The Intersection Between Income and Wealth and The Role of Frugality

President-elect Biden’s tax plan drew a line at an income of $400,000 for taxing the wealthy. It prompted some comments as confusing income with wealth. Some people have a high income but they aren’t wealthy, because they live in areas with high costs of living or because they have high debt from mortgage and student loans and they haven’t had enough time to accumulate wealth yet. They’re referred to as HENRYs — High Earners, Not Rich Yet. On the other hand, some people with high wealth, especially those who are older and had the time to grow their wealth, no longer have a high income. Increasing taxes on higher incomes won’t affect them.

Meanwhile, Stanley and Danko said in their book The Millionaire Next Door that frugality, not high income, is the key to become wealthy. They said most millionaires became wealthy because they shunned flashy spending. If that’s true, increasing taxes on higher incomes won’t stop savers from becoming wealthy.

What’s the relationship between income and wealth? What percentage of people with a high income are HENRYs, and increasing taxes on them doesn’t really increase taxes on the wealthy? What percentage of wealthy people don’t have a high income, and they will be unscathed by a tax increase on higher incomes? Is The Millionaire Next Door correct in saying that wealth comes from frugality, not high income?

Survey of Consumer Finances

The Federal Reserve does a Survey of Consumer Finances every three years to look at the assets, liabilities, income, and demographic characteristics of U.S. families. I found a small gem at the end of one of their research notes — Wealth and Income Concentration in the SCF: 1989–2019. It shows the joint distribution of income and wealth. I reproduce the table here for easy reading:

Table C. Share of families in income group, by wealth group, 2019 SCF

Income groups
Wealth groups


Bottom 50
Next 40
Next 9
Top 1




Bottom 50
0.72
0.34
0.03
0.04


Next 40
0.27
0.56
0.46
0.05


Next 9
0.01
0.10
0.47
0.41


Top 1
0.00
0.00
0.05
0.49


All
1.00
1.00
1.00
1.00

The table divides income and wealth into four groups: bottom 50%, next 40% (top 10-50%), next 9% (top 1-10%), and the top 1%. The table should be read from top to bottom. For example, the last column means that among families in the top 1% in wealth, 4% of them have income in the bottom 50%, 5% of them have income in the top 10-50%, 41% of them have income in the top 1-10%, and 49% of them have income in the top 1%.

To put the percentiles in context, here are the approximate ranges for each group:

Income GroupWealth GroupBottom 50< $68k< $121kNext 40$68k – $201k$121k – $1.2 millionNext 9$201k – $531k$1.2 million – $11 millionTop 1> $531k> $11 million

Source:

Average, Median, Top 1%, and all United States Household Income Percentiles in 2020Average, Median, Top 1%, and all United States Net Worth Percentiles in 2020

To make the joint distribution table also readable from left to right, I created a hypothetical group of 10,000 families. 5,000 families are in the first column. Their wealth is in the bottom 50%. Multiplying the percentages in the rows puts them into different income groups. Doing the same for all the columns produces this table:

Income groups
Wealth groups


Bottom 50
Next 40
Next 9
Top 1
All




Bottom 50
3,600
1,360
27
4
5,000


Next 40
1,350
2,240
414
5
4,000


Next 9
50
400
423
41
900


Top 1
0
0
45
49
100


All
5,000
4,000
900
100
10,000

The totals don’t add up exactly due to rounding in the original table, but it’s close enough for our purpose. Now we can see a clearer picture of the relationship between income and wealth.

Reading across the “Top 1” row from left to right, we see if increasing taxes on the top 1% in income is used as a proxy to increase taxes on the top 1% in wealth, it has a “hit ratio” of about 50%. 50% of the families in the top 1% of income also have their wealth in the top 1%. The wealth of the other 50% caught by the higher taxes isn’t quite in the top 1% but it’s still in the top 10%. On the other hand, 50% of families in the top 1% in wealth will escape the higher taxes. In terms of paying less in taxes, the sweet spots are in the upper right parts of the table — asset rich, income poor.

When we look at each row, we see, as a group, wealth increases with income. An individual person in a lower income group may save more and have more wealth, but when you’re in a higher income group, you only have to be average. Although having a high income doesn’t automatically put you into the same group in wealth, it at least puts you one group below. 100% of the top 1% income group have their wealth in the top 10%. 95% of the top 10% income group have their wealth in the top 50%. It’s very difficult to advance one group from income to wealth. Only 10% of the “Next 40” income group have their wealth in a higher group. Only 5% of the “Next 9” income group have their wealth in a higher group.

Although income isn’t wealth, at least in these broad strokes, income is clearly the driver for wealth. If your income is there, your wealth isn’t too far behind. If your income isn’t there, it’s very difficult to move up by frugality. Conditioned on having the necessary income, frugality then plays its role. I heard this quote from Morgan Housel on a White Coat Investor podcast:

Wealth, in fact, is what you don’t see. It’s the car that’s not purchased. The diamonds not bought. The renovations postponed, the clothes forgone, and the first-class upgrade declined.

I have a feeling if a researcher goes to the DMV and randomly selects 100 registered Porsche owners and 100 registered Honda owners, they will find the Porsche owners as a group still have more wealth despite having spent more money on their cars.

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