Get Ready for the Big Tax Squeeze

11/10/2009 1:12 pm EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

Governments large and small have begun to ratchet up taxes. As a result, expect a slower economic recovery and, possibly, an attempt to increase taxes on retirement accounts.

The tax man cometh.

Not only is it going to be individually painful in 2010, but the collective hit to consumers could be enough to stall the economic recovery as well.

And 2010 is just the beginning. The International Monetary Fund (IMF), in a burst of pre-holiday cheer, warned on November 3 (.pdf file) to expect ten years of spending cuts and tax increases.

That's right…ten years.

Now that I've got your attention, let's start with the short-term squeeze, move to the long term, then see whether there are any strategies for keeping the tax man 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 in New York City. 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 our building in 2010.

It was shocking.

An Example Close to Home

Of course, even though the Federal Reserve says there is no inflation, everything is going to be a little more expensive in 2010 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 seen a big tax increase earlier this year. In June, the city raised the sales tax for fiscal 2010 by 12.5%.

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 had put away about $6 billion for a rainy day. That had made balancing the budget in fiscal 2009 relatively painless. Because of that surplus, the taxes didn't really hit the fan for us until the budget that began July 1 and stretches through next June 30.

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. The state then watched a deteriorating economy open up an additional $24 billion budget shortfall by May.

And big states such as California aren't even at the top of the list when it comes to budget gaps. The top ranking goes to Nevada, with a 30% gap. Arizona comes in a close second.

Many States In a Mess

According to the National Conference of State Legislatures, the total budget gap for the 50 states comes to $145 billion for the fiscal year, which 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.

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

And then, of course, there's fiscal 2011, generally starting next July. The Center on Budget and Policy Priorities calculates fiscal 2011's gaps at $80 billion for the 35 states that have put together estimates. With state revenues expected to continue to deteriorate well into 2010, the final tally, the center estimates, could be $180 billion or more.

The center also projects that states could still show 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 2002-05 recession years was $80 billion in 2004.

Local Entities Lose State Funding

The damage to state budgets and from state legislatures attempting to fix their budget problems tends to roll downhill. 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 health care. The state withheld about 8% of the money due to cities and counties because of the budget crisis.

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

So what do governments do when they face a big shortfall?

First, they cut spending. For example, in Los Angeles, to plug 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 took care of only $300 million of the $400 million gap—without making really drastic cuts to services that even voters who say they hate taxes very vocally like. Cut hours here and there, and voters accept the necessity of the cuts. Try to close a firehouse or four and you get voters marching with signs on city hall.

So spending cuts tend to be the appetizer 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, 23 states had raised taxes this year, and 13 more were considering increases. In the much milder recession of the early 1990s, 44 states raised taxes.

And this is just the beginning of the cycle. States balance their budgets by raising taxes relatively quickly. Often, states are constrained by constitutions that require they balance their budgets, and state governments don't have any obligations to use deficit spending to revive the national economy.

That 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 Group of 20 (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 gross domestic product in 2014. That's more than enough to send global interest rates two percentage points higher than they would have been otherwise. (The US bond market is already ready to freak out on the slightest provocation. See this recent post for more on the reaction to the Fed's November 4 statement on interest rates.)

What Tax Increases Would Mean

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 G-20 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 increasing taxes by about 3% of GDP.

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Doing a rough back-of-the-envelope calculation, a 3%-of-GDP tax increase comes to about $420 billion for the United States. That's an average increase of $4,200 for each of the 100 million people in the US who paid federal income taxes in 2005.

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

  • 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 grow 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.

  • The biggest pools of money for developed-economy governments to tax are the various types 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 an early stage of your working career, it pays to spend a moment or three to think about how changes in tax laws would influence 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. This would make direct investing less attractive than managed or index investing in many financial markets.

  • And, finally, as tax rates go up, it becomes 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 situations of my 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.

More from Jim Jubak:
Reaction to the Latest US Unemployment Report

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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