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Living off capital is playing chicken with mortality

The fable of MooDoona. Planning to sell down capital to pay for your living costs? You are playing chicken with mortality! Good luck with that.
Once upon a time there was a man, we’ll refer to him as Dave, because that was his name.

Dave had a cow named MooDonna, who was a “wonderful magical beast” in the true Homer Simpson sense. She was seemingly ageless, year after year churning out a veritable multitude of renewable foodstuffs including butter, cheese, milk, ice cream and yogurt. He also has a supply of manure he can sell.

One off steak dinner, or renewable source of butter, milk, cheese, ice cream and yogurt

One evening Dave was found himself parked in front of some late night television. He’d hoped to see something witty featuring Jon Stewart or John Oliver, but instead found himself being hypnotised by late night television advertising. After numerous repetitions from breathlessly excited, cosmetically enhanced, big haired presenters imploring him to “ring now, but don’t send any money... we’ll bill you” Dave was ripe for the picking.

And then an advert for certified Aberdeen Angus Steak appeared.

Certified. Aberdeen. Angus. Steak.

A marketing con if ever there was one. Angus cattle are the most popular breed of cattle in the world (according to the authoritative sounding American Cowboy website). There is absolutely nothing special about them.

It is the biggest marketing manipulation since Haddon Sundblom came up with the Coca Cola Santa Claus campaign of 1931 (prior to which Saint Nicholas wasn’t a jolly fat man in a red suit we all know and love today... the current version turns out to be a marketing campaign based upon a 1832 Clement Clarke Moore poem!).

Dave loved a good steak.

The next day a slightly sleep deprived Dave took MooDonna to his friendly neighbourhood butcher, where she was promptly turned into a succulent 32 ounce t-bone steak served medium rare with béarnaise sauce and some sweet potato fries.

Empty plate. Image credit Jon Scally

Once Dave happily digested his way through a meat induced food coma he fancied some cheese and a tall glass of ice cold milk.

Except there wasn’t any.

The next day Dave was making himself a packed lunch to take to work. He went to the fridge for some butter, but there wasn’t any.

There wasn’t any the next day either.

Or the next.

After a few days Dave came to regret selling off MooDonna. He had traded a seemingly infinite supply of dairy goods for a single (wonderful) steak dinner.

Dave was lonely. And hungry.

It sucked to be Dave.

It sucked more to be MooDonna, though she was beyond caring at this point in the story.

There is an old saying that “you can’t have your cake and eat it too”. It turns out this expression applies just as well to beef cattle as it does to cakes... or money.

You can either have money or spend money, but you can’t do both.

Living off capital is playing chicken with mortality

When I read the masses of personal finance bloggers worshipping at the altar of the “4% rule” I think of Dave.

I think Dave was short sighted.

I think Dave traded his scarce capital for a one off return.

I think once Dave’s capital was gone, he went hungry.

If MooDonna was Dave's only store of wealth then he is now going to starve. Or rely on social security. Or sleep in doorways and beg for change outside his local Tesco.

Living off capital is playing chicken with mortality

Income gets taxed more heavily than capital gains

Yet here is the thing.

The financial equivalent of MooDonna’s butter, cheese and milk are dividends, interest and rent.

All three of which are taxed as income.

In fact all three are added to a person’s earned income. This means they are often taxed (apart from a diminishing allowance at the low end of the earnings spectrum) taxed at their highest applicable marginal tax rate.

That means the chances are pretty good that much of Dave’s earned income is actually taxed more favourably than his passive investment income.

Think about that for a second. Tax payers are penalised, in that they are taxed more harshly, for earning passive income. Doesn’t that sound counter intuitive to you? It certainly sounds wrong to me, governments should be encouraging people to establish additional income streams, as it reduces their demands on the pension/social security system.

In fact the story gets even worse.

In the UK capital gains are taxed at more favourable rates than earned or passive income.

If your income + capital gain puts you in the basic tax rate then you pay 10% capital gains tax on the sale of an asset (excluding your own home… which is also stupid, but the subject of another post).

If your income + capital gain puts you into the higher rate tax bracket then you pay 20% capital gains tax.

Now think about that for a second. The capital gains tax rate is half that which is applied to income, either earned or passive!

Is stupidity contagious?

This means the government is actually encouraging short sighted behaviour like Dave’s, taxing people heavily for retaining an income producing asset, while taxing them lightly for selling that asset off.

Had he kept MooDonna he would pay up no capital gains tax, but up to 45% tax on the income she produced.

On the other hand if sold MooDonna, he would pay only 20% tax on the one-off price she fetched.

The story actually gets a bit worse.

Unfortunately the government is using the taxation system to attempt the execution of social policy, and as such capital gains made on the disposal of residential investment properties are slugged with an additional 8% capital gains tax.

Therefore not only is the short sighted disposal of income producing assets being rewarded, but the direct ownership of an asset classes that has a long history of generating wealth for individual investors is being actively discouraged through punitive tax rates.

Stupidity is encouraged

Urban legend has it that Fidelity once conducted a study to identify which of their clients achieved the best investment performance, and what common characteristics they shared. It turned out they were dead, or had forgotten they had an account.

Moral of the story: unsurprisingly buy and hold investing performs better than regularly trading or selling down capital.

What is the answer?

To my simple mind the focus should be on encouraging those behaviours that have the most beneficial outcomes.

One of those outcomes is to encourage people to provide for the own financial needs, via the creation of a multitude of income streams.

Passive income streams scale much better than earned income streams do.

For example a guy I once met was a member of a unremarkable and unsuccessful band. At some point he wrote a song that they regularly performed at gigs, but that had no real commercial success. Somehow that song got noticed and used as the theme song for a successful kids cartoon show made in Japan. Now the guy gets sporadic royalty cheques that over time have been enough to finance the purchase of an apartment.

He performed a little bit of work.

Once.

That has subsequently generated ongoing income without any further effort on his part.

The effort required to earn £1 in dividends as the same as that required to earn £1,000,000 in dividends.

On the other hand there is earned income, where the individual sells off their life by the hour in return for a salary. They only have so many hours in the day that they can sell.

Some people seek further earned income, trading some of their free time for side hustle income. A noble intent, but if most people were honest with how they value their time then their side hustles probably aren’t financially worth their time. They are more like (hopefully enjoyable) hobbies that earn a little income, blogging for example!

So what?

If anything the tax system should discourage the disposal of income producing assets, rather than encourage it.

Dave should have to think twice about whether disposing of MooDonna was financially the right thing to do, with the default answer being no.

3 comments :

Cameron Pollock said...

I enjoy your blog. I'm a fellow Aussie expat, but find myself across the North Sea from you. I agree the basis for your taunt toward the 4% SWR:ers, and I agree with your observation about capital gains lighter tax treatment than passive and often a good amount of earned income. But I question your cow-slaughter analogy. You can't partially slaughter a cow like you can liquid invested capital.

Cheers, Cameron.

Slow Dad said...

Thanks for your kind words Cameron.

I agree the slaughtering of a cow is a tad more immediate than the ~30 year retirement span that Bengen envisaged when coining his 4% "safe" withdrawal rate rule of thumb was designed to last. However the end result is the same, once the capital (or cow) is exhausted the now possibly-not-so-young retiree goes hungry.

Cameron Pollock said...

Yeah, I was thinking more that a dead cow can no longer grow. A fully liquidated investment not reinvested is like a dead cow. But it's possible to carve pieces off a share porfolio, for example, and remain largely invested and exposed to growth opportunities.

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