For those who have gone through life shying away from anything involving numbers, the demonstration of the principle of compound interest is usually an eye-opening revelation.
It’s quite simply, actually. Money set aside today accrues interest, if it is wisely invested. But so does the interest on what you set aside yesterday. Over a longtime span, this snowballing of interest on interest can build up to a sizable nest egg.
That’s why financial advisors always tell you to start saving for retirement while you are younger, even if the amounts you set aside are fairly small. It is also why tax policies that make investment income from retirement savings tax exempt can have such a powerful impact on wealth, even if the income you draw from those plans later in life is fully taxed.
It’s a story about numbers, so it takes a few to explain it. If you are in a 25-percent tax bracket, and set $100 dollars of your after-tax wages aside each month, after 40 years you would have about $134,000 in savings to spend as you wished. But if you saved with pre-tax dollars, in a tax-exempt account, your nest egg would be almost double that size, more than $265,000. Even after paying taxes on the income you draw out, you’d be well ahead.
But the Relevance of the story of compounding is not limited to financial planning. The same phenomenon helps explain why Indiana’s dubious status as a state where people smoke more than average exacts such a heavy toll on productivity and output in the state’s economy.
If that sounds like a stretch, consider the following. We know that smoking and premature retirement and death because of smoking-related illnesses are closely linked. Formally speaking, we might say that the survival rate for a smoker of any age — the probability that they will remain alive until next year — is lower than that of a non-smoker.
In fact, the voluminous research that has been conducted on smoking and health has given us some fairly accurate estimates of these rates, which must take into account other factors affecting health, like weight and exercise habits, which may also vary between those who smoke and those who do not. And the differences in these survival rates, while small, can have an enormous impact on the workforce and the population, through the process of compounding.
Let’s take the optimistic scenario first. If we could wave a magic wand and turn our state’s population into people who had never smoked, we’d all enjoy higher survival rates. As a result, there would be more of us in every age category next year at this time. Applying higher survival rates to that larger group yields yet a larger increase each successive year.
Compounding forward into the future, we can see that a small change in survivability accumulates to much more significant increase in population over time. Many of those who would be added would be in the prime of their working lives.
Now it is back to reality. Indiana is a heavier-than-average smoking state. We pay the price for that in the form of lower, not higher, survival rates. And the compounded impact of that unfortunate fact over the decades of time that have already elapsed is that we have lost many workers and consumers throughout the economy.
That’s not the only way in which smoking impacts the economy, of course. But as we discuss whether or not smokers take more breaks, get sick more often, or require more cleaning up after than non-smokers, we should remember that the largest impact of them all may be the one we don’t see. That is the folks who are no longer with us.
Patrick M. Barkey is director of economic and policy studies at Ball State University’s Miller College of Business.