Road to Retirement: How taxes, deficits and markets are connected

With our political leaders in Washington proposing massive spending packages and higher taxes to pay for them, it’s important for investors to understand how taxes, deficits, and markets are connected.

Big deficits

This year, it is estimated that the U.S. will run a deficit of about $2.3 trillion without any new spending. As you likely know, there is another “infrastructure” stimulus bill being debated in the range of $2 trillion. Let’s assume it passes this year and part of the money is spent in 2021. That could easily push the deficit to $2.5 trillion. Last year, the deficit was about $3.1 trillion, just to give you some perspective.

Corporate taxes

How do you pay for a $2.5 trillion deficit? Politicians think we can do it by raising corporate taxes. Currently the federal income tax rate for corporations is 21%, and the proposal is to increase it to 28%. Will raising taxes by 7% close the deficit gap?

It’s estimated that U.S. companies have taxable earnings of about $2 trillion. So 7% of that is about $140 billion more in tax receipts. A drop in the bucket for a $2.5 trillion deficit. Thus, raising corporate taxes won’t do much to solve the deficit issue.

Billionaire tax

What about all those billionaires out there? Can we tax them and solve the problem? There are 664 billionaires in the U.S., and it’s estimated that they have $4.3 trillion of wealth, according to Forbes. Senator Elizabeth Warren proposed a 2% wealth tax to fix the deficit. Two percent of $4.3 trillion is $86 billion. Again, barely a ripple in a $2.5 trillion annual deficit.

Capital gains taxes

In addition to taxing billionaires, policymakers are floating the idea of doubling the capital gains tax on those who earn more than $1 million a year. In 2018, total capital gains taxes were about $160 billion. It’s estimated that about 60% of capital gains are earned by those who make more than $1 million a year. If we double the tax on those millionaire dollar earners, that’s about another $95 billion in tax receipts.

But of course, if you double the tax, the amount collected is likely to decline because investors will do everything they can to avoid them.  This has happened repeatedly throughout history as capital gains rates rise. It’s unlikely that doubling the capital gains tax would bring in more than $60 billion.

The point of all of this is to give you a sense of how big the budget deficit is. The amount of spending is so massive that it overwhelms any potential tax increases in terms of meaningfully closing the budget deficit. While politicians can raise taxes and debate who isn’t paying enough, no workable level of taxation will be sufficient to cover the spending bonanza.

Less stable markets

How does this impact markets? With so much debt, the federal government will need to keep issuing treasury bonds. And to pay the interest on those bonds, they must keep the interest rate low. By low, I mean the interest rate needs to be below the inflation rate. Thus, if inflation is 2%, the interest rate needs to trend below 2%. Otherwise, the interest costs will consume the federal budget.

If interest rates must stay low, that means bonds will remain a poor investment in terms of wealth building. That’s a big problem because about half the world’s financial assets are invested in bonds. The reason bonds have been popular, particularly in pension plans, is because bonds traditionally offered a high level of safety and a reasonable return above inflation. That used to mean that investors could build wealth with less volatility and risk.

But if investors can’t build wealth with bonds going forward, they’ll likely need to reduce their bond investments and increase their stock investments. Investors around the globe are faced with the same challenge and are coming to the same conclusion: equities or bust. The cumulative effect of this is that wealth becomes more volatile and unstable as more wealth is invested in equities, and less in bonds.

To have a fair chance at growing a retirement portfolio faster than the rate of inflation, investors will have to consider taking more risk by allocating a higher percentage of their portfolios to diversified stocks.  I wish there were an easier way, but the deficit is killing the prospects of building wealth through lower-risk investments.

Charlie Farrell is a CEO of Northstar Investment Advisors LLC. This article is for information and education purposes only. Past performance is no guarantee of future returns, and all investing involves the permanent risk of loss. Consult your individual financial adviser for guidance specific to your circumstances.

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