if every one of us throws as much value out there as we can. We should all contribute because we want to make the world a better place for ourselves and our children, not because we want to buy more widgets. If you can create this value in ways that are not directly taxable, then bully for you. Give away your products and services. Barter them directly for someone else’s products and services. Or provide them only for your own household. In a tribal model, barter directly with another tribe, with items which have no commercial market value or are difficult to value. Report what you must report, but if the value is uncertain the reporting will necessarily be fuzzy. Make this clear in the report. Ask a lawyer.

If you want to go for the gusto and earn lots of taxable income, the principle of a penny saved can still help you. Whenever you think about spending $1.00 on anything, ask yourself if that thing is actually worth $1.87 to you. If it isn’t, don’t buy it. Save your money to buy something that you value at $1.87 or more. Or ask your tax accountant how he can save you money by setting up legal trust funds, etc. If your accountant can save you $1.00 by re-structuring your tax return, that is worth $1.87 also. I don’t recommend the crime of tax evasion. But corporations and wealthy people find ways to reduce their taxes while staying within the limits of the code. Their accountants save them great sums of money, and the accountants are in turn paid well for the value they create. If you can legally re-structure your taxes so that you are not having to earn $1.87 to buy that $1.00 widget, then do so. These wealthy people are not considered enemies of the state just because they work the tax law. They are considered frugal and prudent. You can be too.

I will spend some time over the next few days thinking about the antithesis of this article. If I can think of any great counter-arguments, I will post them. In the meantime, I welcome your comments on this, what may be a controversial topic. Until next time.