We are at a point in U.S. history without precedent. There are levels of government debt typically found at the conclusion of major wars. But rather than containing debt, which has doubled since the onset of the Great Recession, we are at the threshold of serious pressure to finance Boomer entitlements.
For the last five years, the Federal Reserve accommodated a large portion of government financing needs in its effort to reestablish full employment. This has created the false impression that financial markets will absorb whatever debt the government issues.
Though the Fed failed to taper just now, it is on the edge of extracting itself from absorbing the lion’s share of the government’s new debt sale. With reduced central bank absorption of government debt in the offing, the focus shifts back to the ability of the tax base to fund entitlement spending.
For decades, it has been implicitly understood that the Baby Boomer generation would ultimately cause a demographic imbalance of too few workers relative to elder citizens eligible for age-related entitlements. This is generally called the Dependency Ratio, measured here as the ratio of the number of working–age Americans as a percentage of the total population. This is the tax base as measured by the Social Security Administration for the inter-generational transfer from young to old, which will clearly be declining for the next seven decades.
This implies a diminishing base of working-age income earners to support the Boomer generation.
But that’s not all. The Great Recession has further and dramatically eroded the income-earning potential of the young working-age group. The unemployment rate has disproportionately fallen on the young, has eroded their wages and salaries, and, though they are assessed the payroll tax, they pay little income tax in a progressive tax structure. Indeed, the lower half of the income strata funds but 2 percent of income taxes collected by the U.S. government.
The implication is that the contributions by the younger generation to the federal tax base as a source of funding the elderly’s entitlements is a non-starter when the population proportion is diminished along with their economic vitality. So we can forget the presumed great income transfer from the young to the old via taxes and entitlements as the younger generation is struggling to merely support themselves, college degree notwithstanding.
This is the core political-economy issue in all developed countries today, not just the U.S. What is a government to do, irrespective of political philosophy or party when a slowdown in population growth occurs after it has committed itself to age-related entitlements?
If the U.S. is politically unable to diminish its entitlement support, an additional tax base needs to be found, on top of payroll and income taxes.
The obvious candidate to solve the dilemma is a tax on wealth.
Now a wealth tax is a mindboggling proposition for most Americas who believed that the rules of the game are that we work, we pay income taxes when the income is earned, we save, we invest our savings, and we live on the proceeds in older age (in addition to government entitlements we presumably paid for). We already paid tax on income when derived, but a wealth tax implies the government comes back for a second helping again and again every year thereafter.
Given the diehard opposition to any increase in income tax rates, the idea of a fresh new tax would also be expected to create the same legislative stand-off as we are now witnessing over debt ceilings and Obamacare. Furthermore, a wealth tax seems to be a violation of not just the American understanding of the social-economic compact, but many believe naively that the legal/constitutional environment will protect individual wealth — which is suggested in most high school civics classes as something heroic to do with life, liberty and property (with roots in the 14th Amendment and in the Declaration of Independence as originally drafted).
But the financial pressures on today’s government have changed its ethics and standards of behavior — and its interpretation of the economic-social compact — in order to support its previous commitment to politically popular entitlement programs.
While much of this is armchair reasoning, this logic indeed played out. With stealth legislation passed in 2010, when few were paying much attention, the government broke new ground to expand the tax base and target wealth where it has not been targeted before. Not only was there an increase in the capital gains rate, but a new Medicare surcharge is also being levied on investment income and capital gains to those above a relatively high income level. The tax is effective this year for the first time. It is not a confiscation of wealth, per se, but of the proceeds of wealth, whether in the form of investment income or capital gains.
This implies that a tax directed at wealth is, de facto, directed at the older generation because it is they who in large part own the lion’s share of the wealth.
To say a wealth tax is a tax on the wealthy elderly squares with the facts. A wealth tax is de facto an age tax: Census data reveals the wealth of those above 65 years of age have 30 times the wealth of those in the 35-to-45 age bracket and six times the wealth of the 45-to-55 age bracket.
To make this new tax more palatable to the demographic being taxed, this wealth tax is styled as a “Medicare surcharge” designed to reduce resistance by the primary payers who are of Medicare or near Medicare-qualified age. As hoped by its creator, it went down as smooth as silk.
Hence what occurred was a new form of income transfer, not from the young to pay the benefits of the elderly but rather a transfer from the relatively wealthy elderly to the less wealthy elderly.
This makes the title of this blog, “There Will be Wealth Taxes”, incorrect in its tense. Wealth taxes have arrived for the purpose of financing entitlements, and one can only presume that it will become more invasive by reducing the minimum income level that triggers this tax.
Despite these government financial pressures to expand the tax base to wealth, many feel in a vague way that the writing is on the wall. Wealth taxes will eventually reach them if not wealth confiscation as has recently occurred in similar financially strapped economies of Europe.
Many are uneasy about the prospects ahead, not just on the tax side but also about how much in the way of real benefits will be available when their time comes. But despite this uneasiness, most Americans hunker down as there is not a similar guiding American experience of an alternative course of action. Most rely on standard domestic investment management to provide for a retirement as the reliance on government programs is now questionable.
But therein lays a problem, because U.S.-based investment management incorporates SEC imposed investment nativity, which assumes the dollar is the safe currency in which to be invested; that inflation will be low; and that the U.S. is the safe harbor and the place where the economy generates yield with little need for the wealth-protection wrappers that are common in other countries faced with these problems.
Furthermore, the common sense notion of diversification — not putting all your eggs in one basket — is thought to be obtained by taking only long positions in the U.S. markets as diversified by sectors across the economy, along with some diversification between debt and equity.
As a result, investment managers are not allowed the flexibility, even if desired or understood, to adequately hedge against the wealth-compromising risk of sovereign default or downgrades, inflation, financial meltdown, sluggish secular economic growth, currency devaluation or wealth taxes.
But it is clear that there needs to be an alternative path to more fully diversify and protect the fruits of one’s labor and place that wealth in an environment that would allow it to grow. Its owners would need to have access to it legally, pay reasonable taxes, and have some measure of protection from confiscation. These forms of wealth include annuities with foreign carriers and Private Placement Life Insurance from a foreign carrier (PPLI) with your funds in custody outside the U.S.
While the U.S. has recently come down hard on foreign bank accounts whose income has not been reported, foreign accounts are available but do require very faithful tax reporting, just as with U.S.-based income sources.
These vehicles have very desirable features which include tax-deferred accumulation; ownership protective wrappers; privacy (inability to determine specific investments); a much larger playing field of available assets, including assets denominated in other currencies; and favorable tax treatment to income streams when one elects to receive them. Other features include the ability to select private mangers that purchase individual claims (rather than expensively charged mutual funds), and delivery of income streams in a choice of currencies and a choice of countries.
It is important to act now while these assets are not entrapped by de facto capital outflow controls that are in the making.
In conclusion, a strong argument can be made for international diversification of wealth into vehicles that for centuries have been devised to provide protection, growth, access and cash flows in appropriate currencies and places.
I will be moderating a panel discussion about how to seek global wealth diversification and protection at an evening get-together at the AT&T Center in Austin, TX, on October 28.
For information about the issues that will be discussed by the panel of legal, financial planning, and investment experts, and to register in order to reserve a seat, click here: http://thespellmanreport.com/finance/index.html
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