Should we be planning for higher taxes in the future?

[Michael E. Kitces]

With the discussion of our present and rising Federal budget deficits, many planners seem to be taking the view that 'taxes must inevitably be higher in the future' - and are therefore taking planning steps in anticipation of that result, ranging from a wariness towards deferring 'too much' income to the future to completing Roth conversions.

While it is hard to imagine that our Federal budget deficits will be solving by spending cuts alone - implying that some aspect of higher taxation may be likely - does that necessarily mean that we should be taking extraordinary steps to avoid higher tax rates in the future? Or perhaps of greater impact - what if the higher tax rates of the future are not higher tax rates ON ORDINARY INCOME?

For instance, the Federal government generates revenue intended for Social Security and Medicare using payroll taxes (and beginning in 2013, a tax on unearned income for higher income taxpayers). If Congress chooses to address the deficits in entitlement programs by simply increasing the tax rate under the current system - e.g., increasing payroll tax rates - we may face higher taxation in the future, but not the ordinary income we might have anticipated. Higher payroll taxes do not affect our IRAs, for example, even though they are 'higher tax rates in the future'.

Alternatively, it is also notable that we are one of the few developed countries in the world that does not use some form of consumption tax - a national sales tax, or a value-added tax (VAT). What if Congress chooses to 'raise taxes' in the future in the form of a consumption tax, instead of an income tax? Will that affect the strategies we are implementing today?


What does everyone else think? Are you planning for higher taxes in the future? What KIND of taxes of you planning for? What steps are you taking (or not taking) in anticipation of future tax law changes?


Respectfully,
- Michael


=====
Michael E. Kitces, MSFS, MTAX, CFP, CLU, ChFC
Publisher, The Kitces Report, http://www.kitces.com

[Bob H]

Michael:

Interesting question. I'm 99% convinced there will be higher taxes in the future. In Chicago, they raised the sales tax (10.25%). They raise RE taxes. The near-bankrupt state of Illinois also just announced a 9% tuition increase for state schools. (I love when people say there is no inflation.)

The "how" question will come down, unfortuantely, to silly political games. If they continue to play "soak the rich" then income taxes will rise. If they want to hit everyone, then it will be a VAT.


I did a little research on Greece. Did you know their VAT is as high as 26% on some items AND they also have an income tax over 30% with incomes as little as $50K euros? If we start down the VAT road, there will be no turning back. And certainly no reduction in income taxation.


The real question is can the Gov't cut spending. I personally have no issue with paying higher taxes but AFTER the spending gets reined in. And that includes both dysfunctional parties in office.

Without that, we could easily go the way of countries with enormous VAT AND income taxation.



My personal recommendations have been toward Roth conversions and stuffing cash into permanent insurance.

Guess we'll see in a few years...



Bob

[Vig Oren]

Alternatively, it is also notable that we are one of the few developed countries in the world that does not use some form of consumption tax - a national sales tax, or a value-added tax (VAT). What if Congress chooses to 'raise taxes' in the future in the form of a consumption tax, instead of an income tax? Will that affect the strategies we are implementing today?

Mike, Bill Bernstein, in his 2010 book, predicts that income tax rates will rise. But let me ask you this:

Even if tax rates rise, how will it cover the Gov needs if expected returns on investable assets will be so low as Bill Bernstein predicts?

From Bill Bernstein's 2010 book “The Investor’s Manifesto”
here is a forecast to apply from 2009 forward:

EXPECTED REAL RETURNS

T-Bills................(-2%)
Treasury Notes....(-1%)
Corporate Bonds....2%
Lrg cap-U.S..........4%
Lrg cap foreign......5%
REITs..................6-7%
Sm and Value.......5-8%

*********************

Bill Bengen, CFP(r), is also worried about "where is the beef?"

Excerpt from William Bengen’s recent interview:

Bengen, who believes that a buy-and-hold approach does not work when the markets are volatile, has switched over to being a trading investor, a role he says is more appropriate for these times.

"I think it should be part of our education as financial advisors-the nature of post-bubble markets, and how you have to deal with them differently," Bengen says. "They are not the same animal."

And so, a new question is dogging Bengen. The U.S. economy is deeply indebted, investors and corporate managers have gotten used to government bail-outs and unemployment is stubbornly high, he says. If overvalued stocks are returning around 7% [nominal], and bonds are delivering 3% [nominal], then how will investors generate the funds to sustain 4% [real] annual withdrawals?

++++++++++++++++++++++++



So, another kind of revenue, instead of the current tax system, seems to be inavitable. You can't draw blood from a stone!




Avi/Vic/Vig

[Vig Oren]

Is anyone not agreeing with this?



The Obama administration has indicated that it intends to allow the Bush-era tax cuts to expire as scheduled at the end of this year. If that happens, (at least) two important changes will result:

1. Dividends would no longer receive preferential tax treatment compared to other income, and
2. Long-term capital gains would be taxed at a maximum rate of 20% rather than 15%.

Realizing Gains at Current Rates


Obviously, if the tax on long-term capital gains is scheduled to increase by one third, many investors would do well to realize some of their capital gains now rather than later. Naturally, there are exceptions. Included among the group of investors who might not want to realize their capital gains would be:

• Investors who don't expect to need to sell their holdings during their lifetime (and whose heirs could, therefore, take advantage of the cost basis step-up that occurs for inherited property),
• Investors who are currently in the 15% LTCG tax bracket and who expect to be in the new 10% LTCG bracket in later years, or
• Investors for whom the realization of capital gains would have other adverse tax consequences that would outweigh the benefit of the currently-lower rate.

Impact on Asset Location Planning



If dividends are taxed as ordinary income, stocks' tax-efficiency relative to taxable bonds will be reduced significantly. As a result, the benefit offered by tax-sheltering bonds prior to tax-sheltering stocks would likewise be reduced. On the other hand, one aspect of AA will become more important: whether you tax shelter your growth or value holdings. For investors in taxable accounts, growth stocks and funds (with their low dividend yields) will become more attractive relative to value stocks and funds. And to the extent that we can expect that newfound attractiveness to drive growth stocks' prices up (and future returns down), value stocks will become relatively more attractive to investors in IRA or other tax-sheltered account.

*******************

[Bradly T.]

The 2011 sunset WILL increase income/gains taxes next year, HOWEVER, as Bob H. points out, the specific form of tax increases in the future are uncertain. Predict the party in power and you can better predict the FORM of taxation; also based on Presidential signature/veto of course. The Republicans, if in power, WILL (and almost always have) reduce tax bracket rates on earned, dividend, and gains income - for the purpose of increasing revenues (not out of any altruism or conservativism - simple economics called supply side - the smaller slice of the bigger pie!!).


Tax deferred and tax exempt options will look VERY good next year and maybe for a long time to come!! Agree with Vig that active trading and high turnover funds will be even less tax friendly. By the way, the specific root cause of Enron was the taxation disparity between gains and dividends in the 90s - investors preferred gains (even if books were cooked to boost share price) and executive options/bonuses were goosed by same incentives. Only dividends verify profits...all else can be smoke and mirrors. The tax code moves money like no other agent....we need to be careful of the incentives.

[Michael E. Kitces]

Michael:

Interesting question. I'm 99% convinced there will be higher taxes in the future. In Chicago, they raised the sales tax (10.25%). They raise RE taxes. The near-bankrupt state of Illinois also just announced a 9% tuition increase for state schools. (I love when people say there is no inflation.)

The "how" question will come down, unfortuantely, to silly political games. If they continue to play "soak the rich" then income taxes will rise. If they want to hit everyone, then it will be a VAT.


I did a little research on Greece. Did you know their VAT is as high as 26% on some items AND they also have an income tax over 30% with incomes as little as $50K euros? If we start down the VAT road, there will be no turning back. And certainly no reduction in income taxation.

...

Bob

Bob,
Indirectly, I think your Greece example this is part of the point, though. Yes, their aggregate tax burden may be higher than ours, through a combination of their VAT and income taxes. But if their "top" tax rate is only 30%, that's actually LOWER than ours.

What if our future world of taxation here in the US is a significant VAT, and a top INCOME tax rate of 30%. Does that change the planning steps we would take?

Respectfully,
- Michael

[Bob H]

Michael:

Certainly if we knew for sure that future rates would be capped at a lower rate than today the choices and decisions would be impacted. For example, we certainly wouldnt recommend Roth conversions today.

I've done my own survey of trusted tax folks that I use or services I subscribe to and their consensus seems to be, with or without a VAT, future rates have a low probability of being reduced. Think this through... the VAT really hits lower incomes hard. Politically, I don't know how they could due that AND lower taxes on the 1/2 of the population that actually pays income taxes.


Best we can do is make choices based on what is "reality" today. Hopefully we never have filibusterer proof majorities on either side in the future.

Bob

[Bradly T.]

To Vig's point above (that poor future gains and dividend returns will decrease federal and state tax revenues), does anyone know the ballpark % of fed revenue from the taxes paid by investors?? And what % of revenue comes from corporate taxes?? Payroll taxes?? Are individual/family income taxes the largest % of revenue now?? Aren't these the 4 primary revenue sources?? And the VAT is another form of corporate tax....a national wholesale sales (value added) tax stream to the Feds rather than the states (retail sales tax). So the VAT becomes the fifth primary federal revenue pipeline.


While I agree with Bob that the price increases resulting from the VAT would hit the poorest the hardest, I fear the populist rhetoric of "tax those damn underpaying corporations" will gain traction by both the ignorant and the wealthy (the wealthy may understand the price result of VAT but they will also understand it is a substitute for higher rates on them). If Vig's return projections above are correct, then decrease them further by the net effect of VAT - the tax burden either reduces profit (gains and dividends) or reduces sales by pricing increases to offset VAT (which reduces profits). Must also agree with Bob on small chance of other tax relief other than token cuts to feed the populist beast to favor the "new" tax source. As we all know, every tax dollar comes from the citizen pocket either directly or in higher prices....corporation do NOT pay taxes really - taxes are just another cost element to price, paid by customers/citizens. So call it anything you want, I know who's wallet it really comes from and I know that ain't rain on my foot........

[Vig Oren]

Brad, notice here that VAT has nothing to do with the income tax system or "the VAT would hit the poorest the hardest":




http://en.wikipedia.org/wiki/Value_added_tax



It would though affect all via manufacturers raising prices on goods.



I saw a poster saying that it will catch the income tax cheaters.

[Michael E. Kitces]

Brad, notice here that VAT has nothing to do with the income tax system or "the VAT would hit the poorest the hardest":




http://en.wikipedia.org/wiki/Value_added_tax



It would though affect all via manufacturers raising prices on goods.



I saw a poster saying that it will catch the income tax cheaters.

Vig,
VAT-based systems are viewed to be partially "regressive" (affecting lower income folks more than higher income folks), because consumption on basic necessities tends to be a larger proportion of spending for lower income folks and VAT costs typically are passed through as higher costs to consumers. Thus, for example, is the cost of bread is increased for everyone in the country via the pass-through costs of a VAT, it affects "the poor" more than "the rich" since the poor spend more of their income on bread.

There are some workarounds to this - such as excluding certain goods from a VAT in pursuit of diminishing the "burden" on lower income folks - but of course this makes the VAT more complex and potentially more difficult to administer.

Supporters of the VAT also point out that because the tax is typically levied on manufacturers, it is typically much harder to "avoid" and underreport than an individual income tax; thus, to the extent there is less of a "tax gap" (the difference between what the system is supposed to collect, and what it actually does collect), it can be said to stop (albeit indirectly) some forms of income tax cheating (i.e., you may underreport your personal income, but you can't escape the fact that the stuff you buy has a higher price because the VAT was already levied on the manufacturer before the product ever showed up in the store).

Respectfully,
- Michael

[Bradly T.]

Vig - Right. VAT is a whole-sale tax levied on product as it moves through the processing/manufacturing system. Based on how it's applied it IS a regressive tax system by price increases to consumers - the less money you have, the less product you get for your money. Wouldn't this also make imports more competitive and hurt U.S. producers in our domestic market? And our exports would also have a new and higher cost element for U.S. produced goods.


The only way it would reduce income tax cheating is if it were a replacement tax system....but it's not; it's an additional source of revenue not designed to displace anything but increase total federal receipts. Agree it's a harder system to cheat, it just won't reduce income tax avoidance behavior so long as there is an income tax. Still believe the political pendulum will swing again and the other party WILL reduce income tax rates (again, to increase revenue); I can't believe the party of business will allow the VAT if they have the power to kill it; that won't take too many more seats come November.

[Vig Oren]

An interesting history of VAT in Israel (overe ther it is enforced by Customs officers):



Source: http://www.finance.gov.il/customs/eng/mainpage.htm



Q: I am interested in receiving the history of the V.A.T. rates, from the date it came into force until today.


A: The V.A.T. Law came into force on July 1, 1976, at that time the tax rate was 8%.
On November 1, 1977 the V.A.T. was raised to 12%.
On August 1, 1982 the V.A.T. was raised to 15%.
On June 1, 1985 the V.A.T. was raised o 17%.
On July 1, 1985 the V.A.T. was lowered to 15%.
On March 1, 1990, the V.A.T. was raised to 16%.
On January 1, 1991, the V.A.T. was raised to 18%.
On January 1, 1993, the V.A.T. was lowered to 17%.
On June 15, 2002, the V.A.T. was raised to 18%.
On March 1, 2004, the V.A.T. was lowered to 17%.
On September 1, 2005, the V.A.T. was lowered to 16.5%.
On July 1, 2006, the V.A.T. was lowered to 15.5%.

[Bobbie]

Michael,


I agree with Vig. I can't imagine that the Bush tax cuts won't be allowed to expire. This means 3% more in ordinary income taxes for almost everyone (something I just pointed out in my client Roth Conversion webinar as, if they plan to live on about the same income in retirement and convert AND pay the tax this year, they will pay higher taxes in the future on similar income). Also, I have to tell you that we are doing some selling on capital gains assets before 12-31-09. At the least, can you imagine a situation where the cap gains rate would ever be lower than now? I can't. Not on income tax either for that matter.



So, while you make a good point that the increased taxes that must be collected in the future to stave off financial disaster (coupled with spending cuts of course) may come from other sources than income taxes, I think we are at historical lows on all tax rates for now and going foward. It's time to pay the piper.



Bobbie

[Bob H]

[

Bob,
Indirectly, I think your Greece example this is part of the point, though. Yes, their aggregate tax burden may be higher than ours, through a combination of their VAT and income taxes. But if their "top" tax rate is only 30%, that's actually LOWER than ours.

Respectfully,
- Michael

Michael:

Turns out that on top of the VAT, they tax any income over $75,001 (euro) at 40%.
So you have SS at 16%
Income at 40%
and VAT at 21%.

Amazingly... they still (for all practical purposes) go bankrupt.

Bob

[Vig Oren]

The name Kitces sounds Greek to me. If yes, then our friend , Mike, should be a real authority on Greece. Why the hi taxes have not prevented the economic crisis there?