Wealth, or What Can Be Taxed?
The Two Sides of Wealth
The government can tax some of the wealth of private citizens. In order to understand what can be taxed, we must first consider how people make and use wealth.
Amount of wealth from Sources = amount of wealth put to use
This is just to say that, at the end of any given day, month, or year, the amount of wealth any given person gains must be the same as the amount of wealth that they put to use in some way.
Sources of Wealth
Sources of wealth are far and varied. Regardless of the source of wealth, the result is wealth coming into your pockets. We usually call this income.
Sources (or income) = wages + Profits in a business + Interest on Investments + inheritance + etc
Wealth typically takes shape as either active income or passive income. Active income is by far the most common source of wealth. It is wealth that is gained from frequent effort, including hourly wages, salaries, and commissions. Passive income is wealth that is gained without significant effort, such as from interest, dividends, and rental properties. Often, passive income results from the increased value of capital, for example, when a house becomes worth more now than when it was first purchased, or when an index fund (a bundle of stocks) becomes more valuable with the rising market.
Different people tend to have different sources of wealth. People who live paycheck to paycheck—meaning, most Americans—will rely exclusively on their wages, which is active income. A well-established professional might rely primarily on their wages but also acquire supplemental income from renting out a second property. An heir or heiress might rely exclusively on passive income obtained via the increase in the value of their investments.
Uses of Wealth
Uses of wealth can be put into two basic categories. All wealth is either spent or not spent. That is,
Uses OF WEALTH = spending + saving
Wealth is spent in many different ways. Everybody buys food. Everybody buys clothes. Some people—but not everybody—buys a yacht. Purchases like groceries can be thought of as the purest version of spending: people spend their wealth on the object and then use the object until they have to throw it away, without any plans to get money back from the object in question. Wealth can also be spent on things that depreciate, or lose value over time, like a car. That is, when you sell a used car, you will nearly always get less money back than you paid for it.
All of the wealth that is not spent is saved. The simplest way is in cash, or by depositing that cash into a checking or savings account. Such accounts provide convenient and secure access (aka “liquid”) to wealth for everyday expenses, like buying groceries or gas, or they can serve as rainy day funds. These are usually short-term savings. Wealth can also be saved by buying assets that appreciate, or increase in value. This strategy is advised for long-term savings because you typically can sell your assets for more than you bought them for.
Next: Read What Do We Tax?