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The Drag of Taxes and Inflation: A Penny Saved is Worth More Than a Penny Earned

June 7th, 2009 by 
PK
Pennies and copper coins in a pile.
A penny saved today is worth more than a penny in income tomorrow.

"A penny saved, is a penny earned,"

Benjamin Franklin in Poor Richard's Almanack

Ben Franklin broke us with his quote. We've internalized that earning income and cutting spending are (forgive me) two sides of the same coin. However, Ben lived in simpler times; as we'll show you, a penny earned is unfortunately worse than a penny saved. The truth is – in the immediate term – cutting spending is worth more than income.

Tax Drag: A Penny Saved is Worth 1.8 Pennies Earned

After the Great Recession, America got to work... saving.

Before the Great Recession, income felt abundant. People flipped houses, stocks were on a tear, and income felt abundant.

If you dig back through the BEA's archives, there were even a few months people spent more than they earned. People were temporarily spending MORE than they took home and banking on a salary increase.

What's Wrong with Earning More Income?

There's nothing inherently wrong with earning more income. In fact, over a career you need to work on cranking your earnings potential to maximize your net worth.

But in the immediate term, your optimal path to increasing your net worth and improving your lot is to cut spending.

Consider this: for every dollar you earn, you have to pay taxes. If you earn a lower income, this might be Social Security. For higher incomes you might be paying 50% or more between federal, state, or local taxes.

Let's say your marginal rate adds up to 40%:

Earn a dollar:

1*(1-.4) = $.60. (40 cents goes to tax)

To match a dollar saved:

1 / (1-.4) = $1.67 (Earn $1.67 to match a dollar saved)

There you have it. You'll have to fill in your own marginal tax rate, but for a theoretical 40% marginal rate you need to make $1.67 for every $1 you're able to cut in spending!

Balloons: inflation means cutting spending today is worth more than income tomorrow
Inflation erodes the value of future money

Inflation Drag: A Penny Today is Better than a Penny Tomorrow

What about inflation? Good question - let's think it through.

Assume for a second inflation runs at 3%. If you invested a penny you saved on January 1st at 3% post tax in a Municipal Bond at 3% (Municipal bonds are generally exempt from state and Federal taxes), you'd have 1.03 cents on December 31.

It would be worth 1 cent in today's dollars...

Like J. Wellington Wimpy of Popeye's fame said, "I'll gladly pay you Tuesday for a hamburger today". As a commentary on inflation it holds up - future money is worth a small percentage less than it is today.

So, your spending cut today is even more powerful than a future income increase. As long as we don't dip into deflation, moderate inflation means you'd prefer to make money today versus tomorrow.

Inflation and Taxes Mean Cutting Spending Is Worth More Than More Income Today

When we look at the value of money today we're assuming we can predict the future. These scenarios assume a constant rate of inflation and no changes in taxes.

In reality, you also need to build in uncertainty. When you aren't sure how the future will play out, it's often better to plan for the worse and be happy if the best occurs. If you agree, you would expect taxes and inflation to be worse than your plans - so your today dollars are worth even more.

It's like they say: "a bird in the hand is worth two in the bush."

A quick rule of thumb: you need to earn around twice as much in the next 12 months to match a spending cut today. Over a career, income matters more. But, today, future earning can't match cuts you make in spending.

Don't Quit Your Day Job...

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