Your Increasing Tax Burden and How to Avoid It

Point number one is that Obama has confirmed he will take rapid action to cut taxes for 95% of Americans. At first blush, cutting taxes for 95% sounds like a grand idea. However, look more closely. The top 5% of income earners already pay 60% of all income tax, up from the top 36.64% in 1980. The corollary to Obama’s tax reduction, which will go mainly to people who don’t pay income taxes, is that a large increase is scheduled for the high earners.

A hint of the magnitude of the coming burden was offered by The Washington Post on January 2, when it published its assessment of the cost of the bailout as already announced.

According to the Post, if equally apportioned over the 139 million tax returns filed last year, the toll of the bailout would be $61,871 per taxpayer. But taxes are manifestly not apportioned equally. Even before Obama’s tax hikes take effect, 60% of the tax burden falls on 5% of earners –roughly speaking, those who earn $250,000 or more annually.

If you are one of them, your share of the bailout cost will be about $750,000. Pencil that into your balance sheet.

If you have substantial assets, you undoubtedly took your share of losses from the estimated $32 trillion trimmed from stock markets last year. (Stocks worldwide lost 48% of their value.) Trillions more were lost in real estate, bonds and commodities. But it is very possible, especially if your portfolio was well positioned, that you will lose more from bearing your lopsided share of the almost $9 trillion bailout burden than from your investments.

Strategic Option # 1 : You stay the course, taking your marching orders from the lyrics of the great hit song of 1932.

They used to tell me I was building a dream
And so I followed the mob.
When there was earth to plow or guns to bear,
I was always there, right on the job .

Like the everyman hero of Brother, Can You Spare a Dime ? , you can “follow the mob” and do whatever you are expected to do – even if that means paying for everyone else’s mistakes. But remember, the result won’t be much better than that described in other lines from this song of the Great Depression:

They used to tell me I was building a dream
With peace and glory ahead –
Why should I be standing in line, just waiting for bread?

That may sound dire, or exaggerated. But, then again, it may not be.

Strategic Option #2 : Run for the hills. This allows you to put British economist David Ricardo’s “Equivalence Theorem” into practice. Ricardo wrote that investors could see through government fiscal policies, pick them apart if you will, and take individual steps to minimize their costs. One thing Ricardo did not emphasize, however, is that you can simply get out of a country where politicians intend to impose high, disproportionate costs on you.

Whether the government raises your taxes this year or next year, on current evidence it is clear that the view of the Democratic Party is that one person out of 20 should bear more than 60% of the costs of running the government. These costs have manifestly escalated by trillions over the past six months, and they seem likely to rise even higher as the economic downturn deepens.

You probably need to earn millions of dollars over the next decade or two to sustain your lifestyle and provide for your retirement. The question is whether you can best do this in the U.S. or elsewhere.

Even if the U.S. is still the best place to invest money to earn a high return, you may be better off making those investments from another country, one where you will be able to keep more of the money you earn.

An irony of last year’s financial debacle is that before the full measure of the wipeout was evident Congress passed a law designed to add a few feet of financial barbed wire to what The Economist describes as “America’s Berlin Wall” (June 12, 2008, p. 89). The glorious sounding Heroes Earnings Assistance and Relief Tax (HEART) Act imposed new penalties on Americans seeking to escape U.S. citizenship.

As The Economist reported, “That expats want to leave at all is evidence of America’s odd tax system. Along with citizens of North Korea … Americans are taxed based on their citizenship, rather than where they live. So they usually pay twice – to their host country and the Internal Revenue Service. As this makes citizenship less palatable, Congress has erected large barriers to stop them jumping ship. In 1996, it forced people who renounced citizenship to continue paying income taxes for an extra ten years.”

The new law, which the government meant to be more draconian than previous legislation, actually allows for a cleaner break. It establishes a one-time exit tax based on capital gains realizations on worldwide assets. Under the law, any high-income American who relinquishes citizenship must act as if he had sold all his worldwide assets on departure. If the unrealized capital gains taxes on these assets exceed $600,000, you must pay your capital gains tax to make good your escape.

When the government conceived and passed the law in the first half of 2008, the Wipeout of 2008 had not made its way into the consciousness of the Congress. The Congressional Budget Office even calculated that the federal government would net an extra $285 million in exit tax payments over five years. But the collapse in value of almost every category of asset over the second half of 2008 renders the exit tax much less punishing than it was conceived to be.

Indeed, as The Economist observed, “But even as the law tries to prevent people from renouncing their citizenship, it may have the opposite effect. Under the new structure, it would make financial sense for any young American working overseas with a promising career to renounce his citizenship as early as possible, before his assets accumulate. For everyone else, plunging stock and property prices mean now may be as good a time as any to hand back the passport, says Kurt Rademacher, a partner at Withers, a global tax-planning firm.” We explore these issues more fully in Crisis Strategy Alert .

Strategic Option # 3 Whether you decide to stay or go, you have a lot of work ahead of you to recapture losses and recover from the costs of the bailout. Whatever your previous thoughts about retirement, it is fair to assume that necessity will keep you hard at work until you’re the age of Raul Castro or older. If you are a baby boomer, as I am, you face a grueling physical test of your stamina. The next two decades will not be a time when you can allow yourself to lie back and become feeble.

The challenges ahead have hardly been conveniently timed. The financial crash and deepening downturn that threaten the deepest depression since the 1930s may be a prelude to a fall in living standards dictated by demographics.

Rapidly aging populations in most of the wealthy countries, combined with burgeoning retired populations dependent on “pay-as-you-go” transfer programs, are a recipe for falling living standards. Unless productivity increases faster than workforces decline, simple economic arithmetic dictates that living standards must fall. In Western Europe and Japan, more than half of all adults will be older than the official retirement age by 2020. Many countries, including Italy and Spain, will have more residents in their 70s than their 20s.

In a time like that, you don’t want to be one of the frail elderly. Old-age benefit systems and government health care programs in most of the developed countries will be stretched to the ragged margins of bankruptcy. If you depend on them, you are likely to be disappointed. So what can you do? The answer is relatively simple, if possibly unwelcome. Instead of consciously planning to wind down into retirement, you have to consciously plan to extend your vitality.

Mass retirement was an expedient to reduce unemployment in the last depression, when there were up to 20 younger workers to support each retiree. Now, the demographics are much less favorable. It will be much easier to maintain a decent standard of living if you consciously plan to maintain your vitality.