The Writing is on the Wall: There Will Be Wealth Taxes

 

Takeaway

  • Younger taxpayers will not be able to pay for Baby Boomer entitlements due to slowing population growth and diminished economic vitality
  • The government is attempting to fund Medicare and other programs by imposing new taxes on elderly, wealthy Americans
  • International diversification can help protect against wealth confiscation, government default, inflation, and other risks

We are at a point in U.S. history without precedent. The government has reached levels of debt typically reserved for the conclusion of major wars. But rather than attempting to contain debt — which has doubled since the onset of the Great Recession — Washington is facing serious pressure to finance Baby 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.

The Fed is on the edge of extracting itself from absorbing the lion’s share of the government’s new debt sale. The focus is starting to shift back to the tax base’s ability to fund entitlement spending.

The Next Generation: Sluggish Population Growth, Diminished Economic Vitality

For decades, it has been implicitly understood that the Baby Boomer generation would ultimately cause a demographic imbalance of too few workers relative to the number of 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 and 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.

Given the younger generation’s diminished economic vitality, it is unlikely that its contribution to the federal tax base is capable of funding the previous generation’s entitlements. 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 degrees notwithstanding.

This is the core political-economic 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 unwilling to diminish its entitlement support, it will need to find an additional tax base, on top of payroll and income taxes.

The obvious candidate to solve the dilemma is a tax on wealth.

Wealth Tax: Age Tax by Another Name

A wealth tax is a mindboggling proposition for most Americans who believe the rules of the game are that we work, we pay income taxes, we save, we invest our savings, and, in older age, we live on the proceeds (in addition to government entitlements we have already presumably paid for). 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, one would expect the idea of a fresh new tax to create the same legislative standoff we are now witnessing over debt ceilings and Obamacare.

Many people consider a wealth tax to be a violation of the American understanding of the social-economic compact, believing (somewhat naively) that legal and constitutional safeguards will protect individual wealth. (High school civics classes suggest the concept has something heroic to do with life, liberty and property, with roots in the 14th Amendment and the Declaration of Independence).

But the financial pressures on today’s government have changed its ethics and standards of behavior in order to support its previous commitment to politically popular entitlement programs.

Just before Christmas last year, when few were paying much attention to the news, the government broke new ground to expand the tax base and target wealth where it has not been targeted before. In addition to increasing the capital gains rate, Congress also levied a new Medicare surcharge on investment income and capital gains for taxpayers above a relatively high threshold income level.

It is thus 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 own the lion’s share of the wealth.

A wealth tax is in fact an age tax: Census data show that 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 bracket.

To make this new tax more palatable to the demographic being taxed, this wealth tax is styled as a “Medicare surcharge” in hopes of avoiding resistance from those who already or nearly qualify for Medicare. As hoped, it went down as smooth as silk.

Hence what occurred was a new form of income transfer, not from the young to pay for the benefits of the elderly, but rather a transfer from the relatively wealthy elderly to the less wealthy elderly.

Protection from Wealth Taxes and Other Risks

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.

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 just hunker down in the absence of an alternative course of action. Most rely on standard domestic investment management to provide for their retirement, as the reliability of government programs is now in doubt.

But therein lays a problem, because U.S.-based investment management incorporates U.S. 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 a safe harbor where the economy generates yield with little need for the wealth-protection wrappers that are common in other countries faced with these problems.

Furthermore, many people believe they can adequately diversify by taking only long positions in the U.S. markets in sectors across the economy, along with some diversification between debt and equity. As a result, investment managers are not allowed the flexibility to adequately hedge against the wealth-compromising risk of sovereign default or downgrades, inflation, financial meltdown, sluggish economic growth, currency devaluation, or wealth taxes.

It is clear that there needs to be an alternative path to more fully diversify and protect the fruits of one’s labor, and to place that wealth in an environment that would allow it to grow. Its owners would need to be able to access 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 (PPLI) from a foreign carrier with funds in custody outside the U.S.

These vehicles have very desirable features, including tax-deferred accumulation; ownership protective wrappers; privacy; a much larger playing field of available assets, including assets denominated in other currencies; and favorable tax treatment to income streams. Other features include the option to select private mangers who purchase individual claims (rather than expensive 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 capital outflow controls that are currently in the making. 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 flow in appropriate currencies and places.

Dr. Spellman will moderate a panel discussion about how to seek global wealth protection at an event in Austin on Oct. 28. Details are available on his website, The Spellman Report, where this article originally appeared.

Disclaimer

The views expressed are those of the author and not necessarily The University of Texas at Austin.
 

About The Author

Lew Spellman

Professor, Department of Finance, McCombs School of Business, The University of Texas at Austin

Lewis Spellman received his BBA and MBA from the University of Michigan and his MA and Ph.D. from Stanford University. His research interests include...

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