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The term "middle class" wasn't always around. Till about 100 years ago, the middle class wasn't an important part of the American economy, and their purchasing power was limited. That changed after the Second World War. GIs returning home were driven to start their own families, build wealth, and improve their quality of life. Productivity and GDP skyrocketed, homes were affordable, America grew into a manufacturing hub, and families were hungry for consumer products. Consumerism was practically invented in the '50s and '60s.
The future held as much promise as the present – salaries were consistently trending upward. Incomes had increased 178% since 1936, and by 600% since 1901. The average new house cost just 200% the average wage (it's now at 750%). It was entirely possible for 70% of American families to comfortably survive on one salary, 50% to own their own home, and 60% to own a car, pay their children’s tuition, and save enough to retire – with the help of employer pensions.
The middle class was the backbone of the American economy. They bought the things that corporate America sold, they innovated, earned, and worked towards a better life. Getting into the middle class was an aspirational goal. But now, the fear is that the American middle class is disappearing.
Here's why the middle class is shrinking, where their wealth is vanishing, what it means for your money, and how you can stay ahead.
The total population of the middle class in the US has dropped from 61% in 1971 to 50% in 2021, according to Pew Research. As their numbers dwindle, their wealth is shrinking too: "the average wealth of the middle 40% dropped by 7%, or $27,000, since March of last year". That's the biggest drop on record since the 2008 Financial Crisis. But what halted the non-stop rise of the 50s and 60s?
The United States achieved dominance in manufacturing and productivity, but in the 1960s, Japan and Europe started to overtake the US in terms of production, quality, and efficiency. The government dealt with this by printing more money to stimulate the economy – this helped in the short term, but over the long term, it took the dollar off the gold standard. This single move was said to have sabotaged the great American wealth-building machine: "No longer can one generation of Americans expect to live a better life than the previous one." Things got worse over the years:
Finally, this has resulted in a situation where there is a vast difference between where wages should be and where they actually are compared to the average cost of living. High wages are the only income bracket seeing substantial increases in income, and there are three reasons why:
Make more, save more
The first reason – taxes. The biggest difference between the middle class which is majorly composed of salary workers and the upper class consisting of business owners is the W2 form. When you work for a company as a W2 employee, your income and tax withholding get reported to the Federal government, and you have to file a form at the end of the year, pay taxes, and then spend what is left over. As a business owner though, it works the other way around: you get to write off expenses first and then file taxes. For example, all of these could be legitimate business expenses:
Owning a business is of course a lot riskier than earning a salary, but the tax code provides a lot of leniency for small businesses to reinvest and expand. This also means that business owners could save more in taxes.
Second, there's depreciation. Just a year ago, ProPublica published an article titled: "If you're getting a W2, you're a sucker." It told the story of Stephen Ross who showed $1.5 Billion in income from 2008 to 2017, but paid nothing in taxes.
One way to do this is by something called "cost segregation" where your business expenses balance out your profits. For example, if you make $1 Million in profits, and you put down just $100k as a down payment on a $1 Million property for your business, you can write off the property against your profits and profit $900,000 without paying a single dollar in taxes. Of course, when you sell that property, you will have to pay "recapture tax". But if you never sell, you can pass on up to $25 Million tax-free to your children – and that's how the rich get richer.
Third, there's plain old capital gains. You've heard this in the context of the stock market, but the biggest stock owners in companies are the business owners themselves. When they sell their businesses, they will have to pay a maximum of 20% capital gains tax + 3.8% in net investment tax. Compare this to the 37% tax rate for earned income, and you can quickly see how business owners keep most of what they make. How is this causing the middle class to shrink?
Why the middle class is shrinking
The middle class is shrinking because of this simple reason: Wealthy people have disposable income to invest. When interest rates are low, or inflation is high, those assets go up in value, and this is why the richest 1% make twice as much as the rest of the world. While low interest rates can stimulate the economy, banks are more willing to lend to credit-worthy borrowers – wealthy people, in this case – who then get the first shot at cheap money, invest that, and drive up prices before others can invest.
Not everyone agrees that the middle class is shrinking. According to the Brookings Institute:
Another study reported that the middle class is shrinking, but only because they are moving into higher-income groups.
The US has the smallest middle class, but it also has the largest affluent class and poverty class, suggesting that people are either getting richer or they're getting poorer. So how can you use this information to come out ahead?
The income gap isn't contributing as much to the inequality in wealth as an investment gap – the ones who are prepared to take advantage of opportunity when it arrives. Here are three ways to escape the middle class, but move upwards instead:
So overall, yes, the middle class is slowly disappearing. But the good news is that now, more than at any other point in history, the likelihood of moving up into a higher income bracket is much greater.
By doubling down on your career skills, staying out of consumer debt, building your credit score, living below your means, and investing the difference – you have a much better chance of being in that camp.
That's it for this week. I hope you enjoyed this article. Let me know your thoughts by responding to this email - I read every single comment :)
Stay safe, stay invested and I will see you next week – Graham Stephan.