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Arithmetic

A few weeks ago, former President Clinton scored political points while criticizing the economic plan of Gov. Mitt Romney.  He touted the Federal budget surpluses during the final years of his presidency.  He went on to say he was able to balance the budget by simple arithmetic.  He also invoked the simple arithmetic principle to argue that Gov. Romney’s plan didn’t add up and would result in a large tax increase on middle class Americans.

The truth is that neither Gov. Romney nor President Obama’s plans pass the arithmetic test.  A detailed analysis of their plans is far beyond the scope if this article, so I’ll briefly summarize.

The highlights of Gov. Romney’s plan:

  • Cut tax rates by 20% for individuals and lower the corporate rate to 25%
  • Have preferential rates for interest, dividends and capital gains
  • Eliminate loopholes and limit certain deductions for higher income taxpayers

The criticism of Romney’s arithmetic is there aren’t enough loopholes to close which will offset the reduced revenue from the lower tax rates.  Deductions would also have to be limited for lower income taxpayers to make the numbers work.

The main point of President Obama’s plan:

  • Increase the tax rates for people making over $250,000
  • Eliminate the preferential rate for dividends and increase the capital gains rate

These changes are estimated to raise an additional $70 billion in annual tax revenues.

The arithmetic doesn’t work for either of these plans to balance the budget.  For the 2012 budget year, the federal government overspent by $1.1 trillion, and the total national debt has exceeded $16 trillion.  Since the government spends approximately $3.5 trillion each year, it’s a monumental task to close a $1.1 trillion deficit.

The U.S. Treasury collects approximately $2.2 trillion in income tax revenue each year.  To balance the budget under the Romney plan, all current deductions would need to be cut in half to raise another $1 trillion.  Deductions would have to be limited even more if the tax rates are reduced.  The Obama plan is no better.  Even if his tax changes were implemented, he’s about $1 trillion short to balance the budget.  By simple arithmetic, the numbers don’t add up… for Romney or Obama.

We can’t tax our way out of the hole we are in.  We must cut spending in order to balance the budget.  This is not Washington semantics for cuts by reducing the rate of growth or cutting the amount you hoped to spend.  It means actually spending less than the $3.5 trillion we spent last year.

On this front, I give the edge to Gov. Romney.  You or I may not agree with his proposals or priorities, but at least he’s willing to talk about cutting federal expenditures.   He was criticized and ridiculed after the first Presidential debate for trying to kill Big Bird, because he advocated ending the federal subsidy to the Public Broadcasting Service.  He has also been willing to tackle the “third rail” of politics – Medicare and Social Security.

In contrast, I can’t think of one significant cut in federal spending proposed by President Obama.  Counting money which would have been spent for the war in Iraq but isn’t going to be spent doesn’t count in my book.  It’s like saying you cut your spending by $5,000 for the vacation you didn’t take.  Furthermore, the budget deficit for 2013 will still be over $1 trillion without any spending for Iraq.  Instead of talking about spending cuts, the President is pushing for more “investments” (aka spending) for teachers and infrastructure.  These may be good things, but it doesn’t address how to balance the budget, and taxing the rich more isn’t going to close the gap.

Politicians are very good at using sound bites and obscuring the truth.  President Clinton was right… balancing the budget is simply a matter of arithmetic.  In this case, both candidates (and most members of Congress) probably need a remedial math class.

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Social Security Groundhog Day

You may have seen the movie “Groundhog Day” which was released in 1993.  In the movie, Bill Murray plays weatherman Phil Connors who was sent to Punxsutawney , PA to cover Groundhog Day, only to find himself repeating the same day over and over again.  No matter what he does, he can’t seem to escape Groundhog Day.

The annual report from the Trustees of the Social Security Administration seems like its own version of Groundhog Day.  Every report seems to be a repeat of the prior one.  The reports warn of the coming insolvency of Social Security and Medicare, but it’s projected to be far enough into the future, that no one seems to worry too much.

The 2012 report estimates the Social Security system will become insolvent in 2033, three years earlier than what was predicted a year ago.  The fiscal status of Social Security has been known for years, yet Congress and President Obama reduced the employee’s contribution rate to the Social Security system from 6.2% to 4.2% for 2011 and 2012.  The rate reduction was intended to stimulate the economy, and they argued it would have no long-term impact on the solvency of Social Security.  Anyone with a rudimentary understanding of economics and finance could tell you paying less taxes into a system that is already paying out more than it receives, will have a negative effect.  Only Washington politicians are surprised by the updated figures, or at least act surprised.

The staunch defenders of this ridiculous argument also contend the system is solvent for more than the next two decades.  They point to the trillions of dollars in the Social Security Trust Fund as the saving grace to the system.  You can read this article to learn the fallacy of this belief.

There are a couple of other facts in the report which might cause concern.  In 2011, the government collected $691 billion of Social Security Taxes and paid out $736 billion in benefits.  It appears there was a $45 billion shortage in 2011, but there wasn’t.   The Social Security Administration collected $111 billion of interest on its IOU’s from the US government, so it reported a surplus of $66 billion, rather than a deficit.  So where did the $111 billion of interest come from?  It’s part of the $1 trillion of additional debt the U.S. Treasury issued over the past year.

It’s easy to get lost and confused by the Federal government’s accounting methods, which may be intentionally arcane.  So here is the bottom line… call it what you want, but the U.S. government borrowed an additional $45 billion to pay out Social Security benefits in 2011.  If you read the report and analyze the projections, you’ll see this number is only going to grow exponentially over the next two decades.

What is it going to take to change the situation?  I really don’t know if we’ll ever realize what’s happening as long as the government keeps sending out checks.  But what happens if they stop?  It’s unlikely to occur, at least for a long time, but what would have happened if the U.S. Treasury wasn’t able to borrow the additional $45 billion? Since there are no real assets in the Social Security Trust Fund, $45 billion in checks would not have been sent.

So in essence, it’s like we’re stuck in our own Social Security Groundhog Day, but there is a difference between us and the character Phil Connors; Phil Connors recognized he was stuck and tried to change it.  Sadly, most of us don’t believe we’re living our very own Groundhog Day.

Decoding the Debt Debate

If you’re following the current debate on raising the debt ceiling, you’re probably frustrated.  Your angst may be triggered by, the partisan bickering, the lack of great leadership or the uncertainty of what may happen and what it all means.

Politicians from all political persuasions and affiliations have become very adept at obfuscation.  Knowing whatever they say or do can and will be used against them in a future election, politicians have become very proficient in deflecting and dodging direct answers.  They speak in vague terms and try to boil everything down to a 30 second sound bite.

Politicians and political commentators often use terminology that is confusing and often misleading.  You almost need a secret decoder to decipher what they are saying.  I don’t all of the secret codes, but I have a few.

As you listen to the debate, the following are a few terms to keep in mind.

  • The National Debt – The cumulative amount of money owed by the U.S. government. These are actual bonds held by various investors (including the Chinese government and your friendly bank).  The total outstanding debt is approximately $14.5 trillion.
  • The Debt Ceiling – The total amount of bonds the U.S. Treasury is authorized to issue.  The debt ceiling is currently equal to the National Debt.  A law must be passed to increase the debt limit.
  • Deficit – This is the amount of money the government is spending in excess of revenues it collects in one fiscal year (October 1 – September 30).  The deficit for fiscal 2011 is projected to be $1.4 trillion.
  • Credit Rating – Every bond traded on a public market is rated by an independent credit rating agency, which assesses the financial strength of the issuer and the likelihood of default.  The lower the rating, the higher the interest rate required.  For bonds already issued, a change in credit rating will often influence the price at which the bond is traded on the market.

Aside from these terms bantered about, I believe there are a few important factors you need to pay close attention to in any deal that is reached.  These will be the types of issues our  political leaders will attempt to obfuscate.

  • Time Horizon – The time horizon for the spending cuts and additional revenues will be calculated over the next 10 years.   If Congress and the President agree to cut $1 trillion in spending, it won’t all come in fiscal 2012.  They may sound like everything is happening this year, but any plan will be adopted over the next decade.  Raising the debt ceiling is the only thing to take effect immediately.
  •  Timing – Look at the timing for when additional revenue is received and spending cuts are enacted.  If history repeats itself, the revenues will start to be received soon, and the  bulk of the spending cuts will happen in the latter years.  In the world of pork barrel politics, elected officials use government spending to buy votes, and the termination of programs will frequently cost votes.  Thus, politicians have a real incentive to defer spending cuts to another day.
  • Details –It won’t be easy, but do your best to understand the details of the plan.  Congress is trying to make major changes to the tax code, Social Security, Medicare and  Medicaid, and they’re rushing to get it done in the next few days.  I don’t think you want a repeat of Nancy Pelosi’s famous quote, “We have to pass the bill so you can find out what is in it.”

I believe this is a serious issue, and how it is resolved could have far-reaching implications for the future.  No one knows what will happen if the government defaults on its debt, since it has never happened.  As I previously wrote, I think Congress will and should raise the debt ceiling, but it also needs to curtail government spending.  Racking up over $1 trillion of debt each year is just as perilous as defaulting on the current obligations by not raising the debt ceiling.

I also have serious reservations about our leaders’ability and willingness to cut spending.  The 2011 budget compromise is a good illustration of this.  Although they supposedly agreed to $38 billion in spending cuts, most of it was accounting gimmicks and money that wasn’t going to be spent anyway.  One analyst calculated the reduction in spending on specific programs to be less than $1 billion in comparison to fiscal 2010.

As the debate continues forward, follow closely.  Here’s why.  Last week, President Obama was pushing a plan to cut spending by $3.7 trillion and add $1 trillion of new revenue, for a net decrease of $2.7 trillion over the next decade.  Sound like a reasonable compromise?  Before deciding, you may want to consider this.  When the Administration presented their 2012 budget to Congress, they also provided a 10-year budget estimate.  The Administration projected total deficits over the next 10 years to be in excess of $9 trillion.  If the current deal cuts it by $2.7 trillion, that still means we’ll add over $6 trillion to the national debt, pushing out total debt close to $21 trillion by the end of the decade.  Still think it’s a good deal?

To me this is a good example of why we must watch this closely.  Despite the political rancor, everyone in Washington is looking for a deal which will make them look good.  Let’s just make sure the American people get as good of a deal as our politicians.

Tax Tip: Self-Employed Health Insurance

While the debate over health care and health insurance continues in the U.S., there is one thing we call agree on… health insurance is expensive.  If you are paying for health insurance, any tax benefits you receive will help reduce the effective cost of your coverage.

A majority of people in the U.S. receive their health insurance coverage as a tax-free employee fringe benefit.  You may contribute to the expense, but the portion your employer pays is typically tax-free to you.  In order to attain parity between an employer and someone who is self-employed, self-employed taxpayers are allowed to deduct 100% of their premiums in calculating their adjusted gross income.  While it may seem logical and fair, it was not always this way.

In order to take the deduction, you must have self-employment income equal to or greater than your health insurance premiums.  Your salary, wages, interest, dividends, pension and other income are not considered self-employment income.  Thus, the portion of insurance you are contributing to your employee benefits and premiums you are paying while unemployed do not count.  The premiums may be deductible as an itemized deduction, but they do not qualify for the self-employed health insurance deduction.

There are a couple of changes that can affect your 2010 tax liability.

  • Your health insurance premiums are treated as a deduction for calculating your net self-employment income, which will reduce the self-employment taxes you pay.  This benefit is only applicable for 2010, unless otherwise extended by Congress.
  • The IRS has determined that Medicare Part B premiums can be treated as self-employed health insurance premiums.  Thus, if you are over 65 and are having Medicare Part B premiums deducted from your Social Security check, you can deduct the premiums if you have net self-employment income greater than or equal to your Medicare Part B premiums.
  • After March 30, 2010, any premiums paid for a child who is under age 27 will qualify for the deduction.
  • After March 30, 2010, the deduction is not allowed for anyone who is eligible to participate in any subsidized health insurance plan for themselves, their spouse or dependent (i.e., you can’t deduct your portion of the premiums paid as part of a subsidized employer health plan).

If you are self-employed or have self-employed income, the self-employed health insurance deduction may help reduce the cost of maintaining health insurance coverage.  The tax savings may not make get you over the affordability hump, but if you are paying, you might as well take advantage of whatever tax breaks you can.

Tax Tip: Self-Employment Taxes

Self-Employment taxes are Social Security and Medicare taxes.  If you are an employee, half of the taxes are withheld from your paychecks and the other half is paid by your employer.  If you are self-employed, you get to pay all of the taxes yourself.   Lucky you.

Self-employment taxes are assessed upon your net self-employment income over $400.  Without delving into all of the various types of self-employment income, it basically means being paid for your hard work and efforts.  It does not include interest income, dividends, capital gains, pensions or other investment income.  Some of the common forms of self-employed income include:

  • Net earnings from a trade or business
  • Consulting and director fees
  • Tips
  • Payments for any services you provide to another person (e.g., maintenance, repairs, cleaning)
  • Pass through income from a partnership or limited liability company

A portion of your self-employed income may be reported to you on a 1099-MISC or a partnership Schedule K-1, but it’s highly likely that some self-employed income won’t be reported to you.  The income is taxable to you even if you don’t receive a 1099, Schedule K-1 or other tax reporting statement, and getting paid in cash doesn’t mean you don’t have to report the income.

Just like an employee, the tax is divided between Social Security and Medicare.  The Social Security tax portion is assessed at 12.4% on the first $106,800 of income for 2010 and 2011.  Since there is no cap on Medicare earnings, you’ll pay 2.9% on all of your self-employed income, no matter how high it goes.  The good news is that you get to deduct half of the self-employment tax in computing your adjusted gross income.  The bad news is that if you’re married, you and your spouse are subject to the tax separately.

There is one taxpayer favorable provision that you want to take advantage of in 2010.  For this year only, you can deduct your self-employed health insurance premiums in determining your net self-employed income.  It’s a one-year benefit, unless Congress decides to extend it.

Special rules can apply to farmers, real estate professionals, ministers, and investors.  It can get complex rather quickly, and the myriad of potential issues are beyond the scope of this article.  If you have questions or wonder if certain income is subject to self-employment taxes or exempt, you should consult a tax professional. 

With an effective tax rate that can be over 15%, self-employment taxes add up quickly.  Better to get it right, than be surprised with an unexpected tax bill later.

The Fight Over Social Security Reform

February 4, 2011 1 comment

If you’re tuned into the political scene, you know the fight for Social Security is heating up.  Irrespective of your political allegiances or persuasion, this is a battle that you should pay attention to. 

Social Security and Medicare currently cost approximately $1.5 trillion annually, which was 43% of all federal spending in 2010.  The Congressional Budget Office has predicted that the Social Security will pay $130 billion more in benefits in the coming year, than it receives in Social Security taxes.  The 2% reduction in employee Social Security taxes for 2011, which was part of the tax compromise between President Obama and the Republicans, caused the shortfall to increase substantially.

Recently, a couple of influential House Republicans floated the idea of raising the retirement age again, allowing younger taxpayers to invest a portion of their Social Security dollars in private investments, and issuing vouchers for seniors to purchase medical coverage.  Not surprisingly, these proposals sparked an impassioned response from the more ardent advocates of the current system.  Sen. Charles Schumer claimed, ““They want to privatize Social Security. Privatize equals end — no more.”  Such bold statements may be expected as some political strategists have suggested that Social Security is an issue favorable to Democrats, and one that they should try to use to regain some of the political clout they lost in the 2010 mid-term elections.  

If you read through some of my prior posts, you’ll discover that I believe the current system is broke and needs to be reformed.  I may not agree with any or all of these ideas, but I give the proponents credit for taking on this politically-charged issue and considering ideas for reform.  It may not be popular to talk about Social Security reform, but it needs to be done.

Exaggeration and misleading information is part of the fabric of modern American politics, but we need to get beyond it.  Social Security touches the lives of virtually every American.  Accordingly, we need to debate the issues and work towards a solution and not get bogged down in the typical Washington political spin cycle.

The Social Security Trust Fund is one area of this debate where few politicians are willing to be truthful with the American people.  As I pointed out in a prior article, the Social Security Trust Fund doesn’t exist.  Despite what you hear about trillions of dollars in this so-called trust fund or lockbox, it’s not real money.  It’s nothing more than paper IOU’s from the government to itself. 

Personally, I believe many politicians are too afraid to tell the truth, especially the ones who have been in Washington for years.  I think the American people would be outraged if they fully understood how Congress has spent so much money and put our nation on a path that is not fiscally sustainable.  Thus, it’s far easier for politicians to perpetuate the lie that this huge pile of money exists, rather than admit the truth.

The fight for the future of Social Security is just beginning.  I welcome you to join the discussion and debate, whether on this forum, or somewhere else.  I’m all for vigorous debate of the ideas and issues surrounding Social Security.  I’m less concerned about pontificating my ideas than trying to communicate the facts and truth, so you have the information necessary to make well-informed decisions on this issue.  This is why I keep harping on the non-existent Social Security Trust Fund.  Congress can’t make good decisions based upon a faulty premise that they have $2.5 trillion of money which doesn’t really exist.  I hope you’ll join the discussion.

Saving Social Security

Because Social Security impacts the lives of so many people, reforming the Social Security system is probably going to be one of the greatest fiscal and political challenges facing this generation. 

Nearly one-sixth of the population is receiving benefits, and this percentage will grow as the Baby Boomers move into retirement.   The increasing number of beneficiaries will also make it harder for the government to pay the promised benefits.  Social Security and Medicare already consume over one-third of the federal budget, and cost over $1 trillion each year.  The cost will only increase, and despite what politicians say, there is no Social Security Trust Fund to draw upon.  It’s only a bunch of paper IOU’s from the government to itself.  The excess Social Security taxes have been spent on other programs.

Unless some significant reforms are made, I predict a crisis will occur in the next decade.  Here are a few examples of modifications that will help sustain Social Security.

  • The retirement age should be adjusted every decade.  As the average life expectancy goes up or down, so should the age for receiving benefits.
  • Benefits should be adjusted based upon financial need, especially for disability and survivor benefits.
  • Increase taxes, but only after other benefit reductions have been enacted.  In the 75-year history of Social Security, benefits have not been curtailed, but the tax rate has nearly quadrupled.

I don’t see any way that current beneficiaries can be paid if money is taken out of the system, so complete privatization is off the table.  However, there needs to be a lot more transparency of the amount of taxes you pay on an annual basis, and the calculation of your projected benefits.  If Social Security must benefit everyone paying into the system, then let’s treat it more like a private pension plan. 

Having squandered nearly $2 trillion of excess Social Security taxes that was intended to pay benefits to the Baby Boomers, politicians and the Social Security administrators need to be held more accountable for their management of our money.  Social Security is not a 401(k), but more information can be provided than simply showing how much you have earned each year and the estimate of your future benefits.

Ideally, I think Social Security benefits should transition back to a program that is primarily a benefit for people who have little retirement assets or other income to support themselves.  Stop treating it like a private pension plan, where you pay a lot of money into the system, and expect to receive it back with a rate of return.   There will need to be a grandfathering for those who are currently receiving benefits and those close to retirement, but over time, the benefit structure can change.

Allow Social Security to be part of the safety net for those who are vulnerable and in need.  The benefits may not be great, but that’s okay.  It’s not intended to give you a lavish or comfortable lifestyle.  The purpose is to provide basic sustenance so that you can still live independently.  The cost of such a program should decrease dramatically, which should also reduce the tax burden and free up more money for you and I.  Therefore, the reduction in benefits should also be coupled with greater incentives for people to put more money into their own retirement plans.

 In the past few articles, I have made my case for why Social Security is in trouble, and offered some ideas of how to reform the system.  I hope that I’m wrong and the system won’t face a major crisis within the next few years, but from what I know I don’t see how that’s possible. 

I doubt you have agreed with all of my analysis, opinions and ideas.  Good.  My intention was to provoke your thinking and encourage a discussion.  The problem is enormous and no one has all the answers, especially not me, but I do believe that by working with all different types of people, we can avert a crisis and keep Social Security sound for many years to come.