Legal tax avoidance, is it ethical?

Tax really hurts

There are two major themes in this blog, one is how to make money with other people’s money, and the other is how to reduce tax. This is because tax really hurts, $10,000 invested for 30 years at 10% annual return would yield:

$10,000 x 1.1^30 = $174,494

while after taking 30% tax each year, the result will only be:

$10,000 x 1.07^30 = $76,122

and if you let the portfolio grow for 30 years before cashing out, the return will be:

$174,494 x 0.7 = $122,146

Therefore, for investment purposes, whenever we can avoid taxes, we should. But the government also need revenue to perform their duty, so is it ethical for us to avoid taxes whenever possible? I think the answer to this question is yes, here’s why:

The government can print money

Let’s consider how economy works. Suppose there are 4 persons. Person A produces something that person B needs, person B produces something that person C needs, and person C produces something that person A needs. There’s also person D that produces nothing that nobody needs! Although persons A-C form a closed loop that everyone needs something from someone in the group, the needs are in a single direction, they don’t have something that everyone needs to pay back in return.

Now if the government prints some money which cost next to nothing, and give out to person D for free (akin to jobless subsidies) or for some type of service that person D can provide (public servant salaries), then D can buy something from anyone of persons A-C, and then the economic circle start rolling, and everyone can get what they need.

When persons A-C can sell their products for a profit, they will also have money to reinvest and produce more of the products, the government can then print out more money to reinforce the cycle. Therefore, as long as the economy is growing, the government will have significant revenue just by printing money. If the government is frugal as we investors are, this revenue should pay for a significant chunk of their expenses.

We already pay a lot of taxes

When we buy a house, we have to pay property taxes, this is acceptable, because the tax works to improve our lives around our communities. When we buy anything else, we also have to pay sales tax, this is also acceptable, because we only pay the tax if we buy things. But for income taxes and business taxes, I think the current system is screwed. There should be a flat low tax of let’s say 10%, this will encourage hard working because you wouldn’t be penalized for making more money.

Flat tax rate without the complex tax codes for deductions and tax returns will also eliminate the need of IRS, saving the government a lot of useful resources. The reason of income disparity is because of the ability to borrow money in the capitalist country, by taking money from the rich to subsidize the poor won’t work to improve the economy, actually it just encourage businesses to invest elsewhere. And if the economy doesn’t grow fast enough, both the rich and poor will be worse off, and the poor will definitely suffer more because when businesses don’t make enough money, they will just seek savings from the payroll department.

To solve the problem, government should discourage borrowing, and encourage investment in stocks. One of the ways is to eliminate investment taxes completely, after all, the companies we invest in already paid the taxes, why should we pay tax on the same income twice?

If everyone invests their money the way I described in this blog, and no short selling or derivatives trading are allowed, the stock market will be a safe place to invest and the DCA method I described will be even safer. When everybody invests, they will have more money to spend, and this will in turn drive economy to grow further, which is good for everyone, including the government since they can print more money when economy grows faster. Therefore, when we legally avoid taxes, we may actually be helping the government to raise more revenue since we will have more money to spend and they can print more money, this is better than paying taxes.

Stock market can also be a place where the government get their revenue

As I mentioned in earlier posts, modern economic crises are mostly caused by excess products, the way to solve the problem should be to encourage spending. But when the markets are in free fall, a lot of money is locked in the market. Most people won’t sell their holdings because they anticipate the market will eventually recover, but it also mean they wouldn’t have enough money to spend. This will delay the recovery and if economy goes into deflation mode, what happened in Japan can happen anywhere.

Although market is falling, a lot of investors will still have holdings that they bought at significantly lower prices, if the government intervenes by printing money to buy stocks in a controlled fashion so the speed of the drop is slowed, it will allow time for these investors to sell some of their holdings so they will have money to spend. This way, the economy will start growing more quickly and everyone will be happy.

Since it’s a fact that the market will eventually recover, dollar cost averaging is the best way for government to intervene too. DCA works best if we have unlimited funds so there’s no margin calls, and this is exactly the government’s advantage. They can just print the money in a controlled fashion, and pour into the market bit by bit until recovery is clear. This will also ensure that they don’t print too much money as to cause uncontrolled inflation. Since the government only started buying stocks when the market has fallen significantly, their entry price will be pretty low. When the market recovers, the government will set to gain a lot of revenue they can use to do a lot of things without raising taxes.

When both the investors and the government DCA in the above style, the boom bust cycle will get a lot shorter, and the magnitude of the swing will be limited, which will also make the DCA with margin method risk free.

Government is spending too much

There’s a lot of inefficiencies in the public sector, because when your job is secure, no one want to take responsibilities. The economy will be more efficient if the government is lean and outsource as much as possible to the private sector. The most important job of the government is to ensure competition, and the economy will adjust by itself. Again, if the government is frugal and efficient, we really don’t need to pay so much taxes.

The US elections got too crazy over the years, a lot of resources are wasted in the process. Yes we do need democracy, but democracy doesn’t mean bureaucracy. We don’t need all those campaigns, election should be in the local level, where the voters can really get to know the persons they elect. All upper level positions should be filled with election by the elected lower level officials based on the contributions of the candidates. Democracy is important, but what is more important is law and order, if justice can be served, we don’t have to pay too much attention to democracy.

The government also spent too much on arms and wars. It’s true that the government should keep a strong army to defend the country, but fighting too many wars also waste too much resources. On the terrorist issue, prevention is much more efficient then revenge, so the Afghanistan war shouldn’t have started, especially since there’s nothing to be gained in Afghanistan. The Iraq war was started purely by greed of oil, I don’t believe there’s false intelligence, he who has a mind to beat his dog will easily find his stick.

The calculation was, the army has a lot of old arms that need to be get rid of, a war will be the best way to do this as the army will also gain experience and new insights to future developments. The hope was that after destruction of Iraq, the reconstruction contracts will flow through to US contractors, thereby helping the US economy, all of which will be funded by Iraqi oil.

The intention was that the war can struck two birds with one stone, but bad intentions never yield good results. While the army did get rid of excess weapons, the government also spend too much money, and unfortunately most of the reconstruction contracts went to China.

Just from the prevention of unnecessary spending by the government point of view, we should avoid paying too much tax whenever possible, so before they plan something big,  they’ll have to worry about the budget first. Therefore, legal tax evasion is even more ethical.

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frugal vs stingy

As most early retirees have pointed out already, frugal living is the key to save enough for investment and therefore financial independence. I think I also do live a frugal life, but unlike Mr Money Mustache and many others, I won’t trade convenience to squeeze out some extra bucks for savings. As I mentioned in another post, my whole purpose of life is to enjoy myself, that means do things that please me the most, and buy things I like the most. The only reason stopping me from doing so would be the budget. As I pointed out in my rules of investment, we need money to grow money, and to borrow money we also need to have some down payment or collateral. The initial funds have to be saved, and therefore we need to save as much and as early as possible. However, if I have already saved 30% of my paycheck, then I spotted something that will increase my comfort or make me more happy, and I can afford to do so, I’ll still buy it.

Many early retirees advocate an efficient life, meaning you push yourself to spend the absolute möinimum to grow your nest egg, and convince yourself to be happy about it, even after you accumulated enough to afford a more luxurious life. I can’t agree on these points. My goal of life is to make sure at every stage of my life, the quality of life would be higher than the previous stages. To me, frugal living only means living within your means and most importantly, pay only the minimum amount that I know of for the same product. I don’t like to always convince myself not to buy, I would call that stingy. Again referring to my investment rules, money is earned, not saved. Rather than depressing your own desires in order to save, why not try to make use of other people’s money to work for you. That’s a more efficient way of growing wealth.

My thoughts on frugal living

About cars

Many early retirees advocate commuting on feet, bicycles, or when it’s necessary, a used car. It’s true that cars are the single largest depreciating assets we would normally own (except boats, of course), but it’s also the most convenient. Talking about depreciation, food actually depreciate much faster than anything else, it usually does not last much more than 24 hours and most of it is either turned into stools or consumed as energy. Does it mean we should give up on food altogether or consume only low quality bulk cheap food instead? Life is so short, we just need to enjoy whenever we can.

When I’m still a student, I used to cycle to school and work too. But back then my income didn’t justify buying a car, and I was living  near Sydney downtown, where it’s an absolute nightmare commuting in cars. The good part is that it forces me to exercise, but frankly I didn’t enjoy it after sweating all over and still had to study and work in the sticky shirts. On the other hand, my income did justify going to the food court for dinner, where the food was delicious and cheap ($6 one dish with rice). Although eating at home would be even cheaper, I’m not a good cook and didn’t want to waste nearly an hour to cook just to finish eating in 10-15 minutes. My mum is a good cook so I grown up to be a finicky eater, I can tell a dead fish from live ones by taste even if it was dead for only a couple of hours. Life would be miserable without good food, so my definition of frugal life doesn’t include saving on food, especially when food is not a big ticket item and wouldn’t defer my saving plan too much.

In America, all the shopping options are too far from each other for walking or biking, Living closer to work is also not always cost effective (for example, rooms in apartments next to my institute cost $600/mth, whereas the room I rented 10 minutes drive away was only 300/mth). Therefore having a car in the US is a must. Originally I also had the same understanding with other early retirees that a used car is more efficient, so I bought a 1995 Nissan 200sx for $1900. It worked well for me for a couple of years and it was sporty and trendy. I quite enjoyed it at first, but then problems started to show, I had to change the muffler, fix the transmission and finally the radiator started leaking. After 5 years I gave up and donated it to buy a new car. It still worked out to be a good deal considering the amount of money I saved, but the stress and trouble I went through is not worth it.

New cars do depreciate exponentially, but they also provide many useful new functions to keep up with newer technologies, such as usb charging slot, bluetooth sound systems, double or even triple charging spots, etc. It’s true you can add many of these functions with accessories at discounted price, but aesthetically it will look disastrous with all the extra wires hanging everywhere. I think frugal life should be a balance between cost and visual, mental and physical enjoyment. A new car definitely justify buying due to the enjoyments, so the next thing is to ensure I buy at a good deal. Frugal at this point means not buying on impulse and always compare before you buy. I waited until 2010 when the economy was so bad that I could negotiate very good deals, then I read reviews and determined Mazda 3 to be the best overall car for the look, the zoom zoom feel and the fuel economy. The decision was also based on the fact that at the time there was a promotion of 0% down and 0% interest for 5 years at Mazda dealers! Buying cars on finance is important as you can defer payments and use the funds for investments instead, to offset some of the cost. Before I went to dealers, I submitted a message through edmunds.com, then several dealers contacted me with offers. I did not mention the finance offer and was able to negotiate nearly 20% off the MSRP. When I went for the contract, I talked to them about the finance offer and they have to accept it too. The same strategy only landed me with a deal of 10% off MSRP for a Mazda CX-9 two years later due to improved economy, though with the same finance offer. Although the CX-9 is a large car and therefore not very fuel efficient (It did not help to be the all wheel drive version), I like it so much that I rank it as one of the best buys I’ve made so far.

About housing

I would define frugal living as living in as big a place as you need and can comfortably afford without disturbing your investment plan. The decision to rent or buy your primary residence should largely depends on the cost of each option. When I was single, all I needed is really a room to stay in. I eat out most of the time, and a room only cost less than $400/month. In the meantime, the house prices was near historical highs, the rent of a house at that time wouldn’t even cover the mortgage interest. Therefore, it made no sense to buy a house back then. Historically, real estate appreciation is at least 2% below that of the stock market, even before factoring in the high associated costs. The only benefit of buying a house is that you can have a high leverage without having to worry about price fluctuations, and for primary residence, another benefit is the tax-free gains. With price at all time highs, the benefit to risk ratio was not favorable. The safer way to grow wealth back then would be to rent and have the extra cash invested in the stock market. When the market tanked, it gradually became worthwhile to buy rather than rent, especially when I had plan to marry.

As a general rule of buying real estates, if it’s a primary residence, I would like the fair market rent to cover the mortgage payment, tax and insurance; for a rental property, I would need 10 month’s rent to cover the whole year of the above cost to allow for more maintenance and vacancies. At the depth of the financial crisis, I was able to buy properties at such depressed price that even 5 month’s rent would be sufficient the cover all the cost! However, those properties are in less than desirable neighborhoods, and are known to have a high default rate for rents (I experienced this myself, which would make another story). They are OK for rental properties due to the enormous buffer, but we wouldn’t want to live in those areas.  Fortunately, even in desirable areas, there were neighborhoods that are more depressed than others. We found our property east of the railway in Rockville, MD. It’s less classy than properties west of the railway, that’s why we were able to get a reasonable deal that satisfied my criteria for primary residence investments. The 4 br house cost $300k and the rent was about $2000. I could get a 5 year ARM loan at 3.25%, with a mortgage calculator the monthly payment would be $1300 even if all $300k was borrowed, plus tax of $300/month and insurance of less than $100/month, therefore we would be paying $300 less than market rent by owning the house. The house was less than 5 min walk away from the metro station, and less than 10 min walk away from the newly built and increasingly popular Town center. We know straight away we got a deal (The owner selling to us got a better deal, he bought it as foreclosure for $180k, added 2 bathrooms and some minor fix ups, and turned at least $70k profit in less than half a year), even if the price doesn’t increase, we were already better off. Better still, we rented one room out for $600/month, worked out that my wife and I would only pay $550 each for 3/4 of the house. A similar room in the area would rent more than that! In every angle, this would be a worthwhile investment. 3 years later, the economy proved I was right, we were able to sell it for a nearly $100k TAX-FREE profit!

Although in the past few years I’ve made some handsome profits in real estates, it’s only because of the timing of my entry and the locations I chose (the price of the houses in the “better” part of Rockville is virtually unchanged over these years).  In the long run, stock market still yield far more than the real estates market, actually, some beaten down well know stocks such as Las Vegas Sand (LVS) appreciated over 50 times from the financial crisis trough to the highs. The only benefit of real estate investing is the high leverage without margin calls, and the favorable tax treatment of primary residences. If the same can be done in the stock market, there will be no reason to invest in housing. My recent home purchase is a good example. I bought the house in Birch Bay, which is where I plan to retire (featured in the header photo). The house cost $430k since it’s still a depressed market now. I don’t know how much the owners spend 22 years ago to build it, I would guess in the $250k mark. The return over 22 years would only be ((430/250)^1/22)-1=2.5% per year, even if valued at $700k in the peak years, the return was only ((700/250)^1/22)-1=4.8%. Therefore, the numbers have to be right for me to invest in real estate, and I would only put down enough to get the best rate for the mortgage, and have as long a term as possible on the loan for minimum payment. The rest of my funds will still go to the stock market.

About shopping

Frugal shopping to me is basically to buy at a discount. Before buying anything, it’s always prudent to compare prices at different stores, preferably on the internet if possible. However, it’s a bit time consuming to do so, therefore after initial research we formed certain routines for our own shopping, which is listed below for your reference. It’s just our example, you may have better ways, if so we would like to hear about it too. Please share your experience with us.

We do most of our grocery at Costco and a Chinese supermarket. It’s not worthwhile to shop at Costco when I was single, but now I have a family it makes a lot of sense. I have their executive card, although it cost double the normal card, you earn 2% back on most purchases. We generally spend enough to get all the member fees back and then some each year. We also have the Costco America Express card, which is the only credit card accepted by Costco. This card gives another 1% cash back on most Costco purchases, and 3% back on the already cheap gasoline filling.

For the Chinese supermarket, we would use the Citibank double cash card to buy a $500 giftcard at the store, they will then throw in another $25 giftcard for free, this together with the 2% back at Citibank amounts to nearly a 7% discount.

For department stores, apparel stores and hardware stores, I would use the Citibank double cash card to buy giftcards for the stores at Cardcash.com, which can be bought at up to 20% discount. For online purchases, I would normally use Amazon with their credit card, which gives 3% back. At other sites it’s possible to use the giftcards bought at Cardcash.com too.

About credit cards

The shopping part pretty much explained how to take advantage of the cash back discount of various credit cards. Another thing I have to add is about the sign up credits. These credit cards give out between $100-$400 free cash after you spend certain amounts within the first few months. I only sign up for the ones I want to keep because I don’t like the trouble of applying. However, if you don’t mind the trouble, there’s a lot of free cash to be had!

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