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The taxman cometh.

That’s not only going to be individually painful in 2010 but the collective hit to consumers could be enough to stall the economic recovery.

2010, though is the short-term. The International Monetary Fund, in a burst of pre-holiday cheer, warned on November 3 to expect ten years of spending cuts and tax increases.

Ten years.

Now that I’ve got your attention, let’s start with the short-term squeeze, more to the long-term, and then see if there are any strategies for keeping the taxman from our doors.

I got a firsthand demonstration of the tax squeeze about a week ago. I’m the treasurer for the cooperative that owns the building where I live. November is budget time and I met with the management company that runs our building to walk through what it would cost us to run out building in 2010.

It was shocking.

 Of course, even though the Federal Reserve says there is no inflation, everything is going to be a little more expensive in 2009 than it was in 2009. Wages for the workers in our building. Cleaning supplies. Elevator repairs. 3% here. 5% there.

The problem was, however, that some things are going to be a whole lot more expensive.

 Fuel to heat the building is going to cost us about 38% more in 2010 than it did in 2009. That wasn’t a big surprise. Heating oil has climbed in price this year and we got lucky at budget time last year and locked in at one of the lowest prices of the year.

And taxes. Our management company estimates that real estate taxes will go up 18% in 2010. That’s a huge hit and even more painful than the much larger percentage increase in the cost of fuel because our real estate tax bill is roughly five times the size of our heating oil bill.

An 18% tax increase? Gulp.

And then I remembered that we had already taken a big tax hike earlier this year. The city had raised the sales tax in June 2009 for the 2009-2010 fiscal year by 12.5%. (The city’s share of the sales tax went from 4% to 4.5%. Almost all of the rest of the 8.875% sales tax you now pay in New York City goes to the state of New York.)

An 18% tax increase on top of a 12.5% tax increase? Welcome to the post-financial crisis United States of Debt.

Don’t waste time feeling sorry for us here in New York. We’re actually in pretty decent shape because the city put away about $6 billion for a rainy day. That made balancing the budget in fiscal 2009 relatively painless. For us, because of that surplus, the taxes didn’t really hit the fan until the budget that began on July 1, 2009 and that stretches until June 30, 2010.

You may well live in a state or city where the crisis hit earlier and harder.

California, for example, had to close what looked like a $36 billion budget gap in February 2009. And then saw a deteriorating economy open up another budget deficit of $24 billion more by May.

And big states like California aren’t even at the top of the list when it comes to budget gaps. Top rank goes to Nevada with a 30% gap. Arizona comes in a close second.

According to the National Conference of State Legislatures the total budget gap for the fifty states comes to $145 billion for the fiscal year that ends in June 2010 for many states. The Center on Budget and Policy Priorities comes up with an even higher number, $178 billion.

The conference also reports that 26 of the 45 states that reported numbers expect to collect less in taxes in fiscal 2010 than in 2009.

And that’s even though 20 states raised taxes in 2009 to the tune of $27 billion. A slumping economy wiped out all the effect of higher tax rates.

And then, of course, there’s fiscal 2011. The Center on Budget and Policy Priorities calculates that fiscal 2011 gaps (and remember fiscal 2011 actually starts in July 2010) totaled $80 billion for the 35 states that have put together estimates of their gaps.  With state revenues expected to continue to deteriorate until well into 2010, the final tally, the center estimates, could be $180 billion or more.

The center also projects that states could still be showing a collective budget gap of as much as $120 billion as late as 2012.

Just for some context, the worst annual budget shortfall during the 2002-2005 recession years was $80 billion in 2004.

The damage to state budgets and from state legislatures attempting to fix their budget problems tends to roll down hill. In California, for example, the deal to fill the state’s budget gap included $4 billion in cuts in the revenue that Sacramento sends to counties for such things as education and healthcare.  The state withheld about 8% of the money due to cities and counties due to the budget crisis.

That’s contributed to what was in October a $400 million deficit in the Los Angeles city budget for the current year.

So what do governments do when they face a big budget deficit?

First, they cut spending. For example, in Los Angeles, to fill that $400 million hole, the city “gave” early retirement to 2,400 workers, cut the pay of 22,000 more by 4.5%, and told 6,000 more that they’d have to take two days of unpaid leave a month.

The problem with cost cutting is that when the hole is really big it’s hard to find enough money from cuts to fill it—those cuts in Los Angeles filled only $300 million of the $400 million gap—without making really drastic cuts to services that even voters who very vocally say they hate taxes equally vocally like. Cut library hours here and there and voters accept the necessity of the cuts. Try to close a fire house or four and you’ll get voters marching with signs on city hall.

So spending cuts tend to be the dressing that shows voters that politicians have no choice but to serve up a main course of tax increases. Right now we’re on a path that will result in just about every state raising taxes. By June of 2009 23 states had raised taxes this year and 13 more were considering increases. In the much milder recession of the early 1990s 44 out of fifty states raised taxes.

 I think this is just the beginning of the cycle too. States balance their budgets by raising taxes relatively quickly. Their constitutions often require balanced budgets and state governments don’t have any obligations to use deficit spending to revive the national economy.

Which means that tax increases from the Federal government lag tax increases from the states. But that doesn’t mean they aren’t coming.

And not just in the United States either.

A rather scary study  from the International Monetary Fund calculates that governments in the G20, that’s the organization of the world’s 20 largest economies, will—if they do nothing to restrain spending or to raise taxes–face government debt of 118% of GDP in 2014. That’s more than enough to send global interest rates two percentage points higher than they would have been otherwise. (The U.S. bond market is already ready to freak out on the slightest provocation. See my post on the reaction to the Federal Reserve’s November 4 statement on interest rates http://jubakpicks.com/2009/11/04/stocks-and-bonds-take-away-different-messsage-from-the-fed/ .)

The alternative is a package of spending cuts and tax increases equivalent to about 8% of GDP to bring government debt down to about 60% of GDP across the G20 as a whole. A possible plan, according to the IMF, would require letting all stimulus packages expire, freezing health and pension payments in real terms (no increases above the rate of inflation) and tax increases of about 3% of GDP.

Doing a rough back of the envelope calculation, a 3% of GDP tax increase comes to about $420 billion for the United States.

How should this change your investing or tax strategies? (Remember I’m not a tax expert. I don’t even play one on TV so run these all past whoever you talk to about your taxes carefully.)

  • Think about accelerating income into 2009 from 2010, into 2010 from 2011, and so on. Rates are likely to be higher in the future. Similarly, deductions and losses will get more valuable in the out years.
  • In the short-run higher taxes will slow the recovery of the consumer economy as they’ll mean that consumers have less disposable income.
  • Economists debate the degree to which higher tax rates slow economic growth in the long run. (In essence unless you stipulate exactly how the tax increase is structured, it’s an unanswerable  question.) But no one thinks tax increases don’t slow growth to some degree. Higher taxes are just another reason to expect slower growth in the recovery from this recession in the developed economies.
  • Look out for the Willie Sutton surprise (or surprises.) Sutton was a bank robber most famous for his response to a reporter’s question of “Willie, why do you rob banks?” Sutton supposedly answered “Because that’s where the money is.” The biggest pool of money for developed economy governments to tax are the various flavors of tax-advantaged retirement plans. In the short-term (retirement within a decade) I wouldn’t worry about changes to the status of these plans, but if you are an investor at the early stage of a working career it pays to spend a moment or three to think about how changes in the tax laws would change where you would put your money for retirement.
  • I’d bet that we’re in for a period of rising tax-your-neighbor policies. It’s better—if you’re a politician–to tax out of state residents than in state residents, for example. (Out of state residents don’t vote.) And similarly it’s better to tax overseas investors or workers than your own nationals. I think this will scramble the relative merits of direct investing versus managed or index investing in many financial markets.
  • And, finally, as tax rates go up, it becomes more and more necessary to pay attention to the tax implications of investment and trading strategies. I don’t give you advice on the tax consequences of trades when I make them because I don’t know the tax situation of individual readers. But even now you certainly should look at taxes before you make a move. In the future it will be even more important.