Taxation without Legislation - Part I

Milton Friedman, the noted American economist once said that, “Inflation is taxation without legislation” and, lately, there has been a little bit of talk about inflation.  One of the points I’ve heard expressed is that inflation has had a larger impact on lower income households than on upper income households.  Knowing that this might occur as a result of greater or lesser proportions of consumers’ budgets being spent on items with more, or less, inflation, I decided it would be fun to investigate this claim and bring it to our readership. While I could cut to the chase and give you the answer, I have decided to take three weeks to get there.

 

This week, we will look at the characteristics of households in each quintile of income in the United Sates.  (A quintile represents 20% of the population and, if you prefer, think of them as lower class, lower-middle class, middle class, upper-middle class, and upper class.)  Next week, we’ll see what we can learn from examining the expenditures of each quintile.  Then, in week three, we’ll add what the Bureau of Labor Statistics has reported about inflation over the past year and calculate how the overall measure might be different for each quintile.

 

First, to find information on income, expenditures, and rates of inflation, we turn to the US Government’s Bureau of Labor Statistics.  For much of what we will discuss, the source is: http://www.bls.gov/cex/2009/Standard/quintile.pdf.  I have reproduced a portion of the table that describes the characteristics of each income quintile.  Please, survey the table to see what you can learn to reinforce or alter your view of our country’s citizens.  For this week, I draw the following summaries with a parenthetical comment after a point being additional information or an observation.

 

·         When we divide the country into income quintiles, the “top” group begins at a household income of $93,196.  (I have spoken to countless US citizens that, when learning of this number, are astonished to learn they are in the upper-class, as defined by income.)

·         The average income of the highest 20% is more than the sum of all the average incomes of the remaining four groups ($152,022).  (This is not surprising, as there is no upper limit on income but the lower limit is $0.  It is true, however that income in the United States is heavily skewed toward the top and most estimates conclude that around 70% of the total income of households is received by the 40% of households at the upper end.)

·         Income after taxes in greater than income before taxes for those in the lowest 20%, as a result of transfer payments (e.g., earned income tax credits, college tuition tax credits, and etc.).

·         The average age of the household head is greater in the lowest two income quintiles, indicating that low income is associated with older adults.  (While low-income is associated with older adults, it is estimated that from 20% to 24% of all children in the United States live in households below the poverty level. Sources: US Census Bureau and National Center for Children in Poverty )

·         Family size, the number of children under the age of 18, the number of earners, and the number of vehicles owned each increase with level of income; while the number of persons over the age of 65 trends downward as income increases.

·         The gender of 47% of the reference persons was male and female gender was, in fact, the dominant proportion of reference persons for each of the three lowest income quintiles.  Male reference persons, however, represent the majority in the two highest income quintiles.  (According to the US Census Bureau, 44.3% of single female-headed households with children are officially poor and 26.5% of single male-headed households with children are poor, while only 11% of households with children, in married-couple households, are poor.)

·         Rates of homeownership increases with income, with a range of from 40% of those in the lowest quintile to 89% of those in the highest quintile.  (It is quite interesting to point out that the proportion of homeowners that do NOT have a mortgage on their homes is 65% (=26/40) for those in the lowest income quintile and this proportion continually decreases until it represents only 20% (=18/89) of the homeowners in the highest income quintile.)

·         When we consider race, we can see that the proportion of households represented by minorities generally decreases as we move from lower to higher income quintiles.  (While this is true, it is also true that, when compared to the number of poor white households, there are both 46% fewer poor black households and 33% fewer poor Hispanic households than there are poor white households. Source: US Census Bureau)

·         Income is dramatically influenced by the educational level of the household.  While 45% of those in the lowest quintile have a college education, fully 84% of those in the highest quintile have a college education.  (A good education remains the best investment one can make.)

·         While automobile ownership/leasing increases with income, the rate is 31% less for the lowest quintile, when compared to the highest.

·         Finally, both the lowest and second lowest quintiles, on average, spend more than their after-tax income.  (Some of the shortfall may be covered by money that is in savings but much of it will be covered by debt being added to the household’s net worth statement.  Additionally, transfers of income from others – either the government or family members – may also be a way to cover the overage.)

 

This is the current snapshot of our country and her people.  Next week we will assess how each of these quintiles spend their money and what conclusions we can draw from that examination.  We welcome your feedback.

 

Item	All consumer units	Lowest 20 percent	Second 20 percent	Third 20 percent	Fourth 20 percent	Highest 20 percent
Number of consumer units (in thousands)	120,847	24,165	24,120	24,212	24,154	24,196
Lower limit	n.a.	n.a.	$19,175	$35,598	$57,295	$93,784
Consumer unit characteristics:
Income before taxes	$62,857	$9,846	$27,227	$46,012	$73,417	$157,631
Income after taxes	$60,753	$9,956	$27,275	$45,199	$71,241	$149,951
Age of reference person	49.4	51.4	51.4	49.3	47.1	47.8
Average number in consumer unit:
Persons	2.5	1.7	2.3	2.5	2.9	3.1
Children under 18	0.6	0.4	0.6	0.6	0.7	0.8
Persons 65 and over	0.3	0.4	0.5	0.3	0.2	0.2
Earners	1.3	0.5	0.9	1.3	1.7	2.0
Vehicles	2.0	1.0	1.5	2.0	2.5	2.8
Percent distribution:
Sex of reference person:
Male	47	38	42	49	51	56
Female	53	62	58	51	49	44
Housing tenure:
Homeowner	66	40	56	67	79	89
With mortgage	41	13	25	40	57	72
Without mortgage	25	26	31	27	22	18
Renter	34	60	44	33	21	11
Race of reference person:
Black or African-American	12	18	16	12	9	6
White, Asian, and all other races	88	82	84	88	91	94
Hispanic or Latino origin of reference person:
Hispanic or Latino	12	13	15	13	11	7
Not Hispanic or Latino	88	87	85	87	89	93
Education of reference person:
Elementary (1-8)	5	10	6	4	3	1
High school (9-12)	34	44	47	36	30	15
College	61	45	46	59	68	84
Never attended and other	a/	1	a/	a/	a/	a/
At least one vehicle owned or leased	88	67	87	94	97	98
Average annual expenditures	$49,067	$21,611	$31,382	$41,150	$56,879	$94,244
Deficit or Surplus		-$11,655	-$4,107	$4,049	$14,362	$55,707

 

Safeguarding Your Money

by Thomas Duffany III

Office for Financial Success Counselor

 

My wife is much smarter than I am.  If we disagree on something she turns out to be right 90% of the time (don’t tell her I admitted to that!).  That is why I was somewhat surprised when she started asking me questions about how interest is charged if a credit card is not paid off in full at the end of the month.  I answered with terms like “average daily balance method” and “grace period” but more specific questions came including scenarios.  Understanding these principles and their application can help you keep your money where you want it…in your wallet.

 

The Basics 

 

Credit card companies use the average daily balance method to calculate the interest you are charged each month.  The average daily balance is calculated by adding the balance from the end of each day during the billing period and dividing by the number of days in that billing period.  Look at the following scenario:

 

Starting Balance: $0

Purchases:                                                          Balance:                               Total:

Dec 6     $60         Groceries                            Dec 6 – 14            $60         9 days * $60 = $540

Dec 15   $150       Car Payment                      Dec 15 – 17         $210       3 days * $210 = $630

Dec 18   $80         Winter Coat                        Dec 18 – Jan 1    $290       15 days * $290 = $4350

Jan 2      $50         XBox Game                        Jan 2 – Jan 5       $340       4 days * $340 = $1360 

                                                                                                                31 days                 $6880/31 = $221.94

The average daily balance for this billing period is $221.94.  A certain number of days are provided after the billing period ends in which to pay the balance off in full without accruing any interest – the grace period.  The interest rate shown on the statement is the APR or annual percentage rate.  This is the amount you would accrue over the course of an entire year.  Because we are working with a daily balance we will have to adjust the rate to a daily figure:

 

APR (Annual Percentage Rate): 12.9%/365 days = 0.035% daily interest rate

 

Total interest accrued: 0.035% or 0.00035 * $221.94 * 31 days = $2.41 Most credit card companies have a minimum amount of interest they charge, often about $5.  In this instance rather than paying the $2.41 that accrued, you would pay the minimum amount. 

 

The trap many people fall into is to think that $5 isn’t that much.  They make the minimum payment and continue making purchases.  Before long their balance is high and their interest payments are much more substantial.  For instance, after just 6 months of paying only the minimum and continuing similar usage as this example, the balance will be close to $2000 and you will be accruing $20 of interest each month.  If you stopped using your credit card and made only minimum payments it would take you years to pay it off!

 

My wife and I developed a habit of only using our credit card for purchases we could pay off at the end of the month.  This is why she had never made it a point to be clear on the specifics.  However, this particular month we had some unexpected expenses and we had to make some decisions:  How much can we pay now and how can we minimize interest payments? 

 

Common Questions 

 

Question: If I make a partial payment will I still be charged interest on that amount?  Answer: Yes.  Going back to our example, the ending balance was $340.  If you decided to pay $200 that would bring the balance to $140.  However, interest is not calculated using the final balance or the balance after your payment.  It is calculated using the average daily balance during the billing period: $221.94.  Therefore, if you do not pay off the entire balance, the interest charge will be the same no matter how much you pay.

 

Question: I went to my online statement and saw two different balances, a statement balance and a current balance.  What is the difference and on which balance will I be charged interest?  Answer: The current balance includes all charges that have posted to your account up to the present day.  The statement balance includes only the charges posted to the account by the end of the billing period.  Going back to our example, the ending statement balance was $340.  The payment would likely be due around January 26 (21 days after the billing period ended).  If a $60 charge posted to the account on January 10, before you made a payment, the current balance would be $400 and the statement balance would remain $340.  The grace period refers to the statement balance only.  Therefore, in the case of our example, a $340 payment would be sufficient to avoid interest payment even though the current balance was $400.  Current balances are never used to calculate interest payments.

 

Question:  I paid my statement balance in full, so why was I still charged interest?  Answer: Likely because you did not pay the full balance the previous month.  If you make only a partial payment you will continue to accrue interest until you start a billing period with a $0 balance.  Returning to our original example, if you only paid $200 at the end of that billing period, you would start the next billing period with a balance of $145 (accounting for $5 of interest).  Interest for the next billing period would be calculated as follows:

 

Starting Balance: $145

Purchases:

                                                                Jan 6 – Jan 9       $145       4 days * $145 = $580

Jan 10    $60         Clothes                 Jan 10 – Jan 17   $205       8 days * $205 = $1640

Jan 18    Paid the full balance       Jan 18 – Feb 5    $0           19 days * $0 = $0         

                                                                                                                31 days                 $2220/31 = $71.61

Total interest accrued:  .00035 * $71.61 * 31 days = $0.78 (minimum interest charge applies).

 

The next billing period would begin on February 6 with a balance of $0.  If you paid the balance off in full at the close of that billing period you would pay no interest.  Even if you don’t use your card during that billing period you may have an interest charge from the previous billing period.  Be sure to always check your account so you don’t miss a payment (and to prevent fraudulent charges from being missed).

 

We often make things more complicated than they need to be.  There are many other scenarios we could discuss but just remember it always comes down to the same principles: grace period, average daily balance, and billing periods.