We distribute this week’s Nestmann’s Notes as the world waits in suspense over whether America’s voters (in reality, that tiny subset of America known as the Electoral College) will give Donald Trump another four years in the White House – or boot him out in favor of challenger Joe Biden.
But whoever wins won’t make much difference in one important facet of every American’s life. No matter which candidate ends up ahead, your taxes will increase over the next four years.
Crisis in the States
The tax hikes you’ll see first won’t be federal. Thanks to COVID-related lockdowns, state and local governments are facing a financial crisis. California expects tax revenues to decline by $32 billion in 2021 alone. New York State budget authorities estimate 2021 tax collections will fall by $13 billion and by $16 billion in 2022. New York City, which projected a $3.2 billion surplus in 2019, now anticipates a $9 billion deficit for 2020.
What’s more, the laws of every state (with the exception of Vermont) and many cities require a balanced budget. Almost every state has already been forced to make huge budget cuts and furlough or lay off workers.
But some items are untouchable. Guaranteed pension payments to retired government workers, often with generous cost-of-living adjustments, are an example. Some states, like Illinois, guarantee these payments in their constitutions.
How much more you’ll pay depends on where you live, but the left-leaning Center on Budget and Policy Priorities (CBPP) has some helpful suggestions for legislators:
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Increase tax rates for high-earners and/or impose surtaxes on them. New Jersey just enacted a “millionaire’s tax” that will hike state income taxes to 10.75% on anyone who earns more than $1 million annually. California has proposed a similar tax that would bring the top tax rate to 16.8% (on top of the existing federal tax burden). Here in Arizona, a ballot initiative proposes a 3.5% surtax on residents earning more than $250,000 annually ($500,000 for married residents filing a joint tax return).
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Increase capital gains taxes. Many states give tax breaks to residents with capital gains as opposed to ordinary income. CBPP suggests ending those tax breaks and raising taxes on capital gains income. It also wants states to end basis step-ups for inherited property and tax incentives for hedge fund managers.
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Enact and expand estate and inheritance taxes. Eighteen states (and the District of Colombia) impose an estate or inheritance tax. That’s not nearly enough for the CBPP. It believes more states need to put them into effect, and the thresholds for coming into effect should drop.
In states with the highest spending, you can also anticipate wealth taxes. California legislators have proposed such a measure that would apply to anyone with a net worth of $15 million or more ($30 million if you file taxes jointly with your spouse). The tax would be 0.4% of your net worth, payable annually. California also has you covered if you only spend part of the year in the state. You’ll pay a pro-rated tax based on how long you spend there each year.
To calculate the tax, you must report the details of every asset you own to state tax authorities. The one exemption is real estate, since it’s already subject to property tax.
Democrats in New York have also called for a wealth tax, but Governor Cuomo opposes it, for fear it will lead to what is already occurring in California: a mass exodus of high-net-worth individuals to lower-tax states.
But California has an answer to the departure of its wealthiest citizens: an exit tax. Indeed, it’s a key part of the wealth tax proposal. If you flee California, you’ll need to pay the fee over the next ten years, for a total 1.80% exit tax. That may not sound like much, but rates can always be increased (and the threshold required to pay it reduced) to meet revenue needs. If you don’t pay the tax – or underpay it – you would be liable to a penalty of $1 million or 20% of the tax due, whichever is larger.
Business as Usual in Washington Until…
Unlike states and most cities, the federal government can borrow money. And it’s borrowed a lot of it, particularly over recent decades. In effect, Congress has given Uncle Sam a credit card with a multi-trillion credit limit that it raises regularly.
During the Trump presidency alone, the federal deficit has risen nearly 50%, from $19.5 trillion to $27 trillion. There’s also more than $200 trillion in unfunded future obligations promised to future beneficiaries, but with no money set aside to pay.
On Inauguration Day, January 20, the president should announce an immediate spending freeze and introduce a budget calling for a 10% across-the-board spending reduction, including Social Security and other entitlements. Yes, it will be painful, but there’s no way to grow our way out of a $27 trillion national debt.
But that’s about as likely as a blizzard in Phoenix. Estimates from the Committee for a Responsible Budget project that the spending plans outlined in the Republican budget plan would increase the national debt by $4.95 trillion over the next decade. The Democratic plan would increase it by $5.6 trillion.
Of course, an increasing number of economists and politicians now claim deficits simply don’t matter. Both parties have effectively endorsed an economic vision called “Modern Monetary Theory” (MMT). The idea is that like Germany in the 1920s, Uncle Sam can simply print money to pay for its financial obligations.
After all, since the world abandoned all semblance of the gold standard in 1971, any government can literally create as much money as it wants out of thin air. And any government that issues its own currency can always pay its bills with the money it creates.
If investors don’t line up to buy the debt, the Federal Reserve will purchase it instead and add those “assets” to its balance sheet through the process of quantitative easing.
And both parties have been content to let the Fed do exactly that since the COVID crisis started. Total assets on its balance sheet have now ballooned to $7.1 trillion, with the largest components being Treasury securities Uncle Sam can’t sell to anyone else ($4.5 trillion) and dodgy mortgage-backed securities no one wants to buy ($2.0 trillion).
But there are some storm clouds on the horizon. One is the value of the dollar, which has dropped 10% since April. If the dollar continues losing value, Congress and the Fed will need to make some fast adjustments. That could include cutting spending and yes, raising taxes.
But even if Congress does nothing, the lower personal income tax rates the Tax Cut and Jobs Act brought into effect in 2018 will expire at the end of 2025. The top personal tax rate goes back to 39.6%. Of course, Congress could end them sooner if it chooses.
Another expiring provision is the higher exclusion for death taxes. For 2020, estates valued at more than $11.58 million are subject to a 40% tax rate. But absent Congressional action, the threshold will revert in 2026 to $5.6 million, adjusted for inflation between 2018 and 2025.
If Democrats win the presidency and control of both houses of Congress, another possibility is a federal wealth tax like the one Elizabeth Warren advocates. She proposes a 2% annual tax on assets of households with a net wealth of $50 million or more. The tax would increase to 3% for billionaires. Warren believes this tax would be a good way to start paying for proposals such as “Medicare for All.”
The Hidden Danger of “Normalcy Bias”
A psychological concept called “normalcy bias” refers to our tendency to expect that the future will be roughly similar to our past experiences. Thus, when a shock like COVID-19 arrives, we tend to believe that things will return to “normal” relatively quickly, unless we’re directly affected by the shock.
But economic activity isn’t likely to return to normal anytime soon, perhaps for years to come. In the meantime, state and local government have no choice except to either cut expenses, raise taxes, or both.
But there are steps you can take to prepare. We’re proponents of using every legal tax break available, along with socking away money in IRA and other tax-favored retirement arrangements, for instance.
Still, there’s only so much you can do with your investments to prepare yourself for “taxmageddon” in the months and years ahead. You might need to physically relocate.
You can lower your state and local tax burden by moving to a low-tax state like Florida or Texas. But even low-tax states are facing an almost unprecedented fiscal crisis and have been forced to increase taxes and cut spending. To escape state taxes altogether, you’ll need to leave the United States altogether.
A growing number of countries, along with Puerto Rico, are rolling out the red carpet to self-sufficient migrants. While leaving the United States won’t help US citizens or permanent residents (with one notable exception) reduce federal tax obligations, it will eliminate state tax on out-of-state income (although not state exit taxes, such as the one proposed in California).
The Only Solution to End Federal Taxes for Good
And if you want to end permanently your obligation to pay federal tax on your worldwide income? There’s only one way to do it: expatriation – giving up your US citizenship and passport or relinquishing permanent residency.
If you’re wealthy, expatriation could cost you dearly. Since 2008, a federal exit tax is imposed on wealthy expatriates. It’s based on a legal fiction, as if you sold all of your worldwide property at its fair market value on the day before you expatriate. Tax on the fictional gain is due at the time your tax return is due for the year of expatriation. (We explained the mechanics of the exit tax in this article.)
Expatriation is a radical step. But if you’re not ready to take it, be prepared for the long, crooked fingers of Uncle Sam and state tax authorities to pick an increasing amount of your wealth out of your pocket.
