A Current Look at the Deficit and Proposed Tax Changes

Time for an update on our nation's deficit. As you may know, the United States' total debt is limited to a statutory ceiling set by Congress. Currently, this ceiling is $12.1 trillion. As of Friday, November 13, 2009, our nation's debt stood at $11.99 trillion. At our current rate of cash burn (something like $100 billion a month), we don't have very long before we hit the ceiling. Congress will likely increase the ceiling, albeit with some huffing and puffing from deficit hawks, because a failure to do so would constitute a default by the United States and would shut down the government (that being said, such a situation happened before in 1995).

Increasing the debt ceiling may keep the wheels of government spinning, but it does nothing to fix the underlying problem: the gargantuan chasm between spending and revenue. Recognizing this, the Obama administration is floating some interesting proposals for dealing with the epic mismatch:

1) Domestic agencies will likely face a 5 percent cut or a freeze of their budgets;

2) Excess TARP money may be used to reduce the debt (somewhat circular in that TARP is all borrowed funds to begin with);

3) The roughly $47 billion a year Medicare fraud industry will (hopefully) be attacked.

Congress is also looking at ways to "generate more revenue" (read: raise taxes) to not only reduce the deficit, but also to pay for new domestic programs such as health reform. For example, the recently passed health bill contains a 5.4 percent surtax on individuals making over $500,000 and families who make over $1,000,000. Interestingly, unlike most of our tax brackets, this surtax is not indexed for inflation. That means, essentially, that more and more people are subject to the tax as their nominal incomes increase into the area covered by the bracket--a phenomenon called bracket creep.

As currently implemented, the surtax would affect 0.3 percent of taxpayers in 2011 and due to the lack of indexing, 0.5 percent of taxpayers in 2019.

While this may not sound like many taxpayers, it is important to put the indexing issue into context of other, similar bracket creep programs implemented by Congress. For example, the Alternative Minimum Tax, passed in 1970 to target a few wealthy taxpayers, was never indexed to inflation. As a result of bracket creep, the AMT now potentially covers 20+ percent of households. While Congress passes annual "patches" to reduce the AMT's reach, the tax still targets a much larger percentage of households than anyone ever envisioned it would (i.e., instead of just the very rich, those in the $150,000 to $415,000 per year income range). Essentially, 30-40 years of inflation allowed a very narrowly tailored tax to become an all encompassing one.

So let's do some back of the envelope math to figure out how much more of the population will be subject to the 5.4 percent surtax in 30 to 40 years time. America's historic inflation rate of the last century has been about 3.4 percent. So we are looking for the present value of $500,000 and $1,000,000 in 30 and 40 years time given a discount rate of 3.4 percent. Here are the results (rounded to the nearest hundreds):

$500,000 in 30 years = $183,400 in 2009 dollars.

$1,000,000 in 30 years = $366,800 in 2009 dollars.

$500,000 in 40 years = $131,300 in 2009 dollars.

$1,000,000 in 40 years = $262,500 in 2009 dollars.

According to Wikipedia, in 2005, 1.5 percent of households made $250,000 or more in income. Thus, it seems fair to say that the surtax, in thirty to forty years time, assuming no other changes to it or the rest of the tax code, will likely ensnare five times as many households as originally intended when it was passed. This is likely a highly conservative estimate because it assumes there will be no real increases in wages (i.e., increases due to workers being more productive), only nominal increases due to inflation.

So what's the takeaway point here? A non-inflation linked tax is a convenient way to pass future tax hikes without any legislative action. As time passes, the tax ends up taking in a bigger percentage of income simply because inflation continues to tick upwards while the bracket stays constant. America's principal experience with this kind of tax, the AMT, took 30 to 40 years before it started generating an uproar among less "affluent" taxpayers (i.e., those generating somewhere between $100,000 and $400,000 a year in income). As the healthcare surtax currently stands, we will probably see the same debate again in 30 to 40 years time.