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Why the rich stay rich and the poor stay poor

I DON’T believe there is a simple formula to become rich. At least not beyond robbing a bank, winning a lottery, inheriting money from your parents or marrying someone rich.

It’s quite complicated and what works for one person in one time and place may well be ill-suited for someone else elsewhere.

But the reasons why the rich stay rich (and the poor stay poor) are much more straightforward to explain.

Taxes are the most obvious reason and no “Panama Papers” are necessary to bring this to light.

Billionaire investor Warren Buffet has pointed out that his secretary pays a higher percentage of taxes than himself, despite the billions of income he enjoys. This is because the tax code works to the advantage of the rich in a few ways.

First, taxes on labour (salary) are typically much higher than income on capital gains (investments).

Second, the tax code of virtually any country is very complex. This allows the rich to hire fiscal experts that earn their own salary back by exploiting loopholes, litigating with the tax authorities, moving money into separate legal entities and offshore tax havens and maximising all available tax exemptions.

It’s how a US tycoon filed for bankruptcy at least four times without ever becoming poor. The poor don’t have the time, money or knowledge to use the tax code to their benefit.

The second reason is leverage: using debt to increase the returns on your equity – is another mechanism used by the rich.

Although I warned against using leverage in a previous column, the rich are smart enough to use limited liability companies to protect themselves from financial loss or even bankruptcy in case the leveraging goes wrong.

If the poor attempt to use leverage without such protection, they face much greater risks of financial loss than their richer counterparts.

The really rich never work for a salary as they understand you can’t scale that indefinitely. No matter how much you earn per hour, the number of hours you can work in any given period is limited.

The poor usually focus on their own labour, while the rich focus on growing assets which are independent of their own involvement, such as their own company.

Examples are rental income, interest and dividend, which keeps pouring in without additional work. By having multiple independent sources of income, they are also better able to survive financial shocks and can take on more risk.

Contrary to its name, the rich avoid “get rich quick” schemes, as they have the financial literacy to understand it’s a scam.

It’s also how the poor stay poor: they lose their money in these schemes and have to start all over again.

The “old boy’s network” is a milked cliché, but it surely helps to have heaps of social capital besides plain money.

Connections with universities, employers and government will make sure you have access to many more opportunities.

It also creates a network of contacts to pass on to your children to ensure the next generation stays as rich as you are.

This unequal access to opportunities does make it harder for a poor person to become rich and helps a rich person stay rich.

However, there is a silver lining to the increasing income and wealth inequality: absolute poverty has significantly decreased, thanks in no small part to China’s ascent on the economic ladder.

Despite this silver lining, we will never have a world in which everyone’s a millionaire.

Mark Reijman is co-founder and managing director of https://www.comparehero.my/, dedicated to increasing financial literacy and to help you save time and money by comparing all credit cards, personal loans and broadband plans in Malaysia.

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