Unlocking the power of family tax
In FIREDOM, we discuss that income tax is often the largest line item in our expense list. Another equally formidable category of tax that requires understanding and optimization is "family tax."
"Family tax," known as "black tax" in African circles or "brown tax" in Latino or Asian circles, encompasses the set of expenses to support family or close friends.
Family tax has undeniable benefits; however, poorly designed family giving can impoverish the giver while not decisively improving the circumstances of the receiver.
Anatomy of the family tax
Family tax serves as a crucial economic driver. For instance, remittances are the largest and most stable source of foreign inflows to the developing world, surpassing foreign direct investment and development aid. In 2023, over USD 669 billion officially flowed to families globally.
In much of the developing world, family tax can be a safety net, similar to social security in developed countries. Parents care for young children, and when children get old enough, they, in turn, help cover expenses for aging parents. Relatives facing illness or unemployment receive help from employed family members. Those in high debt seek help to avoid the stigma of bankruptcy, dispossession, or jail time. Precarious situations are averted due to this well-understood social contract.
As with anything positive, family tax can become distorted. I have identified two main drivers of perversion: lack of ownership by the receiver and misalignment of incentives between the receiver and donor, both rooted in natural human tendencies.
Lack of ownership: What one does not directly pay for tends to be handled less carefully. When friends or family members receive money without working for it, they may not exercise the same restraint in spending as they would with their own funds. It can be hard to truly empathize with the donor who is typically wealthier. After all, "there must be more money from where they gave me."
Misaligned incentives: The donor's priorities often differ from those of the receiver. Human beings often prioritize instant gratification and status signals. For instance, you may want a family member to use the money you give them to pay for better schools for their children, but they may prioritize spending the money on funerals of an uncle who raised them or purchasing an iPhone, which confers instant social status.
An experiment in better family tax
Now, remember in FIREDOM, we advocate for values-based spending and turning expenditures into investments. As the payer of family tax, you have the opportunity to influence its allocation using a combination of incentives and disincentives. Understanding the receiver's incentive system allows for potential reengineering. I tried it out:
Because I live abroad, family members tend to assume I have a lot of money and turn to me first for contributions to various family events: a funeral of a distant aunt, the second wedding of a cousin, or seed capital for a family friend’s business. The more I give, the more requests came. I did not see the point of overspending on any of these expenses, but many in my family did because these expenses confer status and gratification to them.
A few years ago, I decided to take action and enhance the impact of not only my contributions to the family but also help other family members spend better.
I offered to fund the elite schooling of the daughter of a close relative.