By Joe Templin
Anyone who knows me knows that I am a pretty hardcore nerd. I mean, my email and running call sign is “HeadGeek.” I started college at age 13 because my parents said 12 was too young, and I am still a physicist under my suit.
So being a good nerd I applied the scientific mindset I used as a researcher for DARPA to the U.S. economy - specifically income taxes because of how they affect our clients - and tried to answer the question “Whither go tax rates?”
Note that everything my team and I reference is publicly available information, so go ahead and double-check it and then use it with your clients. Regulators and compliance officers tend to look favorably on data and insight that comes directly from the government’s own published numbers, which is the source data everything in this discussion is built from.
So the short answer to “Whither go tax rates?” is “up.” No surprise in that. But the more important question is “Why?”
We ask this “why” because we wish to look at the elemental principles at work, the fundamental forces that ultimately dictate reality instead of political maneuvering or accounting tricks. Working from baseline economic fact with a historical perspective diminishes the ability of elected officials or clients to dismiss the trends and factors that are inevitably driving tax rates up in the future from politically motivated depressed levels.
Understanding the major drivers of the government’s revenue is critical to an informed discussion and understanding of the impending tax increases.
First, look where we are: essentially historic lows in terms of effective income tax rates. Effective income tax rate is not the marginal rate (tax rate on the next dollar earned, which is derived from our bracketed system), but what the rate is on the entire income. The Unique Minds Consulting Group normalized tax rates for inflation since World War II. This chart indicates a married couple making $100,000 in 2019 dollars is paying less than 16% of their income in federal income taxes.
This is 10 cents less from every dollar of income that the government takes in on these inflation-adjusted dollars today versus during World War II.
A look at upper income earners sees a more dramatic decline in tax rates since the turn of the century.
Twenty-six percent today versus 46% at the end of World War II. Keep in mind that those making more than $100,000 in today’s dollars generate roughly 80% of the income taxes paid in the U.S., according to the Congressional Budget Office, and you realize a glaring hole in revenue is evident.
Numerous factors impact income tax rates, but we are going to isolate and discuss just one here. Note, however, that every factor we analyzed that contributes significantly to income tax rates indicates stress and a need to increase rates significantly. We are discussing only war in this article.
As is reflected in the above graph, war costs money. There is a reason why economists talk about the “guns versus butter” problem, and bullets and soldiers need to be paid for. The first taxes in the U.S. were levied to help pay for the Revolutionary War, and the first income tax in the U.S. was levied to pay for the Civil War. The modern income tax was instituted in 1913 with an eye on the gathering storm clouds of World War I.
|War and Years Fought||Cost in Billions of Dollars (2019)|
|World War I (1914-1917)||$392|
|World War II (1940-1945)||$4,807|
|War on Terror (2002 – 2018 total)||$6,400|
As the War on Terror is still ongoing, it is not unreasonable to project the total cost for it exceeding (adjusted for inflation) all wars of the 20th century combined.
One does not need to be a rocket scientist to understand that the U.S. as always paid for these immense outlays for war by income taxes. In addition, it’s important to understand that with the most expensive war in our history still being fought, income tax rates going up from unnatural lows to levels typical of other wars is basic economics and as likely in the future as the sun rising.
So what does this mean for those of us who guide clients through financial planning? Ed Slott named one of his books The Retirement Savings Time Bomb because he foresaw what I believe you can now prove: Your clients will be paying a much higher tax rate in coming years (i.e. their retirement years) than they ever believed or planned for. You need to shift the tax burden from the future much higher rates to the current hyper-low tax environment. Based on the current Internal Revenue Code, to minimize the income tax bill for your clients, they need to play the tax rate arbitrage through the use of Roth IRAs and cash value life insurance policies.
Joe Templin, CAP, CLU, ChFC, is the Headgeek of The Unique Minds Consulting Group and the director of advanced planning for ELEMENTAL FPG. Joe may be contacted at firstname.lastname@example.org.
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