I remember as a child going to the Hansen Planetarium in downtown Salt Lake City . I was mesmerized by what I saw there. In particular, I recall a large pendulum that swung continuously back and forth, slowly making a path that mirrored the Earth's rotation. Every five minutes or so, it would hit a piece of wood that would fall and make a chime. As it steadily moved its way across the floor, it would slow, then stop, and then gradually pick up speed and then swing the other way.
It would seem our government, our economy, our taxes and our laws go through similar cycles. After the highly regulated periods of the 60's and 70's, the 80's and 90's ushered in the era of deregulation. This freed up businesses to grow, but also opened the doors to those who would take advantage of lower oversight by government. This was punctuated in the early 2000's by the collapse of TYCO, Enron, Worldcom and the like, and more recently with hedge funds unwinding an estimated 60 trillion dollars in credit default swaps in their portfolios, contributing to the freeze-up of our credit markets and a general stock market decline.
The problem with the pendulum swinging back towards regulation is that we have to get used to the idea of government being more and more a part of our lives. Our government, by its very design, makes changes at a sometimes an excruciatingly slow pace. This helps prevent knee jerk responses based on today's headlines. Unfortunately, this sometimes makes it very difficult to make timely and necessary changes.
As this pendulum swings back towards higher regulation, I believe our taxes will swing back up with them, and there's not much we can do to change that.
Former US General Accounting Office Comptroller General David Walker of the US Government stated in an interview June 1, 2007 with Charles Wisniowski:
“Our financial condition is worse than advertised, and we face large, growing, unprecedented and unsustainable deficits based upon our current path. We need to engage in fundamental reforms of entitlement programs, spending and tax policies--and the sooner, the better.” (Source: Mortgage Banking, June 1, 2007)
In July of 2007 he said during an interview on CBS's “60 Minutes”:
"The fact is that we don't face an immediate crisis. And, so people say, 'What's the problem?' The answer is we suffer from a fiscal cancer. It is growing within us. And if we do not treat it, it could have catastrophic consequences for our country.
If nothing changes, the federal government's not going be able to do much more than pay interest on the mounting debt and some entitlement benefits. It won't have money left for anything else – national defense, homeland security, education, you name it."(Source CBSNews.com)
Fortunately, there are some things that can be done as we anticipate that change. I'd like to first make the case for where I believe we are, and then share with you some ideas on how you can apply that information and benefit from it.
Retiring Baby Boomers and Your Taxes
Let's start with how money is spent in our government. The federal budget is divided into two areas: mandatory spending and discretionary spending. Mandatory spending must be spent -it is the law. The only way it can NOT be spent is by changing the current laws. Mandatory spending is made up primarily of Social Security, Medicare, Medicaid, federal employee pensions, and interest on the national debt. Currently this makes up approximately 2/3 of the entire federal budget. (Source: Congressional Budget Office)
When we hear about politicians wrangling over budget cuts or increases, they are generally referring to the discretionary spending, or the other 1/3 of the budget. This includes things like the military, education, roads, and law enforcement.
In recent years, many financial experts have warned that our government is facing a financial crisis as the huge number of baby boomers, approachinging retirement, will begin applying for their benefits. The graph below shows us the number of people in our population by their ages. The red highlighted section on the lower left side of the graph is the group that is currently age 65 or over. This is who we are primarily providing benefits for now. (Source H.S Dent)
(Source HS Dent)
It's a small group relative to the whole. If we take out the interest on the federal debt, we are paying approximately 54 cents of every dollar of revenue that comes in to cover their benefits. According to the Congressional Budget Office in January of 2008, it breaks out like this:
Total expenses FY 2007:
581 Billion (21.5%) Social security
534 Billion (20%) Medicare & Medicaid
202 Billion (7%) Federal Pensions
238 Billion (9%) Net interest on debt
133 Billion (5%) Other mandatory spending
1.68 Trillion (63.5%) Total Mandatory Spending
2.57 Trillion Total Revenue
Now look at the section highlighted in yellow on the same graph, showing the group of baby boomers who are approaching their retirement years. They are the ones who will be stepping up demanding those same benefits over the next 20 years.
Consider this: not including the interest on the federal debt, we are currently paying 54% of all income paid into the federal government for entitlement benefits for the group highlighted in red. That is our CURRENT obligation.
In the future, we'll be paying for the group in yellow. The huge group of people in yellow has also paid their taxes over the years, and will be expecting their benefits. How do we afford that? The government is already spending more than it brings in. As I see it, our government has 4 tools to deal with these increasing expenses:
- Reduce spending
- Go into more debt
- Reduce benefits
- Increase Taxes
The currency printing presses have been working overtime this past year, as one bailout after another has passed in an attempt to stem the tide of a slowing economy. The amount our government has paid for mandatory entitlement spending has increased dramatically in previous decades. The graph below shows how mandatory spending has increased from less than 30% in the 1960's to more than 60% today. Can you imagine what the discretionary spending will look like when the majority of the baby boomers are receiving Social Security and Medicare benefits in the coming 15 to 20 years?
In general, taxes tend to be lower in a strong economy, and higher in a struggling economy. The following graph shows the history of the highest marginal tax rates since they were instituted in 1914. Notice how high taxes went during World War I, and then dropped during the Roaring 20's, only to shoot up dramatically during the Great Depression and World War II. Look at where we are now. We are currently enjoying some of the lowest tax rates we have seen in nearly 50 years. How long do you believe that will last in this economic environment?
As this pendulum swings back, we need to be prepared for potentially significant tax increases and decreasing benefits in coming years. We also need to review those benefits that we may be taking for granted for our own retirement.
This is a time for all of us to re-evaluate the assumptions we may have concerning the benefits we are anticipating, and what will happen to those benefits if taxes go up as expected. It is also a time to take advantage of tax benefits that may be available to you, that could help to insulate you from future tax increases. That will be the topic of the next column.
Thom Hall is a registered representative of and offers securities through Securities America, Inc., member FINRA/SIPC. Advisory services are offered through Securities America Advisors, Inc. Securities America and Financial Strategies Institute are not affiliated.
Securities America and its representatives are not tax advisors and do not provide tax advice. The tax information provided here is merely a summary of our understanding and interpretation of some of the current income tax regulations and is not exhaustive. Please consult a tax advisor regarding your personal situation.
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