Discussions of consumer spending tend to focus on post-tax dollars. This can be misleading because taxes are likely to be the bigger and faster growing expense category for employees in general and retirement investors in particular. When it comes to analyzing expenses and budgets many authors and analysts seem to suffer from “tax myopia.” Taxes are the “elephant in the room.”
The concept of stress tolerance can help us understand when and why a retirement plan might fail by not helping the retiree’s productive adaptation to change. As Paul Ormerod shows in his book Why Things Fail, stress tolerance can be seen as a threshold, above which a person or a system fails. The transition from doing well to failing can be quite abrupt. When the external stress is below the investor’s stress tolerance level, the investor does well. However, once the external stress level increases, even just a little above the investor’s tolerance level, failure occurs.
The destructive power of taxes on income and investments is likely to be felt more painfully by retirees than by employees who are still in their accumulation phase. Also, the stress tolerance of older investors is likely to be much lower than the stress tolerance of younger investors. Retirees are more likely to be on a fixed income. Retirees have fewer years left to make up for errors. While some may have hedged their inflation risk with COLAs and TIPS, how would you hedge your tax risk?
There are many types of taxes. Taxes come in a wider variety of forms than many of us expected when we were growing up, including federal income tax, Social Security tax, Medicare tax, state income taxes, state sales taxes, real-estate taxes, city income taxes, municipal excise taxes, etc. Taxes are levied on income as well as assets. Taxes are levied on realized capital gains as well as, amazingly enough, on unrealized capital gains (i.e., real estate taxes). Income taxes have even been levied retroactively.
Taxes Vary With Location As shown by a recent report, “Tax Rates and Tax Burdens in the District of Columbia: A Nationwide Comparison,” total state tax burden can vary by a factor of 1 to 6. For example, households with an annual income of $150,000 in 2005 would have paid average state taxes from all sources of about $4,000 in Alaska versus $24,000 in Connecticut.
Ben Williams, co-founder of the firms Rational Investors and Retirement Engineering, points out that local governments and municipalities may create even larger retirement planning risks for investors and retirees than the federal government. Municipalities have less fiscal and debt flexibility when they run into problems. Raising taxes becomes the default action. Unaccounted liabilities, such as pension and health benefits for municipal employees, are less researched and less publicly known than the federal problems with earmarks, entitlements, Social Security and Medicare.
The magnitude of these local impacts on an individual is likely to be higher than the federal impacts in many ways, not the least of which will be lowering the value of housing by the amount of the net present value of increased property taxes. Local tax increases will not only affect discretionary income, they will also affect asset values.
Rates Change Over TimeUsing the very same data from a book written by two academics (Elizabeth Warren and Amelia Tyagi), The Two-Income Trap, Todd Zywicki at the blog The Volokh Conspiracy shows a clear example of “tax myopia” by taking taxes into explicit consideration, thus reversing the book’s findings. His analysis shows that the average single income family in the early 1970s had more discretionary income as a percent of their budget (46 percent) than the average dual-income family in the early 2000s (25 percent). In contrast to the conclusions of The Two-Income Trap, he shows that this not caused by rising health, mortgage and automobile costs but rather by rising taxes (from 24 percent of budget to 34 percent of budget).
“Overall,” Zywicki writes, “the typical family in the 2000s pays substantially more in taxes than in their mortgage, automobile expense, and health insurance costs combined. And the growth in the tax obligation between the two periods is substantially greater than the growth in mortgage, automobile expense, and health insurance costs combined.” While we worry about health care costs in retirement, should we not worry even more about taxes?