Understanding the one percent in wealth semantics

Author: Andrew Allentuck, The Financial Post

The rich are getting richer. That, at least, is the usual sentiment behind most stories about income inequality and tax breaks. But what does it actually mean?

Often, when we talk about the “one per cent” we are talking about individuals with high incomes. But describing those people as “rich” may not be accurate.

The issue with the data is that it confuses wealth and income, says Allan Madan, a chartered accountant in Toronto.

“It is a misunderstanding of net assets versus disposable income…. They are totally different concepts,” he says. “One can have a large decline in net assets because of poor stock performance and yet have high disposable income.”

It may seem like a small issue of semantics, but misusing these terms can affect government policy, especially those policies driven by public pressure. After all, taxing the rich first means solving the problem of defining and measuring what “rich” is. It may be simplest to define it as “high income,” as the Liberals did when they introduced a higher tax bracket on earnings above $200,000.

But “rich” is contextual, and depends on age and location as well as income. Take, for example, a young family with both parents in their early 30s working after completing professional degrees — say an engineering bachelor’s degree and an MBA. The couple could have a $250,000 combined income along with hefty student debt. This couple’s income would put them in the upper echelons of all families, but they could have two $50,000 student loans to pay. If they buy a $1 million semi-detached house with a $750,000 mortgage, their net worth could be just the $1 million, less loans of $850,000, net $150,000. When they retire and their incomes drop to, say, $50,000 each, they would have the $1 million house, probably appreciated, and a lifetime of savings, say $3 million in financial assets. They would be millionaires a few times over in wealth but just average in income. Point is — during their high-income years, their situation is tough, because there is not much cushion for large unexpected expenses. Later in their lives their situation is almost bulletproof, in spite of their much lower income.

Underlying the confusion of wealth and income is the fact that, as Madan says, “Governments cannot assess wealth. Tax information, filed or published, cannot show wealth. Those numbers are in the dark.”

Wealth may be real estate, stocks and bonds, art on the wall or — the toughest and perhaps the largest asset class of all — human capital. That makes it very difficult for statisticians to calculate and measure.

There are, to be sure, samplings of some wealth available, such as the Canada Revenue Agency requirement that tax filers report foreign assets on form T1135 and, as a historical base, individual reports of asset values on Jan. 1, 1971, prior to Canada’s implementation of the capital gains tax a year later. Some wealth can be inferred from local real estate assessment records, but none of that data connects wealth with income.

It’s not the fault of the number crunchers at Statistics Canada. Christine van Rompaey, director of the National Economic Accounts Division of Statistics Canada in Ottawa, explained in a letter that, “a common error in describing the economic well-being of households is to equate having a ‘high income’ with being ‘wealthy.’ The problem is that the terms are not really linked.”

“Many households have low income but high wealth — a retired homeowner who owns his or her dwelling outright and lives on proceeds of a pension — while others may have high income but low wealth,” Rompaey says, describing a young Bay Street stockbrokers who has, in this case, a high income but carries large student debt as an example of the latter.

The question of nomenclature would be statistical nit picking were it not for the tax strategies governments adopt.

“Governments make tax policy on the basis of incomes and that notion is carried through to other sectors,” says Brian de Pratto, an economist with the Toronto-Dominion Bank

The misnomers come down to a tug of war between purists at Statistics Canada and those who insist the public sector cope with income inequality. For example, the Canadian Centre for Policy Alternatives, a think-tank in Ottawa, warned on Nov. 19, 2013, “almost a quarter of Toronto-Centre households enjoy the lifestyle of the rich, registering before-tax incomes of more than $100,000.”

For policymakers, the bridge from income to wealth or, for that matter, from wealth to income is shaky.

One can have a good deal of wealth — millions or even billions — and yet have modest income or even no “income” because of write-offs of capital losses, donations to good causes or investment policies, such as putting all of your money into companies or stocks which issue no dividends.

Today, with government bonds paying next to nothing for interest, one may have vast wealth in bonds but little income to show for it. For example, a Government of Canada bond due Nov. 1, 2018 pays 0.65 per cent on an annualized basis to maturity. A couple with, say, $10 million invested in that issue would have $65,000 a year in bond income. If that were the entirety of his or her income base, he’d be wealthy on paper and still be in the bottom half of the income distribution — the median income of Canadian households was $78,870 in 2014, according to Statistics Canada.

There is also the matter of assessment. Valuable art may not be assessed until the death of the owner and that, in the process of probate, is uneven.

“Probate has lagged over the years of asset ownership and not always done,” Madan explains. “Not all assets are subject to probate. In the end, probate records do not show wealth very well.”

Finally, there is the problem of what is in peoples’ heads. The ability of Berkshire Hathaway founder Warren Buffet or Microsoft Corp.’s Bill Gates to create empires and a good deal of wealth for themselves and others comes from their own intellect or, if one wishes, luck — or some combination of the two.

The bridging of the balance sheet concept of wealth, or net worth, with the income statement idea of cash flow is tax policy with egalitarian goals built on the idea that governments can measure wealth. The evidence is that they do not do it well.

This would be just so much dithering about the meaning of words and numbers were it not for the policy implications of bending income statements into balance sheets. As the eminent French economist Thomas Piketty wrote in his 2013 bestseller, Capital in the Twenty-First Century, “From then (the 1980s) on, the return on capital has mounted … and the gap between the rich and poor has widened to the point where we are teetering on the brink of a society with such entrenched hereditary inequality that it can make no claim to ‘meritocratic’ virtue.”

France has used a the Impôt de solidarité sur la fortune (Solidarity Tax on Wealth) since 1981, and data show the tax has been paid by the non-target group of middle-income households, which lack the ability to move their capital. But that was never the intention of the plan of the government that created it in 1981, when tax planners saw it as a social leveller and a way to get some tax revenue. The concept: pay for ownership of wealth with a dip into income.

The target citizens fled to countries that would not tax their wealth, and those who stayed to be taxed included farmers who could not pack up their farms. They’ve sold off land and gone from prosperous to poor, noted British newspaper The Telegraph in a 2014 story. The result has been a shift of assets readily taxable and immobile, such as land, to those, like antiques, which are portable and tough to tax.

As journalist Andrew Gilligan wrote, “the (tax) is economically counterproductive. It makes victims of the poor, and hypocrites of the rich.”

Worse, some would say, it means that income already taxed and saved gets taxed as property. In the end, said critics, one cannot build good policy on bad economics or, for that matter, on confusing income with wealth.

ABOUT THE AUTHOR

ALLAN MADAN

CPA, CA

Allan Madan is a CPA, CA and the founder of Madan Chartered Accountant Professional Corporation. Allan provides valuable tax planning, accounting and income tax preparation services in the Greater Toronto Area.

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