The federal government recently released a report on the nation’s finances, including longer-term projections for a rising deficit, which could mean higher taxes in the future.
On a positive note, the Congressional Budget Office (CBO) report reflects a current decrease in the annual budget deficit for the last fiscal year. The easing of the deficit is primarily due to historic spending related to the pandemic winding down. The longer-term outlook is more challenging, with projected annual budget deficits exceeding 6% of GDP by 2032 — much higher than the average of 3.5% of GDP over the past 50 years.
From a financial planning perspective, the analysis can offer a glimpse of future policy that could impact tax rates and spending.
Here are some key takeaways from the report.
1. Total federal debt is the highest since post-WWII.
Total federal debt (held by the public) is poised to exceed 100% of GDP for the first time since shortly after World War II and is expected to continue rising over the next 10 years.*
Federal debt held by the public
(% of GDP)
Source: Congressional Budget Office, The 2022 Long-Term Budget Outlook, May 2022. Does not include intragovernmental debt.
*The debt held by the public is all federal debt held by individuals, corporations, state or local governments, Federal Reserve Banks, foreign governments, and other entities outside the United States Government. It does not include intragovernmental debt, which is debt that one part of the government owes to another part, such as Social Security trust funds.
2. Although federal revenues increased in 2021, there is still a significant gap as spending increased as well.
Revenues increased by over $600 billion from 2020 to 2021 (an increase of 15%). While deeper analysis is required, one of the drivers seems to be investors selling appreciated assets to realize gains as talks in Congress focused on increasing tax rates in 2022. For 2021 revenues totaled 20% of GDP, significantly higher than the long-term average of roughly 17%. However, federal spending was also historically high, exceeding 24% of GDP.
3. An older population, increased health care costs, and rising interest rates are key drivers of the federal budget deficit.
In fact, 70% of federal spending is devoted to mandatory spending programs, the three largest components being Social Security ($1.1 trillion), Medicare ($868 billion), and Medicaid ($521 billion). As the population ages, this trend will continue. Federal spending for mandatory programs generally requires legislative action to change its trajectory, unlike discretionary spending, which can be addressed through the annual budget appropriations process. Lastly, interest payments on the existing debt are projected to more than double over the next 10 years.
U.S. federal government spending by type
(2021 fiscal year)
Source: Congressional Budget Office, The Budget and Economic Outlook: 2022 to 2032. May 2022.
Mandatory spending types primarily include Social Security, Medicare, and Medicaid. Discretionary spending includes defense and non-defense items. “Other” mandatory items include certain veteran’s benefits, retirement benefits for federal employees, Supplemental Nutrition Assistance Program (SNAP), unemployment, and other government benefits less offsetting receipts.
4. Tax payments from individuals drive an overwhelming portion of federal revenues.
Over 50% of government revenue comes from income taxes, while over 30% is from payroll taxes. Corporate taxes generate less than 10% of total revenues.
5. Federal gift and estate taxes are a relatively insignificant source of revenue.
In 2021 total gift and estate taxes totaled $27 billion, less than 1% of total revenue. Even after a scheduled increase in gift and estate taxes after 2025, revenue from this source is projected to increase only to $43 billion.
Consider the risk of higher taxes
Considering the dubious outlook on the federal budget situation, investors need to consider the risks of higher taxes being proposed to generate more revenue.
Tax increases could take a number of different forms including:
- Increased ordinary income, dividend, and capital gains rates for some taxpayers
- Additional surtaxes imposed at higher income levels or on flow-through business income
- A sharp increase in the Social Security wage base (currently $147,000) to address the program’s solvency issues
- Additional increases in Medicare Part B and/or D premiums for higher-income taxpayers
- A scale-back in certain tax deductions or credits
- Changes to the gift and estate tax laws
Taxpayers should consult with their professional advisors to mitigate these risks. Tax-smart planning could include using Roth accounts to diversify tax liabilities, funding health savings accounts, and transferring wealth if appropriate.
More in: Taxes