There is a fight brewing over taxes!

by Wayne Ferbert on May 3rd, 2012

I found this chart below on the Business Insider web site. It does an excellent job of highlighting the tax problem we face at the end of the year. The problem: when the Bush Tax cuts expire, the tax revenue as a percent of GDP is set to significantly increase.

You see, the GDP is not expected to grow to keep up with the growth in taxes as a percentage of GDP. In other words, the tax bill is going to feel even more painful as it grows faster than the economy. Long term, that is not sustainable for any economy. These two things must be tightly correlated over time – and they usually are as the chart shows.

However, looking at the chart, there was only one other time that tax revenues as a percentage of GDP grew materially faster than GDP – during World War II. But that was a special time in our history. Citizens were asked to shoulder the burden of the war. In other words, they were asked to live with higher taxes. They were asked to live with austerity. By and large, the populace did not complain – but pitched in instead. The war in Europe & Asia galvanized the country.

The current unemployment situation and still tenuous economy will not easily bear such an ‘implicit’ austerity measure. That is what the expiration of the Bush Tax cuts are: they are an austerity measure. But the source of the problem seems obvious on the chart: the two largest spikes in the opposite direction (ie, taxes as percent of GDP shrunk materially faster than GDP growth) were in the 2000s. In other words, it appears that the Bush tax cuts at least contributed to this problem that we have now.  We mortgaged our future to some degree with those cuts.

Even with the expected spike in tax revenue from the expiration of these cuts, we still expect to grow our record US debt. This is not encouraging long term.

I was squarely in the camp that believed the Bush Tax cuts would be successfully rolled in to 2013. Mostly, I just believed that in an election year, both parties would punt on this issue. But now I am not so sure. Maintaining the cuts would bring the chart back in line – but it would delay paying for the problems we know we have with our debt. What a sticky problem.

To me now, three things are a certainty:
This will be a big topic in the upcoming election – and the sides will not agree on it – that is for sure
If the capital gains rate and dividend rates change to higher levels, investing for tax efficiency will get a lot more complicated – meaning having a creative tax planner will become even more important than it was before
Neither #1 nor #2 are good for the market valuations!

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