The 500 Pound Gorilla: The Future of Taxes in America

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Many experts and economists in this country believe that there is only one way for taxes to go in our country– upwards. With the mounting debt we have built up and decreasing taxable revenue coming in from an aging population, it is their belief, and mine as well, that the federal government will be forced to make some tough decisions in order to begin fixing the problem.

This can be a deeply political and controversial subject, especially when speaking about government spending. Nevertheless, the implications are real regardless of the side of the aisle you associate with.

When all is said and done this year in 2014, according to the Congressional Budget office, the fiscal deficit in our country will be $492 Billion which is 2.8% of GDP. This is actually a third down from the $680 billion and 4.1% of GDP in in 2013 and significantly down from the 9.8% of deficit to GDP in 2009.

The deficit in our country has been decreasing! However, that’s not the end of the story.

Again, according to the Congressional Budget Office, if current laws do not change, the period of shrinking deficits will soon come to an end. Between 2015 and 2024, our annual budget shortfall is projected to rise substantially—from a low of $469 billion in 2015 to about $1 trillion from 2022 through 2024—mainly due to the aging population, rising health care costs, an expansion of federal subsidies for health insurance, and growing interest payments on federal debt.

This is the 500 pound gorilla in the room.

If these projections are in fact correct, our Federal deficit as a percentage of GDP will approach the level that it was in 1945 when our country was at the climax of World War 2, the time in our history where we experienced the highest tax rates.

Now, I think it’s important to clarify the difference between debt and deficit because they are two separate things.

Debt vs. Deficit

Basically a deficit is the difference between the money the country takes in and the money the government spends. The debt is an accumulation of deficits over the years. And according to the, the current US Debt stands at roughly 17.5 Trillion even though many economists including David Walker, the former Comptroller General of the United States, believe that number is unrepresentative of the actual debt our country has. 

According to the Congressional Budget Office such high, and rising debt will have serious negative consequences. Federal spending on interest payments would increase considerably when interest rates rose to more typical levels.

In other words, right now with the low interest rate environment, the Federal Government is benefiting by paying less on its debt. If interest rates were to rise, as they will in the foreseeable future according to the Federal Reserve, not only will consumers pay more for capital but the Federal Government will as well.

Not to mention that if the United States were to go to war, government spending on defense would also need to increase likely causing these deficit projections to increase.

Clearly, this is a problem is the main reason tax rates in the future will have to increase.

Can’t we Just Grow Our Way Out of the Problem?

One argument that is often thrown around in regards to dealing with the problem of the deficit in our country is that we can just “grow our way out of it”. In regards to that question, David Walker said this: 

“I don’t know anybody who has done their homework, who has researched history or who’s good at math, who can tell you that we can grow our way out of this problem” -David Walker

 Former Comptroller General of the United States of America

Clearly growth in the economy means federally taxable income increases. That’s fantastic, and we’ve seen how well the economy has been doing in recent months, but that’s not going to be sufficient to solve the problem.

 Spending Will Increase In the Future

The percentage of the financial budget that is spent on entitlement programs which include Social Security, Medicare and Medicaid is roughly 45% annually.

In fact according to the congressional budget office, total spending on mandatory entitlement programs was $861 billion in 2013, projected to be $933 billion in 2014, $1.018 trillion in 2015 and $1.738 trillion by 2023.

This means that the percentage of spending on these “mandatory entitlement programs” is slated to increase!

And where is the budget projected to decrease?

In discretionary defense spending.

At the same time we have to keep in mind that with our mounting debt, the percentage of the federal budget spent on interest alone, will increase.

How Do We Solve the Problem?

To address the problem David Walker, the former comptroller general of the United States, says the government will either have to:

  1. Cut Spending
  2. Print Money
  3. Borrow More Money
  4. Or Raise Taxes

When looking at these four options the only two viable options are to raise taxes or cut spending.

We know the two major parties in our political system are at odds about which one to do. However I do think the elderly voting population would run anyone out of office that wants to cut spending putting in danger the benefits they’ve been paying into their entire lives, which leads us with one option- to raise taxes.

Let’s hash that out. Is that really the only option? let’s look at those four options and discuss if raising taxes is in fact the only option.

Cut Spending

When you look at the spending our country does, in 2013, 42% of “mandatory” spending was on entitlement programs like Medicare, Medicaid and social security. That number is projected to increase to 48% of mandatory spending by 2023, which is 9 short years away.

Where’s the “Fat”?

If you look at where else the federal government spends money, there would be unhappy people no matter where cuts take place. How do you decide between cutting Social Security, which people have paid to their entire working careers, or defense, which keeps our country safe. What about veteran support, which accounted for $80 billion in government spending in 2013?

Deciphering where the “fat” is, is already a point of contention in congress. If the program you benefit from is cut, chances are you will get out and vote. I think a number of career politicians in Washington know that, which makes cutting spending in general a very difficult option.

Continue to Print Money

I understand that a lot of the stimulus in the last five years or so has been done by “crediting accounts” which isn’t necessarily “printing money” however, let’s be honest with ourselves!  During QE3(the third round of government economic stimulus), when the Fed bought bonds from banks it did so by crediting those banks’ accounts at the Fed with reserves that didn’t exist before.

Although this is not technically “printing money”, creating reserves that didn’t exist before sounds pretty close to printing money in my opinion.

To take it a step further, this solution doesn’t even make sense! By essentially creating money or attempting to pay off the country’s debts through capital creation, the dollar will be devalued. There would be a negative global impact and our economy would suffer. It’s definitely not the solution, and the US Government knows it.

Borrow Money

This solution doesn’t make any sense either. This is like paying off your car loan by putting the balance on your credit card. It’s robbing Peter to pay Paul. Essentially shifting money around in the system which in the end, does nothing.

Raise Taxes

To truly deal with the issue we believe the United States would need to raise taxes.

According to David Walker, for the US not to default on the national debts, we would have to double tax rates by 2023, by then the national debt will be 53 Trillion dollars at which point, according to Walker, there would only be enough revenue coming in at current tax levels and population and employment estimates, to pay the INTEREST on the debt.

Taxes are Already so High!

I know what you’re thinking “but taxes are ALREADY so high!”.

Here’s my guess… when the conversation about increasing taxes comes out, the White House will begin a media campaign about this issue.  This media campaign will focus on how much other industrialized countries currently pay in taxes.

We’ve seen the media campaigns in recent years that attempted to change public opinion about healthcare, gay rights and now the minimum wage.

I’m guessing that when the subject of increasing taxes comes about, the media will talk about how in Denmark if you have an annual income of over $55,000 a year you’re taxed at the 60.2% tax rate. Or in the UK and Austria, how the top tax rate is 50%+, or Belgium 64% or Sweden 57%.

Let’s say taxes are raised in the future, what can you do about it right now?

If you currently have a traditional IRA or 401(k), you have invested in a tax deferred vehicle, meaning you don’t pay taxes as the money goes into the account but when you get to retirement and you take money out of that account, you will pay taxes then. The greatest benefit is that contributing to these accounts limits your reported income, and could lower your tax bracket.

The vehicle that you choose really should be determined by where you and your financial advisor believe taxes will go in the future.

Because different vehicles have different tax implications, we believe you should use these vehicles strategically, in a combination that limits your taxes but takes into account your goals and needs.

We suggest is you max out your Roth IRA which allows you to pay taxes on a smaller amount of money now than when you draw it out in the future. If you are close to a lower tax bracket by the amount of money you and your spouse make, we may recommend that you contribute to your 401(k) or traditional IRA just enough to jump down to the next lower tax bracket. Something else to consider is how much of your money you expect to draw out during retirement. A Roth IRA, unlike a traditional IRA is not subject to RMD’s which would allow you to keep the money in your Roth IRA, undisturbed for as long as you live.

What happens if you make too much to use a Roth IRA? There are creative solutions you can elect to manipulate certain life insurance products which can imitate the tax benefits of a Roth IRA. The life insurance route is a complicated one and we encourage you to speak with an advisor about it as an option for you.

Give us a call if you have any additional questions about your specific situation. 360-828-1469