Bonds in the US are generally unattractive at this time, because rates are bound to rise, harming the market value of the bonds. Rate rises are slow in coming and may yet be delayed, but much of the rest of the world is raising rates.
Muni bonds (proxies MUB, CMF, MLN, TFI), which have had the double negative whammy of rate rise expectations and troubled state and city budgets, might do reasonably well under some possible tax increase scenarios that could come out of the Obama administration.
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We don't have a view on when and how much taxes may rise, but we sincerely doubt that the US can get out of its current mess without either raising taxes, significantly cutting entitlements, or creating tremendous substantial inflation. There will probably be a combination. This article examines the hypothetical that we try to solve the entire problem with taxes.
While Democrats cannot afford politically to raise income taxes on their voting base, or to cut much in the entitlements area, they could probably navigate around inflation and various fees (such as energy and carbon taxes built into product prices). However, the announced plan is to seek more taxes from those with the most income.
Let's see how far taxing the upper income population could go to solve the national budget crisis. There is a lot of talk about fairness, equity, income disparity, giving back, responsibility and so on, but not much substantive financial detail in the rhetoric. Well, here are some numbers that aren't bathed in political values -- just math.
According the Congressional Budget Office, Obama's budget proposal for 2011 shows $2.23 trillion of revenue and $3.63 trillion of outlays. If we take those as they are, the deficit is $1.4 trillion. We have read and heard higher numbers, but let's stick with the CBO number.
According to the Bureau of the Census, there are approximately 113 million households in the US as of 2010.
The Income Distribution:
According to the Federal Reserve, Census of Consumer Finance, the top 10% of households in 2007 (the last full published data) had a mean income of $398,000. That 10% includes all of the billionaires and probably most of the millionaires.
Data from the Bureau of Census places the mean income for the top 5% at $295,000. However, let's use the much higher Federal Reserve number of $398,000 for the top 10%.
According to FactCheck.org, only approximately 2% of households earn $250,000 (as married couple) or $200,000 (single head of household). Accoring to Obama, we can limit the tax impact to that small 1 in 50 group.
Current Tax Contributions:
According to IRS figures compiled by the Tax Foundation, there were approximately 140 million tax filers in 2008.
The top 1% had a mean taxable income of $1.2 million (aggregate income $1.69 trillion) --- and they paid 38.02% of all income taxes. Their average tax rate was 23.27%
That group certainly includes all the billionaires.
Yes, we know that taxable income is lower than gross income in many cases, but these are the numbers available to us, and they adequately illustrate our point.
The next 4% of tax payers numbered about 5.6 million, and they had a mean taxable income of $221,686 (aggregate income $1.24 trillion). They paid 20.7% of all income taxes. Their average tax rate was 17.21%
The subsequent 5% (to bring the total to 10%) of taxpayers numbered about 7 million, with a mean taxable income of $132,823. They paid 11.22% of all income taxes. Their average tax rate was 12.44%.
Collectively, the top 10% had a mean taxable income of $275,539 and paid 69.94% of all income taxes, at an average rate of 18.71%
The bottom 1/2 of tax payers, had a mean income of $15,355, and paid 2.7% if total taxes at an average rate of 2.59% of income.
The 40% between the top 10% and the bottom 50% (plausibly the "middle-class") numbered 55.98 million tax payers, with a mean taxable income of $62,439, and paid 27.36% of all taxes.
According to speeches by President Obama, increased income tax burden would fall on those in the 2% making more than $200,000/$250,000.
US Budget Deficit as Percent of Taxable Income of Top Earners:
Putting those gross numbers together, we see that there are 11.3 million households with a mean income of $389,000, aggregating to $4.5 trillion (according to the Federal Reserve). The budget deficit of $1.4 trillion is equal to 31% of the aggregate income of the top 10% of households.
If we use the taxable income base reported by the IRS, the top 10% of tax payers have an aggregate taxable income of $3.9 trillion. The budget deficit is 35.9% of that amount.
If we limit tax increases to the top 5% of earners, the budget deficit is 47.8% of their $2.9 trillion of taxable income.
If we limit tax increases to the top 1% of earners, the budget deficit is 83.1% of their taxable income.
Tax Rate Implications of Taxing the Rich To Solve The Deficit With Taxes:
If we combine the current tax burden with the necessary additional tax burden to fully solve the deficit with taxes, the effective tax rate on the top earners would be:
- Top 1% as a group: 106.4% (23.3% current + 83.1% additional)
- Top 5% as a group: 65.0% (17.2% current + 47.8% additional)
- Top 10% as a group: 54.6% (18.7% current + 35.9% additional)
An income tax rate of more than 100% on the top 1% is impossible. Why work at all, and then they would have to confiscate assets on top that. So any thought of making the "billionaires" pay-up to solve the problem is great theatre, but pure nonsense from a math point of view.
An income tax rat of 65% on the top 5%, or 54.6% on the top 10% is within the realm of possibility, although the consequences could be severe. Certainly the shock of the adjustment would make investing an order of magnitude harder.
The problem is the consequences will be severe no matter what we do. We've had the party, and now it's time to pay, but we don't have the money.
Does History Support Tax Rates That Exceed 1/2 of Income?
Yes. Historical data from the Tax Foundation, shows that as recently as 1986, the top income ordinary income tax rate was 50%. In fact it was much higher in some earlier periods:
- 1986: 50%
- 1981: 69%
- 1980: 70%
- 1964: 77%
- 1963: 91%
- 1953: 92%
- 1945: 94%
We imagine that few actually paid those rates, but the facts show that some Congress/President combinations actually enacted taxes at very much higher levels than today for the wealthiest tax payers.
This is a table of the year-by-year top ordinary income tax rates and income thresholds to be in those tax brackets. Click to enlarge:
This is a table of the dividend tax rates for those years. Click to enlarge:
This is a table of the capital gains tax rates for those years. Click to enlarge:
Back to Muni Bonds:
While we can't really imagine being willing to work very hard to make money if the government would take 50% to 70% of it (maybe you would, but we wouldn't), it apparently can happen, because it has happened.
The world did not come to an end in those times, but it is hard to imagine the stock market rising or the economy growing under those circumstances. It is easier to imagine the stock market declining and the economy shrinking.
In any event, if such huge slugs of income were confiscated by the government from high earners, those earners would have a lower capacity to support debt, and therefore the demand side for consumer debt and mortgage debt would probably decrease -- moderating rate increases.
The government's requirements to borrow would decrease, and the foreign governments (such as China) that support our Treasury issuance, would be less likely to demand higher interest rates -- further dampening interest rate increases.
So with moderating interest rates, and massively increased tax rates, tax-exempt muni bonds would very possibly become far more attractive -- and the adverse impact of rate increases (moderated as they might be), would quite possibly be outweighed by the tax shelter benefit of the muni bonds.
For Every Action There Is An Equal And Opposite Reaction (and the Law of Unintended Consequences):
Just as the economy is likely to decrease, in our view, if the government taxes a substantially larger share of private income. And just as we think muni bonds would see a major surge in demand as investors seek tax shelter, we imagine the government taking steps to prevent that tax shelter from being realized.
We imagine in such a dramatic time, the government would do something to limit the tax shelter utility of muni bonds, such as capping the percentage of income that can be tax exempt, creating graduated tax-exemption based on total income, or bribing states into issuing only taxable muni bonds (Build America Bonds).
Real estate values would probably fall for larger homes. Property tax collections would fall for cities and towns, Then in the whole chain of unintended consequences, states and cities would face altered supply and demand forces, due to fall in revenue and possible limitations on investor benefit from owning muni bonds.
Who can really say how it all might shake out. Turmoil would be the rule of the day for a while.
However, in the short-term, muni bonds would most likely see a rise in demand, and some appreciation in price, in addition to creating valuable shelter.
This is how we see it working out for muni bonds, if tax rates on the upper 10% are seen as the solution to the budget deficit, even though some level of interest rate increases may occur at the same time.
Muni bond have actually had a nice recovery so far this year amidst the push-pull-tug of lousy municipal finance, rising rate expectations, and tax shelter.
Disclosure: We do not hold MUB, CMF, MLN, or TFI in any managed accounts as of the publication date of this article.
Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advise to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer found on our site available here.