Reduce Spending vs Increase Income

I currently aim to save 85% of my after-tax pay (as recommended by Early Retirement Extreme). I try not to tell too many people in real life about my high savings rate, but back in the days when I was more naive, I’d talk about my savings rate all the time, and one common response I hear is the recommendation that I should be focusing on increasing income rather than reducing spending.

My response to this recommendation is: why not do both? Why not increase income and reduce spending at the same time? Why assume that you can only do one or the other?

While I recommend increasing income and reducing spending at the same time, I recommend you put more effort into whatever gives the biggest bang for your buck. In other words, do what gives the greatest return on effort.

For example, when I graduated from university and started working, I was earning only $40,000, and four years later that has approximately doubled. I have received only one promotion. I am on a fixed salary with zero bonuses. I get paid the same amount regardless of my performance. I don’t consider this to be spectacular, but I have been saving approximately 80% to 85% during that time, and adding my salary plus my passive income from investments, my total income today puts me into a higher tax bracket whereby I pay approximately 40% on income tax. In other words, due to progressive income taxation, higher income is rewarded with higher taxes. I am a big fan of progressive income taxation mainly because it earns government significantly high tax revenues while also reducing the gap between rich or poor, but there is no disputing that for some people progressive income taxation reduces the incentive to work hard because once you are at a certain income, effort is not sufficiently rewarded.

This is why I prefer to save. Saving is easy. One very easy way to save money is to automate. For example, talk to HR and ask them to send 85% of your income into a separate savings account. All this will take about one hour. Assuming you earn an average salary of $50,000 and pay zero tax, you will be saving $42,500 per year. In other words, one hour of work will give you are return of $42,500.

Now suppose I were to try to increase my income. I’d have to search for jobs, catalogue my skills and achievements, update my resume, write a CV, talk to referees, apply for the job, talk to the relevant contact at the firm, practice for the interview, go to the interview, and follow up after the interview. All this will take maybe 50 hours and even then there is no guarantee I’ll get this job, and even if I do, the increase in salary is only about $10,000, and that is not counting taxation.

Which gives the better bang for your buck: one hour of work yielding $42,500 or 50 hours or work yielding $10,000? This is extreme example, but I think it illustrates my point.

Everyone is different. For those working in jobs that pay performance bonuses (e.g. real estate agents), a structure is in place that rewards hard work, so there is no question that you should be working hard at achieving these performance targets. Furthermore, while automatically saving 85% of income is easy for some, if your circumstances are such that you must spend a lot (e.g. you have a mortgage, children, or expensive housewife) then you may have no choice but to focus on increasing income rather than reduce spending.

The bottom line is that is does not matter whether you make money by making money or saving money (“a penny saved is a penny earned”). What matters is that you devote your limited time and efforts to whichever area provides the greatest return.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s