Taxes Destroy Wealth

My title is a bit bold, but math will prove me right.  No, I am not going to use multi-dimensional calculus or other forms of advanced math.  The “complicated” math I am going to use is simply done using a compounding or future value calculator that can be found several places on the web or even in the app store for your phone.  For ease, here is one you can use to verify the math.

Let’s do this whole thing telling a story.  October 21st this year marked the day on which Marty McFly used the time travel machine that Doc Brown built out of a modified Delorean.  Let’s assume for moment that while Marty and Doc are out doing their thing, you find the DeLorean and go back in time to visit your great grandfather late in the year 1912.  After recovering from the shock, you convince your ancestor to take the $100 dollars you hand him and invest it in the stock market on January 1, 1913.  Your ancestor does your bidding and invests in a mutual fund that does exactly what Dave Ramsay says happens with good mutual funds: “gives you an average rate of return of 12%.”

By the skin of your teeth you make it back to 2015, get out of the car, and return it to its hiding place without being noticed.  Awesome plan right?  I am sure you are wondering, “How much money do I now have?”  Using the calculator I mentioned above, the year (N) is 102 (the number of years from 1913-2015), starting amount is $100, and the interest rate is 12%. The result is: $10,477,033 (I am rounding: the actual amount is $10,477,033.01)

Eureka!  Congratulations! You can now retire.  But hold on a minute my dear Watson; you do not have the whole story.  I know this is a story, but any good story is rooted in reality.  The reality is, you have had to pay taxes on your growth every year.  Looking through the history of the tax rates in the US, we learn that the average maximum tax rate is 58.3%.  When we factor in that average tax rate what do you think the account value would be? (This requires a slightly more complicated calculation – i.e. doing 102 calculations each time subtracting out the taxes paid from your account) Would you be surprised to learn that your account would now be worth a massive $14,554?  Immediately you feel jaded and cheated by our blood sucking government for stealing $10,462,479 from you.  But guess what? Looking at the history, the government has only collected $20,209 in taxes over that time.

That is only a total of $34,663 that your $100 dollars has generated over the last 102 years. WHERE IS THE OTHER $10,442,370 you demand!  The simple answer?  Taxes destroy wealth.  Notice I did not qualify whose wealth they destroy.  To put a finer point on it, the title of the article is not “Taxes Destroy YOUR Wealth.”

Here is the odd thing, if taxes were lower what would have actually happened?  Making the same calculation using a 25% tax bracket your account value would be $656,905 and the government would have collected $218,935.  Certainly not $10 million, but a whole lot more than $14,554, and better for the government as well.

That is a cool you say.  Let’s lower the taxes to 15%.  What is your account value now? $2,006,886 and the government collects $354,139. Getting better…

This entire discussion proves what is called the Laffer curve.  Simply defined, there is an optimum tax rate that gives the maximum to the individual and the maximum to the government.

In our scenario the optimum tax rate is 9%.  Under these conditions you have $3,899,472 and the government collects $385,652.  This total wealth generated by the original $100 you took to the past is still $6,192,009 less; wealth has simply been destroyed because the growth of the money was hampered by taxes. (Note: the optimal tax rate does vary based on what we believe the growth rate will be, but generally the optimum rate is between 10-15%.)

What I am showing you is not new; it is well documented and understood.  In fact, Ibn Khaldun, a 14th century Muslim philosopher, wrote in his work The Muqaddimah: “It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments.”  It is this same Ibn Khaldum that Laffer gives credit for “his” curve.

Need further proof this is well known?  Listen to the politicians when the talk about tax rates, they are all talking about 10-15% flat taxes.

So how do you want your money?  In a taxable or non-taxable environment?  Tax-deferred is exactly what is says: tax deferred, i.e. pay taxes later.

Don’t misunderstand me, taxes are necessary, we need roads, bridges and other basic things, but the more they take the less they and us get.

Conclusion: Taxes Destroy Wealth.