THE BLOG
12/05/2012 11:47 am ET | Updated Feb 03, 2013

The Fiscal Cliff and the Two Percent

The top story in the news these days is the "fiscal cliff." I'm a general studies major and don't know all that much about taxes and net worth, so I need some help understanding who the top two percent are.

The Democrats are proposing increasing taxes on the wealthy, that is, the top two percent. I think most thinking Americans -- Republicans and Democrats -- have come to realize that we cannot solve our country's financial problems unless we increase revenue and cut expenses, so I'm not concerned here about the "merits" of whether or not the wealthy should pay more taxes. What I'm concerned about is who the wealthy are that should be paying more taxes.

As I understand it, the Democrats are proposing to raise taxes on the top two percent -- that is, those individuals who are making $200,000 per year or more and those households making $250,000 per year or more. I'm having a problem with defining wealth in terms of annual salary. Am I wrong in my thinking?

Suppose someone (let's say her name is Alice) started a small business from scratch several years ago when her husband left her and their three young children to fend for themselves. After struggling for several years to take care of her family and keep her business going, this year Alice is finally making some real money. But to get where she is this year, for many years she had to scrape and borrow from every possible source. Now that she's turning a profit, Alice has to work at paying back those loans, including a short-term second mortgage on her house and loans from her parents who need the money now that they are retired.

Just because Alice makes $200,000 this year, she is, in my way of thinking, far from being wealthy. In fact, she is heavily in debt. Furthermore, she has not been able to put any money into an IRA, a 401(k), or any other retirement account.

We see this same "bottom-line" repeated in real-life scenarios again and again, whether they pertain to owners of a new or well-established business: they have had to borrow money to get where they are now, will probably have to continue borrowing money to stay updated and competitive, and have very few assets to show for their many years of having to struggle. Yes, they now are making $200,000 or more, but are these people really wealthy?

Let's take a completely different situation. Joe has been a relatively successful businessman who has been a savvy investor and manager of his money. Through the years he has invested in low-income growth funds that produce little current income, as well putting the maximum amount allowed into an IRA account annually. His wife doesn't work outside the home, and Joe intentionally keeps his annual income just below the $200,000 level.

He puts lots of money back into his business on a regular basis buying new equipment and updating his building, thus increasing the value of his business. He built a home-office addition to his house, paid for by the business. And since he and his wife use their house for meetings and entertainment related to his business, the business paid for new kitchen appliances and better air conditioning equipment, as well as for refurbishing the main areas of the house every few years. When they travel, he tries to do something related to his business, so at least his expenses can be reimbursed by the business. And, occasionally, when Joe and his wife want to do something special, he takes a little over $200,000 in salary, knowing that they will be in a higher income tax bracket that one year, but the next year he will be sure to have his salary back below that $200,000 level.

Joe's investments and IRA account have continually increased in value, as have the resale values of his business and his house. As his low-income growth funds have continued to increase in value and Joe has realized more annual income from them, he has taken a lower annual business salary, keeping his total income below the $200,000 level. As the cash reserves of his business have increased, Joe has used those additional funds for expansion and acquisition purposes. He has very little debt and lots of valuable assets.

Just because Joe manages to keep his annual income below $200,000 for most years, does that really mean that he is not wealthy and, therefore, should not have his taxes raised?

Let's compare the Alices of the world to the Joes of the world. The Alices have very few assets, lots of debt, and no retirement funds or financial reserves, but are considered wealthy because they are finally able to turn a profit of $200,000. They would have their taxes raised under the plan floated by the White House. The Joes, on the other hand, who have little or no debt, have nice houses, businesses with cash reserves, and lots of long term growth investments, as well as IRAs that they add to each year, make less than $200,000. They are not considered wealthy -- thus falling into a lower tax bracket than the Alices. This just doesn't make sense to me. What don't I understand?

Who can help me out with this? Who are the wealthy?