Everybody ought to be familiar with the concept of marginal utility, which is the utility/use/satisfaction that adding one more unit brings. For example, suppose you like ice cream cones. Then the marginal utility of the first cone is high. The second is a bit lower, but once the belly fills up and the blood sugar starts spiking, the marginal utility drops to zero or even negative.
Marginal utility is a very important quality to consider. It underlies the entire philosophy of when enough is enough. For instance, I could have kept working and earned even more money, but the utility of that money was far lower than the money and cash flow I already had, especially considering that I wasn’t going to use it anyway.
For me my main consideration when buying stuff is not how much it costs — I can buy pretty much everything a normal consumer buys — but how much of a hassle it is to own it.
Marginal tax rates work on a similar principle. They determine how much of the last dollar you earn you get to keep. What is really interesting is that tax rates are different depending on how the money is earned.
Since I no longer have a salary we dropped into the 15% tax bracket on earned income.
First, this means that qualified dividends which is my dominant source of income is taxed at 0%. That’s right, I don’t pay taxes on that. Note that this is due to the Bush tax cuts of 2001/03 which are scheduled to run out in 2011 if they are not extended(*). Hence $1000 in dividends means $1000 in my pocket.
Did you notice, I don’t need to pay taxes. Outrageous, right?
(*) Naturally I am very interested in whether they will be extended on not.
Compare that to my freelance work. Since DW’s work puts us in the 15% bracket, this means that it is taxed at 15%. I reason thus, since DW is salaried and thus can’t change her income whereas I am free to work as much as I please. However, I also pay social security taxes which comes to 15.3%. I get to deduct half of those pretax, which means I get a deduction of 15.3%/2*15% = 1.15%, a mere pittance, but thanks anyway even though it is phrased to sound better than it is. Hence my marginal tax rate on freelance work is 15+15.3-1.15 = 29.15%.
I consider social security payments to be useless from my perspective. There is no reserve as the government is borrowing from the trust to fund general operations, like wars, legendary $800 toilet seats, free roads, various Mickey Mouse projects, etc. Besides, the system is scheduled to go broke in real terms, so I just see this a normal earned income tax with a euphemistic name.
Naturally, compared to having money working for you, working for money under the small business taxation really has to be worth it. However, frequently it is more worthwhile to work for myself (0% tax on replacing my own water pump myself) rather than working for someone else to get money to pay someone else to work for me. No need to complicate things, right?
This does not suggest being completely self-sufficient. Marginally speaking, some skills are just not worth learning e.g. things you only do once or which needs serious tools. However, other things are better done yourself.
In my political opinion, taxing work is dumb(*). Tax is always incentive to do or use less. The communist experiment has failed. For anything which is annoying (most work) we can expect people to do less if they still get the same utility. In other words, when it comes to work, people ain’t stupid. I would much rather see a national sales tax or even better, a national value added tax (which makes it harder to cheat), replace all sorts of income taxes. This would provide incentives to work more and use less, in other words, make the country wealthy. The current tax structure is defined to make people consume more. Therefore the current tax structure is highly profitable and thus I don’t foresee it changing due to the lobbyist nature of government (what we have is somewhat of an indirect plutocracy). It’s too bad.
(*) And tax payers are kept dumb by taxing income as it is earned rather than demanded a lump sum once a year. Salaried people never see the social security tax, nor do the see the socialized healthcare tax for the older population.
Daily Yakezie: How Much Is Your Time Worth @ Eliminate the Muda!, Are Employers Making Crazy Assumptions? @ Sweating the Big Stuff, & What is Financial Literacy? Part 1 @ Canadian Finance Blog
Originally posted 2010-03-12 12:43:45.