Income and Interest - Don't confuse them

It is quite common for the concepts of income and interest to be confused and the terms used interchangeably. Bonds are often called ‘Fixed income’, but at other times as ‘Fixed interest’. Company profits are commonly called ‘income’. Some investment products that focus on company dividends are known as ‘Income funds’. Rent received on a property may be known as ‘rental income’. And of course, we all know about ‘income tax’. If we are to be precise in our use of these important terms, we need to understand the conceptual foundations of the two terms.

Many people understand income as their wages derived from employment. For a self-employed person it would be fees received for goods & services, net of various costs. Many people think income is the money paid into their bank account or that paid to them in cash. However, the money paid to a person in this manner is not income. Instead, the money is the good that has been exchanged for the income.

Income is better conceived as a steady flow of goods and services. Income is the hairdresser cutting the hair of a client. Income is the milk produced by the diary. Income is the goods and services that people use. A non-productive person may be getting paid a wage, but they are not generating an income.

When you are employed at a company, essentially you are paid in the surplus (after costs) goods and services of that company. Those surplus goods and services are typically sold by the company in exchange for money and then that money is used to pay wages. Wages could be paid in the form of company scrip with that scrip then used to purchase goods & services, often historically at the company store. Alternatively, you could be paid in the form of the goods and services. That is, however, subject to the problem of declining marginal utility for most goods and services. You only need so many haircuts and can only consume a certain amount of milk before getting sick. You could of course, exchange those surplus haircuts or milk for other goods and services. However, as haircuts and milk are not the most marketable goods / services, it is more efficient for you (or the company on your behalf) to exchange the surplus production for the most marketable good (money).

Importantly, income by its very nature is perishable. That is why surplus income must be exchanged, normally into money (the media used for indirect exchange). If the hairdresser doesn’t have a client who wishes to have his/her hair cut, then there is no income. If the milk is not drunk or used in production of another product, then it goes off and there is no income.

Income is therefore the goods and services we help produce. When a person is young and healthy, in their prime active years, they will consume some of this income (mostly through indirect exchange) and convert the remaining income into wealth. If the quality of the wealth is high, then in the future when the person is aged and can no longer produce an income, they are then able to offer that wealth to someone else in exchange for income. Wealth is therefore a form of store of future income.

Interest is quite a different concept. It is the incentive we are paid to convert short-term wealth to long-term wealth. If interest rates are zero or otherwise subjectively ‘too low’ for many, there is no incentive to hold long-term wealth. Instead, money is hoarded during active years and then dis-hoarded when that person is no longer productive. Long-term wealth is an important component of capital formation with the associated community benefits arising from capital investment. Similar to wages, interest is essentially paid in the surplus goods and services of that company. As such, it is quite similar to dividends, but given priority. A cap on interest rates is provided by the entrepreneur. If interest rates rise to too high a level, the entrepreneur will offload his capital and purchase bonds/own equity. If interest rates remain too high, the next marginal entrepreneur will never get into business.

It is important to understand the concepts of income and interest as they are key issues in the accumulation and then deaccumulation of wealth throughout our lives.