O'Sullivan Wealth Management Investment Update - Let them eat cake!

Sep 12, 2018 | Kevin O'Sullivan


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Though it is clear that the world’s population is significantly better off than in the times of the French Revolution, there are inequities that currently exist that are proving to be vexing for many...

“Let them eat cake!” The infamous quote that is often attributed to Marie Antoinette, has served as an anecdote illustrating her poor understanding of the state of poverty in which the peasants of France lived prior to their storming the Bastille.

 

Though it is clear that the world’s population is significantly better off than in the times of the French Revolution, there are inequities that currently exist that are proving to be vexing for many. The rise of populism in many hot spots around the world are a testament to the anger and frustration felt by many. These populist sentiments can be distilled down to the sense that people are not as well off as they believe they should be.

 

While the world’s general affluence is much better off than even 100 years ago, there is a case to be made for the populists.

 

Facts point to a widening of the gap between the very wealthy and the middle class. In Canada, according to a report entitled born to win, by the Canadian Centre for Policy Alternatives, the top 87 richest families grew their wealth by 37% from 2012 to 2016, from an average of $2.1 billion to $3 billion. While the median Canadian family grew their net worth about 15% during the same period, from $257,000 to $295,000. Similar statistics prevail across much of the developed world.

 

A key component of wealth creation is having disposable income. In order to have disposable income, one must have surplus money after taxes and expenses. While this might appear to be fairly obvious, the tax structure in Canada, and likely much of the developed world, favours a specific type of income over others. This structure fosters the continued growth of wealth within the wealthy class.

 

Diving in deeper we see that of the 3 primary forms of income (earned income, dividends and capital gains) the vast majority of the population will have earned income. Earned income is also taxed at the highest rate, especially for middle class households and higher. At the top tax bracket households will pay 50% tax on earned income. Conversely dividends and capital gains are taxed at 34% and 25%, respectively, at the top rate.

 

Of the 87 wealthiest Canadian families, the majority of their wealth is invested in assets that generate dividends, with the possibility of capital gains. While these families are also often in the top tier of earned income, the above report shows that the bulk of the family income is in the form of dividends or capital gains which are taxed at the two lower levels.

While almost all investors will try to optimize their exposure to the lower taxed income streams, they are constrained by the limited disposable income they have to invest as a result of the high rate of tax paid on their earned income.

 

Consequently the availability of disposable income, and by extension the growth of their net worth, are hampered. At the other end of the spectrum, the wealthiest families benefit from favourable tax rates on their invested disposable income and residual wealth, allowing them to grow their fortunes at a considerably faster rate.

 

Canada is also unique among the G7 nations in that it does not have an estate tax. Instead, the estate of the deceased files a final tax return. Most of Canada’s G7 peers have an exclusion of a specified amount (for example $10 million) that will be tax free to the estate upon the death of the deceased. Thereafter, the estate is taxed (for example at 40%), with the remainder passing on to the heirs. While we like to see entrepreneurs enjoy the rewards of their success, the absence of an estate tax tends to reward future generations who invest for dividends rather than entrepreneurial innovation.

 

Capitalism and democracy live in a delicate balance. We work to fulfill our dream of building a better life for ourselves and our families. Some are more fortunate than others and build spectacular dreams. Democracy means that we all vote for what we believe to be fair. Fair taxes, good government, paved roads, a quality education, and infrastructure for our communities and country. When one segment of the population grows at the expense of the other, the sense of fairness becomes tainted, with resentment and frustration not far behind.

 

The result is a polarized society that indulges in scapegoating. By not addressing the root cause of the problem, wealth distribution distortions continue to grow fueling populist anger, potentially leading to social unrest.

 

The recent strength in the financial markets has been driven by entrepreneurialism and innovation by good businesses with strong management. This is the hallmark of capitalism at its best. While suggesting a revisiting of Marie Antoinette’s fate might be a bit extreme in the current environment, creating an equitable environment which allows for an effective balance of capitalism and democracy will ensure strong institutions for our communities, and continued prosperity for all.

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Special report Wealth