The deck is stacked in favour of the capitalist – Will you beat the house?

In the world of earnings, the investor receives a free lunch… which few seem to be eating.

Labour & Capital

Britain is a nation of hard workers. We work longer hours than many of our close European neighbours. We seem to collectively agree that toiling hard and earning a week’s wage is an honest and respectable lifestyle.

Our focus on employment distracts us from the other great worker in the United Kingdom, a tirelessly generous contributor to our total production: capital.

In the economic sense, capital is the machinery, infrastructure, & technology that keeps the economy running at top speed. Capital simply allows us to do our jobs better; either by manufacturing more goods, delivering a better service or reducing waste. Capital plays an important part in the production of goods and services, and therefore also receives a share of the income.

While employees receive a monthly wage slip, capital generates income for its owner in a variety of forms such as rent, dividends, license fees and capital gains.

Labour’s Share of the Pie is Shrinking

The global population in work is 3bn. The average annual salary is just under $1,500.

In comparison, global capital has an estimated value of $600tn ($600,000,000,000,000). This is equivalent to $200k for every person in work. If a conservative rate of return (4%) is applied, this implies that $200k of capital earns $8,000 a year.

Is this starting to look like an uneven relationship? Is it actually possible that capital could earn more than labour?

The answer to both questions is a resounding yes.  While capital is put to work alongside humans to produce output, the owner of the capital also captures any profits created. Profits represent the excess value produced but not shared with employees. This element can be sizable. The lopsided nature of this relationship is visible when you consider the numbers on sweatshops, where employees can be paid as little as 62p an hour to produce £45 T-shirts.

As the rate of technological progress accelerates and wages increase, industry has a greater incentive to become capital intensive. This means that with each passing year, a greater share of the work burden is performed by capital rather than people, so in turn, capital receives an even greater share of the income. Consider for example, the 3.5bn search queries that Google’s server network processes every day, relative to the size of the Google Search team.

Google's data centres comprise of approximately 1,000,000 computers servers.

Google’s data centres comprise of approximately 1,000,000 computer servers.

From Employee to Capitalist – By 35

Receiving wages or receiving passive income from capital. Which option would you choose if you had a completely free choice?

Of course – owning capital sounds like the easiest option by a long mile. But I hear your exasperated response – getting into that privileged position itself is the challenge!

Is it a challenge? Yes. One equal to the 35 hours of effort per week (and associated stress) that we are apparently happily to exchange for income already? Nope.

If you want to speak to a successful capitalist who has shaken off the shackles of wages – look no further than your nearest pensioner! Converting from a labour method of earning income, to a capital method is the same as the pathway to a successful retirement. The only difference is that the timeline is condensed. In the UK, it is possible to switch from employee to employer of capital by the time you are 35.

This is a shockingly low age, but certainly possible. In fact, the deck is tilted advantageously towards anyone building up liquid assets with the aim of creating a passive income. I will highlight some of these advantages in the following sections.

Advantage 1: Returns are higher than you think

The return on savings is a crucial factor in how quickly your nest egg can roll up into an amount large enough to earn a return equivalent to a wage. The interest rates currently offered by banks are labelled as a raw deal for savers at the moment, and partially that’s because many of them are. But some criticism is unfounded, due to ignorance of inflation. When inflation is taken into account, we’ve never had it so good. Take a look at the table below which demonstrates the point:

2015 v2008 savings rates

The table demonstrates that the right bank account is increasing the buying power of cash at faster rate now than back in 2008 – when no one was complaining. What does this mean? It means that negative PR regarding saving returns has been overexposed. Investors willing to take zero risk have never had it so good. However,  cash should only play a small part in a portfolio of assets where a high level of passive income is the objective. A real return of 5-6% can be achieved over the long term through investing in a variety of options:

Debt: Funding Circle – A peer-to-peer lending platform to small & medium businesses, offers an estimated annual return of 7.1%

Shares: UK listed companies are currently paying high dividend yields. The FTSE100 as an average is paying out 4% in dividends alone. Funds that specialist in tracking the highest yielding companies have yields in excess of 6% such as the iShares UK Dividend ETF.

Property: Property Partner, allows private investors to invest in buy-to-let property, and this year it provided an annual return of 13% to investors.

This is not investment advice, but a snapshot of the current options available. It shows that over the long term, a 6%-8% average annual return can be achieved by an ‘armchair investor’ with the right strategy. Google ‘example asset allocation portfolios‘ to learn more about how to spread risk.

Non-cash options are higher risk, but this is the risk inherent to owning real capital and living off the income it directly produces. Bank accounts are like placing a real asset alongside a very expensive insurance policy that guarantees a fixed return. The insurance works, but carries a 4% charge and squanders your return accordingly. 4% might not sound like a make-or-break sacrifice, but over a 30 year period, 4% would mean the difference between a £333k portfolio, and a £1 million portfolio.

Advantage 2: The taxman loves private investors

When you think about it, salaries are an expensive way to earn money.  Take a look below to at the total payroll tax paid at each level of salary.

Marginal Tax Rate Graph2

The graph above shows that folks on the UK’s average salary (£26,500) experience a marginal tax rate of 32% on each additional pound earned. National insurance accounts for a significant portion of the basic rate tax bill.

Payroll is the item most heavily taxed by the chancellor because it is easy to immediately collect. A nation of workers is a very captive base of taxpayers, and therefore payroll tax increases are effective at filling the treasury coffers, because very few employees are willing to leave the country to obtain a better rate elsewhere. In contrast, capital is dynamic and tax-sensitive. If the chancellor raises tax rates on capital held in the UK, the underlying assets can emigrate, or the wealthy owner of the assets may relocate instead. This produces an offsetting effect which dulls the benefit that the treasury receives when raising capital tax rates, and indeed appears to be a driver pushing capital tax rates ever lower.

The highlights of the private investor tax regime*

  • Capital gains: First £11,100 is tax free (Capital gains annual exemption)
  • Bank Interest: First £1,000 is tax free (Personal savings allowance)
  • Rental income from property: First £10,600 is tax free (Income tax personal allowance)
  • Dividends: First £5,000 is tax free (New dividend allowance), and basic rate of 7.5% applied thereafter

(* Some of these allowances will be effective from April 2016 onwards).

Each of the exemptions and allowances listed above are completely independent of one another. So before we even think about ISAs – we have established that theoretically £27,700 of gross income could be earned each year before tax is paid on that income.

It gets better: the rates that apply when allowances are used up are typically more generous than PAYE and NIC. For a basic rate taxpayer, dividends are taxed at just 7.5% and capital gains are taxed at 18% – a far cry from the 32% incurred on a payslip.

Of course, an overview of tax efficient investments is not complete without discussing an invaluable part of the investors toolkit – the ISA! Up to £15,260 can be paid into an ISA per tax year and all the interest, dividends and capital gains from investments held within them (such as cash, bonds and shares) are tax free.

Corporation tax is levied on company profits before they can be distributed to shareholders, and therefore this has an indirect impact on the dividends received by investors. The UK rate is already the lowest in the G20 and is set to fall further to 18% by 2020.

Introducing your second pay rise

To visualize this tax advantage, I’ve created the chart below showing the dramatic effect of taking a tax friendly approach. Compare the effect of a £15,000 pay rise from employment for a higher rate tax payer, with receiving it as tax-free income from investments:

Effect on tax £15k increase

For higher-rate taxpayers, the additional income goes 72% further when earned in a tax-free way. For basic rate taxpayers, the impact is still a significant 47% boost.  Therefore the tax-free passive income approach becomes very much the ‘path of least resistance’ when trying to maximize your income whilst you are in work.

Advantage 3: Diversification

Starting from scratch, the only way to initially build up a sum of capital is to find a good job and be successful at saving as much as you can. Even in the best case, there will be a 10-20 year period when you are following both a labour and capital strategy. In such times, your small but growing source of passive income could really help you out of a tight spot.

Salaries tend to grow in bursts, but also plateau for extended periods. Salaries are also dependent on you being fit, healthy and able to commit your time. ‘Don’t put your eggs in one basket’ is a frequently used and well understood maxim – but people do not generally apply this principle when it comes to their most important financial matter – their income.

Investments also deliver volatile growth, but this won’t be closely correlated to your wage growth, and therefore this adds a degree of stability to your overall income.  Investments also compound at the same rate blissfully ignorant of their size (whereas wages are constrained by pay norms and pay bands). It feels great to finally spread that risk and appreciate that you have a safety net – both in terms of the income smoothing, and of course the investment lump sum itself that you can fall back on in hard times.

The Technology race: Why you might not be as important tomorrow

So far in this article, I have hopefully restored some faith in that returns from capital can be high and tax can be low. I’ve also highlighted that a second income stream acts as a useful insurance policy in case an employment situation suddenly sours.

manvsmachine-1However there is another, forward thinking reason to focus on building your liquid assets as well as your skills. It’s because skills now have expiry dates. Some experts predict that 30% of current jobs will be redundant by 2025, and will be performed by artificial intelligence or robots instead. Jobs at risk include manual labour jobs traditionally vulnerable to technology – such as manufacturing workers – but also middle class ‘white collar’ jobs such as sales and accounting.

At the same time, government support for retirees and the unemployed is being reduced through cuts to welfare spending and the demographics of an aging population. Whilst the value of the state pension is (currently) protected, the sustainability of the scheme depends on the effective date being continuously pushed back, such that the younger generation cannot conceivably factor in their state pension into their savings strategy any longer.

 

 

Final thoughts

This article isn’t an attempt to point a finger or pull apart the rights and wrongs of capitalism. I’ve described my view of the way the system currently works, and hopefully encouraged others to be aware of several important trends that affect our income.

Unlike the older generations:

  • We expect labour to receive a smaller and smaller share of global income
  • We cannot rely on a job for life & may need to retrain to have multiple careers to remain in employment
  • We cannot rely upon generous state support in retirement

These are fundamental changes to the rules of the game – but are you really playing it any differently to your grandparents in response to this seismic combination of trends?

Consider again the advantages available to our generation:

  • With the UK being a highly developed nation with low inflation, we can divert a larger portion of our wages into savings whilst maintaining a comfortable lifestyle
  • The tax regime for capital is extremely generous, allowing investments to roll up at a faster rate
  • Investing itself is also more affordable than ever – as innovation, reform and competition in the peer to peer and fund management industry to is reducing the fees paid to middlemen.

Labour and capital is a historic economic partnership, but many factors seem to converge and forecast capital as being the clear long term winner. In twenty years time – will you be caught out with all your eggs in the wrong basket, and forced to make sacrifices to adapt?

We can all make small changes to begin diverting money away from consumption and towards growing a pool of capital. In doing so, we will reduce our reliance upon a wage, and begin receiving a fairer share of the prosperity of the modern age.

Could you truly pivot away from labour and live from capital alone? Please leave your comments below.

 

Simon OatesThe deck is stacked in favour of the capitalist – Will you beat the house?

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