Why Can’t Average People Invest Like the Rich or How to Solve the Income Gap

We hear a lot these days about income inequality. There is even a website call inequality.org. I have written previously about income inequality in my article “The Real Story on the Income Gap” (Manahan, 2021). If you haven’t read that article, you should. The purpose of this article is not to explain the reasons for the income gap (my previous article did that) but to explain why the income gap is important.

The income gap is important because people who earn more money can do something that people who earn less money cannot do – invest. The higher the U.S. income group, the larger the share of that income is derived from investment profits (Inequality.org, 2021). Simply put, people who earn more money can allocate part of what they earn to investments. Those investments grow and as they grow, they throw off more investment income.

Some politicians have advanced solutions to the income gap problem. Bernie Sanders, Barbara Lee and Rhashida Tlaib have proposed charging corporations an extra tax if the top earners in the corporation (CEOs) earn more than fifty times the bottom earnings. Of course, this tax only affects executives of very large corporations, but ignores the reality that many of the top earners in our society are entertainers and sports figures. Further it is somehow unclear how the government taking in more tax dollars from corporations is going to help those people at the bottom end of the earnings spectrum.

The real problem, as I have noted above, is that lower income people are not able to invest. Yet one of the best ways of increasing one’s income, is to invest. But why is it that people of lower income cannot invest? The answer would seem obvious – they don’t make enough money to be able to pay for the necessities of life and still have money left over to invest. But as is often the case, the obvious answer is not always the correct answer. Let’s look a little closer.

According to U.S Census, the median household income in 2018 was approximately $63,000. That means half of the households made more than that, and half made less. So, we could say this is an average American household. We then must ask the question, “Why is it that a household earning $63,000 does not have enough money to make investments?”

It really is not that difficult to figure out. I am using Bob, a single non-homeowner as my example. In my example I am going to assume Bob lives in California. I am also going to assume Bob earns $1,212 per week (roughly $63,000). The actual economic cost to Bob’s employer is approximately $68,000 (the employer must pay payroll taxes of about $5,000 which could otherwise be paid to Bob). If we run the pay rate through a simple payroll calculator you will see that Bob receives $45,709.04 out of the $68,000 that he costs his employer. In effect, the government takes $22,290 of the $68,000, or about 32.8% of Bob’s compensation.

Okay, so what does Bob do with the rest of his money? Well, Bob pays several other taxes. First, he pays $2,462 in hidden taxes (Riley, Schlecht, & Berthoud, 2001). Next, he pays $997 in sales tax (Lougheed, 2018). Then he pays $908 in Federal corporate income tax and another $300 in State corporation income tax (all corporate tax is passed on to consumers in the form of higher prices for goods and services). That now brings the total tax burden on Bob to $26,958 which is approximately 40% of what Bob earns. And remember, Bob is an “average” American earning $63.000 a year. So, in this land of freedom and liberty, the government is taking 40% of the average earnings of Americans.

Out of Bob’s earnings of $68,000, Bob is now left with $41,000 to pay all his personal expenses. Bob is a frugal kind of guy. He lives in an average one-bedroom apartment in Los Angeles ($1,600 per month), his utilities are $180 per month, his phone bill is $150 per month, and his car payment is $392 per month (the average car payment for a used car in the U.S.). Bob’s modest food budget is about $60 a week. He pays $1,500 a year for insurance, and his car requires one tank of gas per week (about $60). If we deduct all of that, Bob is left with a little over $5,500 per year, or a $107 per week, to pay for everything else, including clothes, car repairs, entertainment, medical co-pays and deductibles, household needs and so on. No wonder Bob does not have anything left over to save and invest.

So why is it that Bob doesn’t have anything to invest? Now the answer is very obvious. It is because the government is taking 40% of everything that Bob earns. While somewhat dated, the book Costly Returns (Payne, 1992) estimates that American taxpayers pay an additional $0.65 for each $1 paid in taxes for additional economic burdens created by government and its rules and regulations (and that is probably more today given the massive increase in government rules and regulations). If you add that to the $26,958 tax burden on Bob, the real tax and regulatory burden on Bob’s earnings are $44,480, or over 65% of what Bob earns.

Yes. The income gap is a problem. But the problem is not that some people get paid too much, the problem is that for average folks (most of us) so much of our earnings are taken away from us by government, that we simply don’t have enough left over to invest. When the average person in the US is paying 65% of their income in taxes and costs related to the tax and regulatory system, there is just no way for the average person to get ahead.

Want to solve the wage gap? Want to increase the real earnings of the average person so the average person can save and invest like the highly compensated people do? It not that complicated. Significantly shrink the tax burden and significantly shrink the size of government at all levels, and you will suddenly find the average person saving and investing just like the rich folks.

Works Cited
Inequality.org. (2021). https://inequality.org/. Retrieved from https://inequality.org/

Lougheed, K. (2018, September 18). How Much Does Your State Collect in Sales Tax Per Capita? Retrieved from Tax Foundation: https://taxfoundation.org/state-collect-sales-taxes-per-capita/

Manahan, M. (2021, September 13). The Real Story of the Income Gap. Retrieved from https://professormanahan.com/2021/09/13/the-real-story-on-the-income-gap/

Payne, J. (1992). Costly Returns. ICS Press.

Riley, B., Schlecht, E., & Berthoud, J. (2001, July 27). Hidden Taxes: How Much Do You Really Pay? Retrieved from Institute for Policy Innovation: https://www.ipi.org/ipi_issues/detail/hidden-taxes-how-much-do-you-really-pay