Two forces suggest that tax rates will increase in the coming years. First, the economic impacts from the Coronavirus have caused fiscal budget deficits at the national and state/local levels to explode. To prevent a deterioration in services, tax revenues will have to increase. The second force pushing taxes higher is social: income and wealth disparities between the wealthy and poor have increased to levels not seen since the gilded age. Many believe the way to correct this imbalance is to tax the wealthy at higher rates and distribute the benefits to those who are economically disadvantaged.
Governmental Budget Deficits
The Federal Government has enacted several relief packages in response to the economic damage caused by COVID-19 and is debating another measure now. The most notable of these acts included the CARES Act passed at the outset of the crisis. These measures have authorized $3.7 trillion in additional spending. As of July 31st, the Congressional Budget Office reported a budget deficit of $2.8 Trillion through the first 10 months of the current fiscal year which ends September 30th.
To pay for these measures, the government has ramped up its issuance of bonds dramatically. In 2020, the US Treasury anticipates that the government will issue an astounding $5.4 Trillion worth of bonds. This figure is twice the $2.7 Trillion issued in 2019. Total Federal Debt now stands at about $25 Trillion. To put this in context, the US Economy is roughly $20 Trillion so the government debt is about 125% of this total.
State and Local Governments can issue bonds to cover spending similar to the Federal Government. However, most of these entities do not have the ability to run annual deficits. As an example, New York State’s Budget for Fiscal 2020/2021, which runs from April until the end of March, was projected to be $175 Billion at this Spring. Given the rapid loss of tax revenues due to the economic impact from the virus, New York’s budget deficit is expected to be $14 billion according to a letter Governor Cuomo wrote to NY’s congressional delegation in late July. The figures for New York City are even more dire. New York City’s revenue is projected to decrease by roughly $8.5 billion this year, which represents approximately 10% of the full budget, according to the CBC (Citizens Budget Commission). The City will have to cut services extremely aggressively as it did during the recession in the mid-1970s.
These tremendous Federal, State and Local deficits suggest that tax rates will be going up substantially. The Federal government has no plans to close its budget deficit, but if it did, it would have to collect an additional $23-24,000 from each of the 128 million households in the country. Similarly, for New York State to balance its budget, the state would need to tax each household in the state an additional $1,100. This figure does not sound excessive but high earning residents that are expected to pay the majority of any shortfalls are mobile and could leave the state if their tax burden increased.
Income and Wealth Inequality
The COVID shock has hurt lower income households much more than higher income households both medically and economically. While many knowledge workers can work from home, lower income workers are more tied to their place of work. Service sector workers such as waitstaff, hotel workers and flight attendants have lost millions of jobs. The unemployment within the CARES Act which provided an additional $600 per week expired at the end of July so that many of these people will be impoverished quickly without additional support.
Income inequality has been increasing in the United States since the 1970s. The wealthiest 1% of tax paying families earn $1.3 million per year while the average of the next 99% earn about $50,000 annually. Household balance sheet inequality is even greater. According to a Brookings Institute piece from last year, the top 1% of households owned 29% of the wealth which is larger than the amount of wealth owned by the entire middle class (defined as a group that earns from the 21st percentile to the 79% percentile of American households). The disparities are even more striking at the top of the spectrum where the top 1% of the wealthiest 1% own at least 15% of the nation’s wealth. As an extreme example, Amazon’s CEO and Founder, Jeff Bezos’s wealth increased $74 Billion this year alone. According to a recent article on Bloomberg, it grew from $115 Billion in the beginning of the year to over $189 Billion now.
The two ways to reduce this inequality are to either enact policies to raise the incomes and wealth of poor and middle-class households or to lower the incomes of the wealthy. While many believe the former is the better policy, it is much more difficult. Therefore, we expect Federal and other governments to raise taxes to address these equity concerns.
Politicians used to be concerned that running on a platform of higher taxation would reduce their chances of winning elections. Bernie Sanders changed this paradigm and did not shy away from telling the electorate that he would raise taxes, especially on the wealthy. To cement his support with progressives, Joe Biden has adopted this stance. In recent communications, the Biden campaign has proposed the following:
- Income Tax: Increase the top income tax bracket to 39.6% from today’s 37%.
- Social Security Tax: Apply this tax of 12.4% to all income over $400,000. This would increase marginal tax rates to 52% for high income earners.
- Capital Gains Taxes: Tax Capital gains as current income which would increase the rate from a top level of 28% to 39.6%. Biden also proposed eliminating the step up in cost basis on death.
Additionally, state and local governments will most likely increase their income and property taxes. Property taxes will almost certainly be headed higher since residential real estate outside of city centers is booming as the wealthy flee cities. Also, expect fees associated with car ownership and any sort of licensing to increase.
Strategy if Tax Rates Rise
In most years, we try to minimize capital gains in taxable accounts. This strategy helps augment after-tax returns which is important since these are the funds available to support current and future cash flow needs. Given that we expect higher taxes in the future, we do not recommend minimizing taxes this year. The opposite strategy of maximizing realized gains might be the better strategy since it will be a relative bargain to pay taxes now.
Where possible, it may also make sense to accelerate income into 2020 by strategies such as deferring expenses until next year. Many business owners have the flexibility to influence when income is earned through tax planning and we recommend these individuals work with their advisors to optimize.
Finally, it may be beneficial to convert Traditional IRAs and 401Ks to Roths to pay taxes at today’s rates. There are many wrinkles to this strategy, but it is advantageous to withdraw funds from Traditional IRAs at the lowest rates possible.
Everyone’s tax circumstances are unique so that our advice is not uniform for all clients. For instance, a high earning individual who is planning to retire this year would be better off delaying gains for future years since his or her marginal rates may be lower in the future even if taxes rise across the board. We plan on engaging our clients on this issue over the remainder of the year.