The Tax Man Cometh – Again, and Again, and Again

President Joe Biden released his plan for massive tax and spending increases. It is a budget only in the loosest sense of the word. If you drafted a household budget using the same methodology and ideas as this latest federal proposal, you would soon be heading to bankruptcy court.

While it is difficult to determine the worst part of the president’s budget, the tax increases are a strong contender. He wants to increase the top marginal income tax rate, including the Obamacare surcharge, to 43.4 percent. When you include state and local taxes, many areas of the country would have top rates over 50 percent. New York City would be approaching 60 percent. What incentive do Americans have to work more when the government is going to take 60 cents on the next dollar they earn?

The president’s 10-year plan also raises the corporate tax rate to 28 percent, an increase of a third over current rates. That makes it disadvantageous to start or keep a business in the U.S., thereby encouraging corporate inversion. It also ignores the fact that corporations do not pay taxes—employees, investors, and customers pay those taxes indirectly.

Even more egregious is the proposal to effectively double the top capital gains tax rate, which currently stands at 20 percent, or 24.6 percent including average state and local tax rates. Biden wants to hike the top rate to 43.4 percent, retroactive to April. Once you include state and local capital gains taxes, the combined average rate would be 48 percent. Even worse, at least one member of Congress is seeking to make the tax increases retroactive to January 1, 2021. Savers have no way to plan their investments when governments change the rules of the game after a play is over.

To elucidate the lunacy of these rates, let us briefly look at a few practical examples.

Suppose you invest $100 during your career, and that investment earns you a 5% nominal annual rate of return. After 30 years, the investment will have grown about 332%—such is the power of compound interest. Do not get too excited, however, since inflation averaged 2.5% a year and now your real rate of growth on that investment is only about 110 percent—such is the power of the hidden tax of inflation.

Alas, the tax man cometh, but Biden is not looking at your real 110% return on investment; he is looking at your nominal 332% return. With a 43.4 percent tax rate, you owe $144, but once you factor in the average state and local tax rates, you owe $159, leaving you with just $173. On the bright side, that is still a nominal return of 173%.

But what is your real rate of return? Once you account for the lost purchasing power from inflation, your real return after three decades is a measly $63. That means your real after-tax annual rate of return was a paltry 0.16%, courtesy of President Biden.

Let us go down the rabbit hole just one step further, for the sake of the millions of retirees in this country and their millions of children. When you are retired, you usually shift your savings out of growth-oriented investments towards ones that have lower returns, but are considered safer, since your primary concern is not losing your savings at an age when you can hardly replace them. Assuming a rate of return equal to inflation, we will say 2%, your savings are growing in nominal terms, but not in terms of purchasing power. In other words, you’re actually gaining nothing.

Alas, the tax man cometh yet again, and the government is still not satiated. The $100 you had when you retired has grown to $122 after a decade. When you are done paying 48% in taxes, you are left with about $111. Remember, though, that these apparent gains were strictly inflationary. Do not dismiss this scenario as fantasy—inflation is currently sailing high above the return on AAA-rated securities, and it is a multiple of the 10-year Treasury note yield. After taxes, you are left with less value than when you started your retirement a decade ago. Your real rate of return is negative.

Alas, the tax man cometh one last time. As you draw your final breath, some government accountant is fiddling with his abacus, calculating your unrealized capital gains. You read that right—he wants to tax your savings, even if you have not sold your investments yet. Currently, when you die and pass investments on to your children, those savings receive a “step-up” in their basis, which, for tax purposes, just means the cost of those investments is redefined as the value at the time of your death. Thus, your children do not owe tax on gains from your lifetime. Biden wants that to change.

It is hard to overestimate the damage that this will do to intergenerational savings, the capital stock in the country, and long-term real wage growth. Once again, assets that were held by an individual for a long period of time, like a house, will have seen large nominal gains because of inflation, but maybe only modest real gains, or maybe none at all. When your heirs cannot afford the massive taxes, they will have to sell off what you left them just to pay the tax bill.

What incentive will you have to save, invest, and pass a little wealth on to your children or grandchildren? Very little, unless you are wealthy enough to afford an army of tax lawyers and accountants who will shield your income and savings from the IRS.

For the rest of us, however, there will be no safe harbor from this storm. The tax man cometh, unrelenting, unwavering, and undaunted.