The core of this text is a thought experiment, not science – and it’s perfectly OK if you disagree with it. I found this thought experiment to be an interesting take on an eternally debated topic.
Inequality
First, a few basics: the income scissors are probably melting, but what is certain is that the distribution of society’s wealth follows the so-called Pareto distribution (“20% of people own 80% of the wealth” – the specific numbers are probably different). Few people understand that this distribution is not describable as a normal “bell curve” distribution (such as the height of people). Moreover, it is fractal, which in practice means that if you envy people’s wealth when you are poor, you will also envy them when you are rich (if you were to become part of the 20% of people who own 80% of the wealth in the country, you would likely be part of the 80% who own only 20% of the wealth of that cohort, and you can envy the 20% of your cohort just as much as before).
Who creates technological progress
I don’t think inequality is bad. One reason is that wealth is created from above, not from below. Poor people usually use everything they have to survive. A rich person can afford to buy a new cell phone, a new treatment, or something similar. What is a luxury now will eventually be a commodity. I don’t know what John Adams in the 18th century would have paid for a good contemporary dentist, but I don’t think even George III had the kind of dental care that is common in most of the world today. The bottom line is that I’m not talking about who made the iPhone or the dental tools. The iPhone didn’t originate in a Chinese factory in Shenzhen where it was made (or “completed”), but it originated in the minds of people who gambled that the upper middle class would buy it. And this drives innovation that indirectly benefits even those people who did not contribute to its production.
How rich people don’t pay taxes if they don’t want to
But let’s get back to taxes. Let’s start with some basic information on why rich people often don’t pay taxes. Two basic things are the impact on policy and the opportunities for tax optimization. Influence over politics (or the judicial system) means that politicians in a democracy need votes to get elected. These are relatively easy to buy with money. I’m not just talking about billboards, but also the use of modern technology to target political propaganda. A politician is a person who converts the right words said to the right people into votes in elections. At least a successful politician. Which is one of the reasons why I absolutely don’t care what a politician says in a political campaign, his only goal is to get votes, he doesn’t present you with his vision of the future. Because invariably the poor man will go into coalition. Even Obama, who was commander-in-chief of the US armed forces for eight years, despite his speeches, could not stop the war in Iraq, and the number of bombs dropped during his administration has reached a new record.
Of course, the people who finance political campaigns demand something in return, and of course some backdoor, whether in the law or in the judicial system, which allows them to avoid paying taxes, is easy to deal with. These backdoors are not available to everyone and often have high fixed costs.
Premature optimization
A friend and I were having brunch in Singapore. He also invited two of his friends who had a super tricky task – they needed to get to Russia in a few days for an important meeting with an investor, but didn’t have the necessary stamp (in this case, the stamp had the pretentious title of “visa”). According to all the official claims, the time to get this magic stamp is thirty days and it cannot be expedited. If this were the market, it would not allow such inefficiency. But in fact it is subject to the market. Visas are issued by embassies, and even the Russian ambassador is just an ordinary corruptible civil servant. There are several such ambassadors in neighbouring countries with the right stamp, and a courier who can deliver passports and cash in an envelope. As we were having breakfast, our acquaintances were doing a competition to see which ambassador could put the right stamp on a passport for how much money and how many hours. The impossible turned into the possible.
Meanwhile, my friend and I have been discussing the topic of tax optimizations. I asked him about whether Singapore is really a tax haven, how much tax he pays and then we got philosophical about how we think the tax optimization system works (neither of us had enough experience). In the meantime, our fellow brunchers found a stamp supplier, arranged for a courier to deliver their passport in a couple of hours and bring it straight back to them, and booked their flights to Moscow. Since they were experienced businessmen, we asked them about tax optimization. The instructions were simple. Step one: make a lot of money. Step two: Buy a “I don’t want to pay taxes” service on the market from one of the many consulting firms that provide this service. Then they started kind of laughing that first, the start-up entrepreneurs come up with a sophisticated tax-optimization scheme that costs thousands of dollars, and then nobody buys their product. First, you need to focus on the product you’re selling. And then if you feel like you would be paying too much tax, someone can solve it.
I haven’t gotten around to making “too much money” in my life since then, but this story brought me closer to the just-in-time optimization approach in both of its levels. How does it relate to size? A lot of companies address “how do I grow” before they even have a product or service that anyone wants to buy. They try to solve the “how do I make a million pots” question before it is able to sell one pot. Figuratively speaking – it sets up a call center before it has a paying customer.
Tax optimisation
This brings us to tax optimisation. A janitor or a primary school teacher who works for the state has minimal opportunities to optimise. A taxi driver has much easier opportunities to not report income, but once he has recorded it on the meter, he has a hard time generating enough expenses (and paradoxically, services like Uber reduce the opportunity to hide income significantly – when an uber driver receives money to their bank account from Uber, he can’t pretend he didn’t get it – unlike the twenty in his pocket). An entrepreneur who has several dozen companies in different countries has much higher possibilities. He can generate income in countries where it is not taxed, use various trusts, and so on.
These schemes have some fixed costs (e.g. for setting up offshore companies), but the wealthy entrepreneur in particular has various legal fictions through which he can deduct costs. Why can’t ordinary people deduct costs? Because they are employed. Here I would like to point out that there are countries where a person does not have to be employed, but can just invoice their work. In that case he can deduct the tax deductible expenses from his tax base.
Most people don’t understand tax optimisation at all. Mainstream newspapers often say that a Slovak company is owned by a “shell company from Cyprus” – and therefore does not pay taxes. But a Slovak company (with exceptions) pays income tax in the country where it generates income, i.e. in Slovakia – and pays this taxed income to the owner in Cyprus. The aim of these schemes is probably more to hide the real owner (the moment the state bans doing it this way – which would severely restrict international business – there will be a very lucrative institution of nominee owners). Another use might be to limit taxes on the sale of a business, but that’s a fringe scenario.
I think those two reasons alone make it clear that if a rich person doesn’t want to pay taxes, they won’t pay them. But this hasn’t been the promised thought experiment yet, these are just the usual and obvious reasons.
A thought experiment
Let’s talk about why even rich people who want to pay taxes and don’t optimize or pay off politicians usually pay relatively little in taxes. The reason is the structure of prices and money production.
Most people think that a business pays something like income taxes (and taxes on dividends, etc.). But for an entrepreneur, the taxes paid are a mere expense, it’s the same expense as materials, rent, etc. So any increase in taxes will be reflected in the price in the long run. I think part of the reason for this is that margins are fairly stable across industries; “what’s the margin in your industry?” is a very common debate among entrepreneurs who do business in different areas. When I first spoke to competitors, I found that the operating margin in our industry was very similar, without agreeing on it in advance. We converged to it.
I think one of the reasons for that is that, accounting-wise, there is risk included in the profit, which is quite different in different industries. Risk is also an expense, but it is not tax deductible, so a large part of the margin provides coverage for different kinds of risks (demand reduction, input price fluctuations, legal risks, changing environment…). For this reason, I think the return on capital (after tax) that entrepreneurs target is much more stable than the profit itself. If this is true, then income tax is a mere cost that translates into the final price of products and services. The businesses do not pay taxes, they just collect them.
Thus, I think that the income tax is not paid by the company that generated the income, but by the end customer. But this assumption is not necessary for this to be true, it is enough to realise that the company earns money by selling its products and services, so every dollar it earns comes from the end consumer. In order to pay income tax, the company has to earn it from the consumer, and if it does not make a profit, it pays nothing. So, ultimately, the money to pay the taxes comes from the consumer’s wallet – not from the ‘wealthy entrepreneur’. He does “declare” the taxes and remit them to the state, but it is the consumer who has paid them. (On the other hand, income tax is on average about 1-2% of a company’s sales, so abolishing income tax probably wouldn’t reduce prices much, but on the other hand it would bring competition, since it’s a substantial part of the return on capital – but that doesn’t apply to other taxes, which the consumer pays, VAT in Europe is around a fifth of the price of the end product, excise taxes on gasoline are also a substantial component of the price, which are also reflected in the prices of products bought by people who “walk everywhere” – someone has to bring those tomatoes to the marketplace).
The fact that taxes are paid by “rich companies” is an illusion in my opinion, they are paid by those of us who use the services of these companies. What is interesting from this point of view is that a company that optimises taxes well can then give us better prices (and make even more money, because they have lower prices, but they have more customers because of them, so tax optimisation is a competitive advantage). People usually perceive firms that tax-optimize as immoral, but the interesting insight is precisely that they actually “inadvertently” provide us with a better service (unless they have some other, e.g. monopoly advantage, secured by a state license, a state-guaranteed patent, etc.).
Let that sink in for a moment – even if you don’t fully believe it, just for the sake of a thought experiment, try assuming that all taxes are paid by end consumers.
Consumption structure
To understand why poor people pay the most taxes on their production, it is important to understand what poor, middle class (whatever that may be) and rich people do with their wealth. A poor person consumes everything they earn – on something called a ‘shopping basket’, which is different for everyone (which is why the official government measurement of inflation by the rise in the consumer price index is nonsense). They spend it on food they don’t grow themselves, on rent, utilities, health care, and children’s education. The poor live hand-to-mouth and don’t save for the future, i.e. they consume everything. And, as we assume in this thought experiment, all value added taxes, consumption taxes and income taxes are paid by consumers. This means that they convert almost 100% of their production into consumption and they tax that.
The opposite extreme is the rich person. Suppose he is significantly richer than a poor person (say, by a factor of a thousand). Wealth in society has a Pareto distribution, but stomach volume is still a gaussian (and I don’t suppose it has a very strong correlation with wealth). By that I mean that after a rich person buys three mansions, six cars, two yachts, and one private jet, he won’t consume that much – a large part of his wealth will be investments, which will largely be shares in companies (whose income taxes are paid by their customers), gold (which doesn’t generate anything taxable until they sell it again), and other commodities, maybe some bonds, bitcoins, and the like. A rich person is not physically able to consume directly proportionally more than a poor person. Yes, his house may be much more expensive, but his day-to-day consumption is much lower relative to his total assets. The rich man saves and invests more as percentage of their wealth / income.
Price structure
Another very significant effect is the production of money, which is also a tax that most people do not see. And it is highly unpredictable. At the moment, this effect can be felt, for example, in the IT sector in Slovakia. Thanks to EU funding programmes, a billion euros have flowed into the IT sector. But it hasn’t created as many new programmers (although bad tongues will claim that suddenly first year university students have become senior programmers, it has still at worst tripled the number of programmers). This means that the supply of programmers has been relatively stable, but the demand has increased. This is newly printed money that has flowed into the economy. It was not money that was created by production.
So the programmer has been earning more lately, not because he produces more, but because the government has decided to pour fresh “newly printed” money into this sector and not, for example, into growing tomatoes (agricultural subsidies are another story).
The effect is that programmers can afford a new iPhone, better tomatoes, and better housing. So, indirectly, they also raise house prices (although these are rising thanks to newly printed bad money flowing into real estate and the construction sector via mortgages). This effect of rising prices (and the implications for business) is described very well by Richard Maybury in his book Clipper Ship Strategy.
But the bottom line is that most people think that the new money is coming into the economy at a steady rate. That is very easy to disprove. The M1 money supply in November 2016 was 7156510 million. At the end of 2015 a little over 6000000 million. The euro is used by about 337 million Europeans. I assume you didn’t notice that between 2015 and 2016 you got (7156510-6000000)/337 = €3431 from the government (if I took the M3 stock as a proxy, it would be roughly €1514). If some government official or central bank employee knocked on your door and handed you this money, please give me their contact details as they must have forgotten about me.
But this money went somewhere. Compare that to how much you or any “rich person” pays in taxes and it is clear that the effect is far from even. Someone benefits from it, and someone else loses. One billion of such money has distorted the Slovak IT sector beyond recognition, thanks to this there are activities that fight corruption. The “problem” is that they want to help by trying to direct this flow of money somewhere else (fairer, better, “value for money”, etc.). It’s just that at the heart of the whole distortion is the flow of that money itself. Which is not to say that it’s not good to fight corruption, just that if that money is also used in a “manner consistent with all morals” way, it would still be distributed unequally. Certainly one family of four will not get €6000 a year (M3 increment) or €13600 (M1 increment) every year.
Entrepreneurs (at least those who are successful) are very good at being able to identify this flow of money. The most common use of this money flow is to sell to those who get the money first and buy from those who get it last, i.e. sell at higher prices to people who can afford the higher prices (have access to the “new euros”) and buy from those who haven’t noticed the new euros yet (and thus haven’t had time to raise their prices enough).
Of course, holding euros (or euro-denominated bonds) in an account is probably the worst strategy for saving, because this effect will destroy wealth faster than the wind blows sand off a rocky beach. And that brings us to the middle class, who, while not having a stake in companies, stocks and gold, will save something, such as for better housing. So the middle class doesn’t pay as much tax on consumption, but it saves much less than it thinks it does by saving in an account because it doesn’t take advantage of the new money effect; it’s even on the wrong side of that effect.
Consider, for example, a family that is “saving for housing”. That is, they save euros in a “savings account” which, if they go through a lot of trouble, earns 5% p.a. Their neighbour takes out a mortgage at 3% interest and buys a new house. There are fewer houses on the market, so house prices have gone up (of course, new houses are being built too, just be aware that the other neighbour is also building – also on a mortgage – and so there are fewer workers, not to mention those who are building roads with EU subsidies and so cannot build your house – unless you offer them a particularly good pay). What does this mean for the saving family? That the prices of what they are saving for are rising much faster and it pays to tap into a source of new money (loans, euro funds) rather than save. And that brings us back to the new money effect. It does not pay to save (i.e. to decide to “consume less”), but to latch on to the source of new money and to pass on the saving through rising consumer prices to everyone else. Imagine that I now build a house on a mortgage, cause house prices to rise, and workers’ prices rise because of me. This new money will reach them (and the original owner of the land I bought from) and, depending on what they buy, cause other prices to rise. Thus, the people who consume all these goods (houses, land, workers, food, and the booze the workers buy) can consume less because of the higher prices. So everyone saves on my house. Cool, right? Do you think a poor person or a middle class person is more likely to get a mortgage?
Once again, to make it sink in better – poor people, despite being able to consume less due to rising prices, are “saving” for the houses of richer people who get the mortgage. And not just on houses, mortgages are just one of the few avenues by which wealth moves from the poor to the rich. European Union subsidies are another fine example. The whole thing is invisible, nobody’s account balance is going down, suddenly a playground or a church in a village is being renovated for ‘free’ with EU funds, and everybody is happy that we have the European Union. And then we just grumble that those tomatoes and houses have gone up in price again, ah, those evil greedy businessmen, don’t we? Next time you grumble about higher prices, look at the European Union logo and the words ‘Built with European Union funds’. That is the real reason why prices are going up – and the poor are poorer.
A rich person very often has some euros (“cash is king”, especially in times of crisis, when a rich person buys everything cheaper that panicking people want to get rid of to cover losses), but a large part of his assets are “supermoney”, such as shares of companies, or real estate cash flows. And of course he owns buildings, houses, factories, businesses, cars… Everything is subject to some wear and tear, but rarely as much as inflation.
(Almost) conclusion
The welfare state, in my opinion, is not paid for by rich people. It is one big illusion that makes poor people think that rich people give part of their production to the poor. I think that most of the taxes and the “inflation tax” (the effect of producing new money) are paid by the people who consume most of their production and don’t save, the people who use the government’s bad money. Just to see this you need to immerse yourself in thought experiments and not just look at tax returns (which will create a very nice but inaccurate illusion in you of who pays taxes) nor the balance in your account (because a euro today and a euro two years from now are not the same thing – and it depends on who you are selling to, those who have access to new money or those who sell tomatoes on the street market).
And then we have the champagne socialists, who are doing startups from EU funds, sipping organic specialty coffee (I like it too, at least we have something in common) and are indignant about the injustice in the world – rich people should pay taxes. Their goal, which they present, is to raise taxes on the rich and help the poor. What they absolutely do not understand is the tax structure and the structure of the new money. Moreover, as they live off that new money, they will beat their breasts for the introduction of progressive tax or for an increase in income tax for the rich, the introduction of dividend taxes, but they will never agree to what would really help – the introduction of decent money, without government intervention and distortions and pumping it into selected sectors of the economy. Why? Because that is what benefits their non-profit that gets grants, their startup that is funded by a government startup fund or a euro-fund grant.
What to do about it?
If you manage to save anything, save it in something other than fiat money. It’s different for everyone, for me it’s a good investment in my education and development – i.e. I’m increasing my value in the marketplace and I want to have more options and skills on how to start and run a business (the more I know, the more efficiently and in more areas I can run my business).
If you have children, it will be an investment in your children’s health and education. These are dividends that no central bank will ever take from you. Of course, don’t learn something that won’t be needed in the age of technological advancement. And I don’t mean that you should go to a state university to study something useless, educate yourself in something that will help you personally or knowledge of which is of great value in the marketplace. In other words, educate yourself in what will allow you to help more people (including yourself).
Another good way to save is to store value in precious metals (e.g. gold) and in bitcoins.
Try to think what other ways there are to avoid falling victim to this effect. Think about what you are financing and what you are giving up in terms of your lifestyle. Not only are we the victims of disproportionate taxation, but it is because of us, the taxpayers and users of bad money, that projects that are against our values come into being. Not because ‘we didn’t speak up’, not because we didn’t vote or voted badly in elections. It is because we work, we buy and therefore we pay for it with our taxes.
If you think that taxes fund orphanages, the poor and the disabled, think about whether those many millions of new euros will really end up with a homeless person, an orphan, a disabled person or someone that really needs help. If not, the second important realisation is that we don’t need more money (whether from the rich or anyone).
I wish you much optimism, and I suggest you think about what you can do personally – and I don’t mean now a campaign, a website or a political party, but really personally – how you can change your behaviour to tilt the equation in your favour. If you get richer, if you give yourself the luxury, you will also help me, who have not contributed in any way, because you will be funding progress that benefits us all – and the poorest disproportionately more. If you want to contribute to society, don’t pay taxes you don’t have to pay, save, invest and create. And of course, if you want to help those who need help, you don’t need the state to do it, I assume you can find those who need help yourself.