Middle Class Traps: How the Rich Get Richer (and How to Escape)

Many middle-class individuals feel increasingly anxious despite working hard to save money and buy a house. Simultaneously, the world's wealthiest individuals continue to accumulate wealth, often without seemingly putting in the same effort. This isn't necessarily an individual failing, but rather a consequence of systemic design. This article explores the reasons behind this growing wealth disparity and offers some potential strategies for the middle class to improve their financial standing.

The Growing Wealth Gap

It is a well-known fact that wealth is concentrated at the top. Approximately 1% of the world's population controls nearly half of the world's wealth. This is a significant increase from 2010, when the same group controlled 35% of global wealth. Conversely, the bottom 50% of the world's population controls less than 2% of the world's wealth.

Data from the United States shows that middle-income earners' income has barely increased over the past 40 years. When adjusted for inflation, middle-class income has remained essentially stagnant. In contrast, the income of CEOs at major companies has increased by a staggering 940% over the same period. This illustrates a systemic transfer of wealth, where the rules are often set to favor the wealthy.

Traps Contributing to Middle-Class Financial Struggles

Here is an explanation of the tax collection mechanism and the risk traps for the middle class.

Tax Collection Mechanism

The current tax system often disadvantages the middle class. Middle-income earners typically have taxes automatically deducted from their wages, leaving little room for optimization. This is often referred to as "taxing at the source."

In contrast, wealthy individuals often derive most of their income from sources like stocks, dividends, and rent, which are considered capital gains or passive income. Capital gains tax rates are generally much lower than wage tax rates. In the United States, for example, the highest wage tax is 37%, while the capital gains tax is only 20%. This disparity exists in other countries, too, such as the UK where the highest salary tax is 45%. Furthermore, capital gains taxes can often be deferred; taxes are only paid when the asset is sold.

Even when an investment performs well, the tax savings on capital gains compared to wage income can significantly boost returns. Buffett once admitted that his actual tax rate was lower than his secretary's because a significant portion of his income comes from company dividends and capital gains, rather than salary.

The Three-Fold Risk Trap

Many middle-class individuals unknowingly expose themselves to a "three-fold risk" by concentrating their assets in areas closely tied to their employment. This happens when:

• Their primary income is their salary from a single company.

• They own stock in that same company, often purchased at a discount.

• They own a house near the company to make commuting easier.

While this seems logical, it creates a dangerous vulnerability. If the company faces difficulties, employees could face:

1. Job Loss: Loss of their primary income source.
2. Stock Value Decline: A drop in the value of their company stock.
3. Housing Market Impact: A decline in local housing prices due to economic hardship and potential foreclosures.

Unlike the middle class, wealthy individuals often diversify their assets across multiple properties and global markets, making them more resilient to economic shocks.

The Good and Bad of Debt

Wealthy people use debt to grow wealth. Middle-income people, however, use debt to become poor.

• The Rich: They borrow money to invest in income-generating assets like rental properties or factories, where the revenue covers their expenses. They use financing and leverage to make money using other people's money.

• The Middle Class: They take out consumer debt such as car loans and credit card debt. Or loans for education and home renovations.

Data suggests that a significant portion of the wealth growth of the rich comes from leverage. Taking a huge loan to buy a house at the wrong time can be a huge mistake and can become a negative asset.

Wage Growth vs. Asset Growth

Wages have not kept pace with the rise in asset prices, leaving the middle class struggling to maintain their standard of living. Data shows that wages in the United States have increased by less than 200% in the past 30 years. In contrast, house prices have risen by 800%, and the S&P 500 index has increased by 1,500%. So those who rely on asset growth are doing much better.

Social Anxiety

Middle-class individuals are often caught in a cycle of social anxiety, particularly regarding their children's education. They may invest heavily in school district housing, private schools, or tutoring, attempting to give their children a competitive edge. But the rich can solve their problems by using their wealth to give donations or human resources.

Profiting From Panic

The wealthy often capitalize on market downturns, while middle-class individuals are disproportionately affected. During economic crises, such as the 2008 financial crisis and the COVID-19 pandemic, wealthy individuals and institutions often acquire assets at depressed prices, profiting when the market recovers. This is possible because they have sufficient cash flow. The middle class can only sell assets when prices are at their worst because they lack cash flow.

Strategies for the Middle Class to Break Free

It is possible for the middle class to improve their financial situations. Here are some strategies to consider:

1. Reject Consumerism: Be aware of the consumer culture designed by capital. Focus on the use value of things.
2. Build Asset-Based Income: Accumulate assets that generate cash flow, such as index funds or rental properties.
3. Diversify Income Streams: Don't depend on a single source of income. Explore side hustles or small businesses.
4. Optimize Taxes: Explore legal ways to minimize your tax burden, such as utilizing retirement accounts.
5. Control Spending: Avoid excessive consumerism and prioritize needs over wants.
6. Maintain Liquidity: Have 6-12 months of cash for emergency expenses.
7. Expand Your Knowledge and Network: Expand your circle of friends and broaden your sources of information.

The ultimate goal is to understand the rules of the game and make informed decisions to improve your financial well-being. By identifying the rules of the game, you are on the way to breaking out of the circle.