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Balance sheet, not income statement
Even very high current compensation is an inefficient way to build the net worth that makes that flexibility possible. Current income has two problems: it is very tax inefficient, and it is hard to keep life from creeping into how it gets spent. A graduate with a group of friends wants to live in the same neighborhood they live in and drive the same kind of car, and before long spending rises to match.
Search funds, a model where investors back a first-time CEO to buy and run a company, avoid both problems. The CEO is paid enough to lead a normal, full life but not an excess amount, and holds a significant ownership stake in the company. With no room for excess spending on a current basis, it works like a forced savings program. At the end of four, five, six, or seven years, the CEO has built very significant net worth, and none of it was current income.
Why does lifestyle creep happen?
Psychologists Philip Brickman and Donald Campbell described the hedonic treadmill in 1971: people adapt to better circumstances and return to a similar baseline of happiness. As income rises, what felt like a luxury becomes normal, and the next level of spending starts to feel necessary. Comparing oneself with peers who earn and spend more speeds the pattern. A 1978 study by Brickman and colleagues found that lottery winners were not markedly happier than a comparison group.
Why do wages face more tax than equity?
In the United States, wages are taxed as ordinary income and also carry payroll taxes. Gains on stock held for more than a year are generally taxed at lower long-term capital gains rates, and only when the stock is sold. Until then, unsold gains keep growing untaxed. Payroll taxes apply to wages and generally not to long-term gains.
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