Orlando's Outlook: Who wants to be a millionaire?

Bottom Line The fiscal policy clock is ticking. The presidential election was less than a month ago, Congress’ lame-duck session is rapidly winding down, and we’re now only 31 days away from plunging off of the dreaded fiscal cliff, where automatic tax increases and spending cuts totaling some $600 billion would drag the $16 trillion U.S. economy back into a purely voluntary recession, with perhaps a negative 3-4% Gross Domestic Product (GDP) next year. The bad news is that investors have been whipped around with every headline and dueling press conference out of Washington this past month, as stocks fell by about 6-7% in the 10 days after the election. But the good news is that stocks have recovered most of that lost ground over the past fortnight, with the VIX trading at a near-cycle low of 16 at present. If investors were truly worried about plummeting off this cliff, then the volatility index would likely have already spiked to 50, as it did during the fated summer of 2011. While the dizzying array of legislative proposals and counteroffers to potentially resolve this crisis have been largely unproductive to date, there’s a central issue that—if properly defined and agreed upon—should get the ball rolling in the right direction. To wit: who really are the “rich” in this country? Once we know exactly where to draw that line, the revenue increases and spending cuts under discussion should fall quickly into place, extinguishing this ticking fiscal time bomb in a timely fashion.

Millionaires & billionaires President Obama has thus far focused his efforts on raising taxes on “millionaires and billionaires, who can afford to pay a little more,” and that’s fair enough.  But he defines these people as the top 2%, individuals who earn $200,000 or more—and families earning $250,000 or more—annually. 

That definition, however, is seemingly at odds with members of the president’s own party.  Consider this sample of opinion:

• “$250,000 makes you really rich in Mississippi, but it doesn’t make you rich at all in New York, and there ought to be some kind of scale based on the cost of living of how much you pay.” — Sen. Chuck Schumer (D-N.Y.), Sept. 20, 2011
• “Tax cuts for those earning over a million dollars a year should expire.” — Rep. Nancy Pelosi (D-Calif.), May 23, 2012
• “About a quarter of those who will pay more taxes will not be wealthy Americans but middle-income Americans.” — Sen. Max Baucus (D-Mont.), Nov. 27, 2012
• “Under a million, people don’t feel too wealthy here.” — Rep. Nita Lowey (D-N.Y.), Nov. 18, 2012
• “I support President Obama’s proposal to eliminate the Bush tax cuts for high-income taxpayers. However, I prefer a cutoff point somewhat above $250,000—maybe $500,000 or so.” — Warren E. Buffett, chairman & CEO of Berkshire Hathaway, Nov. 26, 2012 

These guys are really rich Bloomberg Markets magazine just published its annual list of the world’s 200 richest people, and two well-known Americans were near the very top:  Bill Gates, the retired founder of Microsoft, was second with an estimated $64.4 billion in wealth, and the aforementioned Mr. Buffett was fourth with $48.4 billion. 

We can all agree that Gates and Buffett, for example, are doing just fine financially, and that they can both readily afford to pay higher tax rates. But by drawing his income line at $200,000 for individuals and $250,000 for families to define “rich,” President Obama is clearly suggesting that everyone in this income bracket is doing equally as well, and they should all be taxed at the same rate. We disagree. 

How are those “rich” families doing by comparison? The economic reality is that a family of four living in a good school district in a high-tax state with one kid in a good private college—at an after-tax college cost of $50,000 per child per year—is simply not rich. They’re getting by, but raising their taxes will have a deleterious impact on consumer and business spending, and thus economic growth.

Consider this back-of-the-envelope analysis. The average of the eight highest-taxed states (California, Hawaii, Oregon, Iowa, New Jersey, Vermont, New York and Maine) and the District of Columbia boasts a 9.64% tax rate. At the other end of the spectrum, there are also nine states that have no state tax (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming). The average tax rate of the remaining 33 median states is 5.79%. 

So President Obama wants to raise the marginal federal tax rate on these families from 35% currently back to the old highest marginal rates under President Bill Clinton at 39.6%; add in the high-tax state average of 9.64%; add in the local and property taxes for a good school district at an estimated 10%; and finally add in the Social Security tax on the first $113,000 of income at a restored 6.2%. 

That adds to a total tax rate of about 62.0%, levied on $250,000 of gross family income, yielding $95,000 of net after-tax income. Subtract $50,000 in annual college costs—a family at this gross income level would be ineligible for financial-aid packages—and we’re left with $45,000 in disposable family income, or $3,750 per month.  From this sum, the family will pay for their mortgage, utilities, and groceries, make their car payments and gas up the rig, buy insurance and clothes, and save for a modest vacation and retirement. Is our hypothetical family “rich?” Hardly. But according to President Obama, these folks are just as rich as Gates and Buffett. 

So if President Obama wants the truly affluent to contribute more—through either higher tax rates or less deductions or both—then he needs to pick a more appropriate spot to draw the line without negatively impacting the economy. A family of four earning $250,000 and sending a kid to college should not be taxed in the same bracket as Bill Gates and Warren Buffet, period.

While we rarely find ourselves agreeing with the likes of Sen. Schumer and Speaker Pelosi, et al, this time we do. Raising the definition of “rich” to at least $500,000—and preferably to $1 million—in gross income is an excellent starting point to coalesce bipartisan congressional support on reforming the tax code.  

Houston, we have a spending problem Up until now, however, all of the congressional discussion has been about raising revenue, to which House Speaker John Boehner (R-Ohio) and the Republicans have already agreed. But according to the Congressional Budget Office (CBO), we as a nation have a spending problem, much more so than a revenue problem, which President Obama and our Democratic congressional leaders are seemingly choosing to ignore. 

The CBO projects that federal spending as a percentage of GDP spiked from about 20% in 2007 (before the onset of the Great Recession) to 25.2% in 2009 (due to the surge in government transfer payments), and will recede to only about 24% of GDP by 2022, because of the demographic surge in entitlement spending.

In contrast, revenues were about 19% of GDP in 2007, they plunged to only 15.1% in 2009 when the Great Recession hit, and the CBO is projecting that they will gradually recover back to about 19% of GDP by 2022, which is within the normal historical range of 18% to 20% of GDP for both revenues and spending. 

The corporate CEOs who met with President Obama in the White House in recent weeks made this point abundantly clear—we as a nation need to cut our out-of-whack spending by a ratio of four-to-one, compared with raising revenues, in an effort to balance both at about 20% of GDP. 

We can’t campaign our way to a balanced budget The solution to the fiscal cliff debacle, in our view, is obvious. We need to reform entitlements, so that we gradually reduce spending from 24% to 20% of GDP over the next 10 years, and we need to reform the tax code to enhance revenues back up to 20% of GDP over the next 10 years. The time for campaigning and stump speeches is over. We’d like to see President Obama and Congress don their green eye shades, roll up their sleeves, sharpen their pencils, and negotiate a fair, balanced and bipartisan solution to this fiscal policy mess.