Will Obama Tax the Middle Class? YES!

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
April 26, 2011

IN THIS ISSUE:

1. Who Really Pays Income Taxes?

2. Will Obama Raise Taxes on the Middle Class?

3. Are Americans Desensitized to the “T-Word”

4. S&P Debt Rating Downgrade Revisited

5. Conclusions – The End Won’t Be Pretty

Who Really Pays Income Taxes?

In President Obama’s so-called “deficit reduction speech” on April 13, he vowed to end the Bush tax cuts at the end of 2012 for the “millionaires and billionaires,” which he later identified as those individuals making over $200,000 a year and couples making over $250,000 (go figure). This was the same speech where the president had Representative Paul Ryan seated in the front row and proceeded to berate him personally for his controversial new budget proposal.

The Weekly Standard described Obama’s deficit reduction speech as follows:

“Barack Obama’s budget address last week ranks among the most dishonest and dishonorable presidential speeches in generations. It contained an avalanche of false and misleading statements. It was shallow and bitterly partisan.”

The dirty little secret that everyone, including Obama, knows is that you can’t make a significant dent in the deficits by raising taxes on the so-called “wealthy.” Yet the main theme of his speech was that our fiscal problems would vanish if only the wealthiest Americans were asked “to pay a little more.”

Let’s put this tax-the-rich concept in perspective. According to Internal Revenue Service data, the taxable income in excess of $100,000 for those earning that much or more in 2008 was about $1.582 trillion. Even if all of these Americans – most of whom are far from wealthy – were taxed at 100% of their income in excess of $100,000, that $1.582 trillion in additional taxes wouldn’t even cover Mr. Obama’s $1.65 trillion deficit for FY2011.

For purposes of discussion, let’s take a look at who pays income taxes and who does not. The data presented in the table below is based on IRS income tax data for 2008, the latest figures available.

Percentage of Income Taxes Paid by Adjusted Gross Income

As you can see, the top 50% of tax filers pay 97.3% of all income taxes paid, while the bottom 50% of tax filers pay only 2.7% of all income taxes paid. Most shocking of all, the IRS reported that 45% of households pay NO INCOME TAXES at all. They either do not make enough money and/or get enough tax credits from the government that they do not owe any income taxes. It was Alexis de Tocqueville who said:

"A democracy cannot exist as a permanent form of government. It can exist only until the voters discover they can vote themselves largess out of the public treasury. From that moment on, the majority always votes for the candidate promising the most benefits from the public treasury, with the result that democracy always collapses over a loose fiscal policy, always to be followed by a dictatorship."

Don’t get me wrong – I’m not saying that Obama wants to be a dictator. What I am saying is that it may be futile to expect politicians of any party to make the hard decisions necessary to bring government spending under control since politicians, as a general rule, tend to make decisions based on voter reaction and not sound economic principles.

There are large voting blocks of Americans who pay little or no income taxes but do benefit from government largess so, as I have said all along, it’s more likely going to be the bond market that brings the spending party to a halt rather than fiscal responsibility on the part of our elected representatives (more about that later on).

President Obama is a good example of putting the political before the reasonable. He has to know that eliminating the Bush tax cuts for the top 2% of taxpayers won’t reduce the deficits significantly, but he says it anyway because it’s good politics. The CBO has projected that keeping the Bush tax cuts for the top 2% of taxpayers will cost $690 billion in lost revenues over 10 years. That averages out to only $69 billion per year, or about 4% of Obama’s projected budget deficit of $1.65 trillion this year.

However, for sake of argument, let’s say that we do decide to “soak the rich.” We’ll even increase the “fat cat” tax target from the top 2% to the top 10% of taxpayers by AGI, or everyone with income over $113,799, including joint filers. That’s five times Mr. Obama’s 2% promise.

The IRS data for 2008 show that the top 10% of taxpayers have an aggregate income of $3.4 trillion. Even if we taxed ALL INCOME earned by the top 10% of taxpayers at a rate of 100%, the resulting $3.4 trillion in tax revenues would still not be enough to cover Obama’s proposed FY2012 budget of $3.7 trillion! And remember, the top 10% already pay 69% of all total income taxes, while the top 5% pay more than all of the other 95% combined.

While a 100% tax rate on all income is unrealistic, the point is that the “rich” aren’t nearly rich enough to finance Obama’s entitlement state ambitions – even before his healthcare plan kicks in. So now the question becomes, where will Obama get the money to pay for his spending without reforming entitlements?

Will Obama Raise Taxes on the Middle Class?

Throughout his presidency Obama has promised not to raise taxes on the middle class. Yet the mathematical reality is that, in the absence of significant entitlement reform, Washington will need to soak the middle class – because that’s where the big money is.

I predict that if Obama is re-elected, he will propose to eliminate ALL of the Bush tax cuts at the end of 2012, and that he will impose further tax hikes on the middle class as well as the rich in 2013 and beyond. Never mind how devastating that will be for the economy and job creation (or should I say job elimination), that’s the only way he can finance his big-government agenda. Take a look at the chart below:

The Middle Class Tax Target

In his deficit reduction speech on April 13, President Obama announced that he would convene a new “bi-partisan budget summit” in May when lawmakers will be asked to come up with a legislative framework for comprehensive debt reduction. Presuming that “Debt Commission 2.0” doesn’t get started until sometime in May, we aren’t likely to see any specific recommendations until late in the year.

Since there is a presidential election in 2012, Debt Commission 2.0 won’t propose to raise taxes on the middle class. That would surely cost Obama a second term. But what will almost certainly be on the table is the elimination of virtually all tax deductions. These include the deductions for state and local tax payments (especially property taxes), mortgage interest, employer-sponsored health insurance, 401(k) contributions and charitable donations.

Debt Commission 2.0 will almost certainly point to the latest Paul Ryan budget and argue that it also proposes to eliminate most of these popular deductions. But the big difference is that the Ryan budget would lower the top tax rate to 25% to offset the eliminations of deductions. I can promise you that Debt Commission 2.0 will NOT recommend cutting taxes!

The irony is that even as Obama says he merely wants the rich to pay a little bit more, the elimination of these popular deductions would impact the middle class the most. The elimination of these deductions would threaten the economic recovery and cause unemployment to go back up. If the home mortgage interest rate deduction is eliminated, it will be another disaster for the housing market.

The elimination of these deductions may only be the first phase. If Obama is re-elected, I predict he will try to eliminate ALL of the Bush tax cuts at the end of 2012. It will not surprise me if he lobbies for further tax hikes on the middle class as well as the rich in 2013 and beyond, or supports a VAT (Value Added Tax) – since he will no longer have to hold back to get re-elected. Never mind how devastating that will be for the economy and job creation; but that’s the only way he can finance his big-government agenda.

Are Americans Desensitized to the “T-Word”?

We now seem to be locked into trillion-dollar budget deficits as far as the eye can see. However, the discussion about this historic level of government spending seems to be falling on deaf ears. Could it be that Americans have become desensitized to trillion-dollar budgets and trillion-dollar deficits? I definitely believe that this is the case.

The following table is an excerpt from a table produced by the Office of Management and Budget (OMB) using data provided by the Congressional Budget Office (CBO). It shows receipts and outlays by the federal government over a 31-year span from 1986 through estimates for 2016. This multi-year summary allows us to easily spot changes in spending trends.

Summary of Receipts, Outlays, and Surpluses or Deficits

Some observations: It wasn’t that long ago that all federal government outlays were less than a trillion dollars. You need only go back to 1986 to find total government outlays for that budget year of $990 billion. Once hitting the trillion-dollar mark in spending in 1987, it took until 2002 (15 years) before government outlays eclipsed the $2 trillion mark. Even then, the deficit was still manageable at only -$158 billion. Ahh, the good ol’ days.

The next jump to $3 trillion came more quickly, taking only six years for outlays to reach $2.98 trillion in the 2008 budget year, which easily rounds up to $3 trillion. After that, however, we hit the spending afterburners with outlays rising from the $3 trillion mark to the $3.8 trillion of spending in Obama’s 2011 budget in only three short years.

As a general rule, total spending must be judged in comparison to total income. After all, most of us will spend a bit more if our income increases. Unfortunately, that didn’t happen with the federal government because of the global financial crisis. In fact, the crisis brought on additional spending to stimulate the economy as tax revenues fell from $2.5 trillion in 2008 to $2.1 trillion for 2009, 2010 and estimated for 2011.

The result is that we went from a $458 billion deficit in 2008 to a $1.4 trillion deficit in 2009. Folks, that’s an INCREASE of just shy of $1 trillion in one year!

Since then, we have been running trillion-dollar deficits and are likely to do so, or close to that, in the foreseeable future, even though the table above says otherwise. When looking at projections, you must remember that the CBO bases its budget and deficit estimates on the assumption that all of the Bush tax cuts will be repealed for everyone after 2012, which is not a sure thing.

While there are other points of analysis I can make in regard to historical and projected budgets, the main reason that I printed the table above is to note that Americans have become accustomed to hearing about trillion-dollar deficits, but in reality most have no idea of just how big a trillion dollars is.

It can often be hard to conceive of a trillion dollars but it may help if you can put it in terms of a million dollars, which most people can get their arms around. The note below the title of the above table says that the figures are in millions of dollars. Thus, you have to take the number given above and multiply by a million to get the answer.

For example, if you were given a million dollars on January 1 and told to spend it all by the end of the year, you’d have to spend $2,739.73 per day to get it done. To spend one trillion dollars over the course of one year, you’d have to multiply this number by one million, or $2.74 billion dollars per DAY! Absolutely mind-boggling!!

The 2011 federal budget estimate shows outlays of $3.82 trillion, which is represented as $3,818,819 million in the above table. That’s right, the projected expenditures for this fiscal year are almost four million million. Mathematically, it looks like this:

$3,818,819 X $1,000,000 = $3,818,819,000,000 ($3.82 trillion)

Now, let’s move to the national debt. The current total national debt, including intergovernmental holdings, is almost $14.3 trillion. Using our shortcut, that means 14 million million. And don’t forget, the federal government continues to add to this flow of red ink every day.

Looking at the national debt another way, the largest annual budget surplus of the modern era was back in 2000 when it hit $236 billion (including a nice contribution from the Social Security surplus). In order to pay off the current total US debt of over $14 trillion, we would have to run this $236 billion level of annual surpluses for 59 consecutive years, and this doesn’t include any interest accrued on the debt over that time or the possibility of lapsing back into deficit spending.

S&P Debt Rating Downgrade Revisited

Are you starting to get the picture about the sheer magnitude of our accumulated debt? It’s clear that the credit rating firm Standard & Poor’s (S&P) has. Last week I included a short note about S&P announcing that they had changed their outlook for the US Government debt rating from “stable” to “negative.” This is the first time this has ever happened, and it’s a big deal.

Last Monday’s announcement from S&P regarding the increased chances of a downgrade of the US Government's AAA debt rating came as a surprise to many, but not my readers. I have been saying all along that the bond market will not allow our elected leaders to ignore continued trillion-dollar deficits as far as the eye can see. We’ve now witnessed the market’s first step.

As I see it, there are several important aspects of the S&P announcement beyond the obvious warning of a future debt rating downgrade. First, S&P said that unless something changes, the US could lose its top debt rating within two years, so for the first time, we now have a time window. The White House and Congress have kicked the can down the road for a long time. Now we’re getting an idea of where that road might end.

Speaking of kicking the can down the road, S&P expressed little confidence in the ability of the White House and Congress to reach an agreement on deficit reduction before the 2012 elections. In fact, S&P doesn't expect any meaningful deficit reduction until after 2014, which incidentally, is beyond their two-year time window mentioned above.

This means that S&P evidently doesn’t expect our elected officials to do anything about deficits until after the US government loses its AAA debt rating and their backs are against the wall. Perhaps S&P's pessimism is a result of the recent 2011 budget cuts that we now know were mostly smoke and mirrors.

A final note is that, in a surprise move, many investors actually leaped from the stock market into Treasury bonds last week just after the S&P downgrade. Are you surprised? I think everyone was. Investors, spooked by negative news about government debt, moved into the very asset that caused the market turmoil – Treasury bonds. I think there are a couple of good reasons for this reaction. First, US debt is still among the most secure in the world. Even with our current problems, you’d be hard pressed today to find a safer investment than US Treasury bonds. My chief concern is just how much longer will we be able to say that?

Of course, Obama immediately came out to calm everyone’s fears about the US defaulting on its debt, which was to be expected. The real question is whether our elected leaders got the message that S&P was trying to send. Unfortunately, I tend to side with the S&P on that question. Something needs to be done soon to rein-in our ballooning national debt.

Conclusions – The End Won’t Be Pretty

We have covered a lot of material in this week’s E-Letter including a lot of detailed budget projections and “what-if” scenarios, all to try to determine if Obama is going to target the middle class for tax increases. Based on what I have presented this week, I think the only answer you can come up with is Yes, but not until 2013 – if he is re-elected.

Our analysis showed that the “rich” alone cannot support the level of deficits and government spending, even if you assumed you could confiscate all of their income. That being the case, there’s no way that tinkering around the margins is going to get us where we need to be, budget-wise.

Unfortunately, we must place our faith in politicians to address these problems and come up with a viable solution. So far, our elected officials have been long on rhetoric and short on solutions, including President Obama in his deficit speech last week. So short, in fact, that Standard & Poor’s used their inability to come up with rational measures to address the deficits to fire a shot across the bow of Congress and the White House, but so far to no avail.

With cuts to entitlement programs supposedly off the table and tax increases only for the “rich,” there’s no way that Obama and Congress can plug the holes in the budget without turning to the middle class, for the simple reason that this group is where the money is.

In closing, it is now becoming clear that we have reached the age of unsustainability. Common sense tells us that we simply can’t keep going down the same path and kicking the national debt can down the road. Some sources, such as the CBO, have been saying this for years. Others, like the S&P, are joining an ever-growing chorus of experts and analysts who believe that the current trend in US spending and debt is unsustainable. When will our elected officials get the message? Not until the bond market blows up, unfortunately.

Very best regards,

Gary D. Halbert