Perspectives

The Smart Bird: On Pensions, Debt, and Taxes

To boil this down to its simplest form

Competition exists for the future government revenue among services, debt owed to the top 3% and older social obligations like pensions and social security. Much of the new debt created is cutting in line in front of old obligations and will get paid first before social obligations are due to you. Better yet, the new debt wants the government to default on the old obligations. It’s working.

 

Some History of Government Pensions

I read an old Rand report on the history of military pensions a few years ago. It was quite illuminating.  Here is what I remember.

In 1940 they did not have computers to do all the calculations required to make deductions and track retirement accounts for the millions of personnel in the military. To keep it simple they decided to underpay the military (and federal employees too) compared to their civilian counterparts and consider that as paid-in for retirement benefits later.

Once computers allowed these computations, the government required the military (and federal government) to set aside an amount in a virtual military trust fund to properly account for the cost of personnel in the budget. They started these virtual set-aside accounts in the 80’s at zero not taking into account any past reductions in pay. So even if there was really money set aside (there isn’t just like social security), it does not reflect the value accumulated from underpaid salaries.

When retention became a problem, the government “caught up” military pay with civilians but they left the benefit formula the same. This means the pension benefit would be calculated on a higher base wage than it was meant to, but…

…what is not understood about military pensions is that they are not based on total salary they are only based on a portion of pay which is approximately 70% of total pay today.  The military has shifted more pay out of the base pay category used to calculate pension benefits over the years.  So while one part of the formula appears to overpay, the other part takes it away.

So that “50% military pension at 20 years” you hear about is actually about 35% of the final year salary which usually does not compensate for the loss of income when one transitions out of the military late in their career. And then the federal government gets the higher marginal tax on this “deferred income” or “retired reserve income” when a retiree gets another job – so that 35% comes closer to 25% after-taxes of the final salary.

My Soapbox

Military retirees are also considered “retired reserves” and can be recalled back to service involuntarily in times of emergencies. As highlighted in Trump’s executive order allows Air Force recall up to 1,000 retired pilots for active duty.

It also should be mentioned that the military never pays overtime, yet working long hours is common in the ranks and on deployments.  I worked approximately 55 hours on average during the last 12 years of my career when home and seven-day work weeks on four years worth of deployments.

Of course with the advent of computers the government could also require the tracking and pay for overtime, but we know that is not going to happen.

The military uses the 20-year vesting as leverage to deploy service members with over 15 years overseas away from family for long periods of time.  Lowering eligibility to 15 years will challenge military assignment planners.  I expect recalling retirees and stop-losses will become the norm for critical career fields.

Most military retirees take a pay cut when they retire.  If they left after a few years and entered another profession then by the time they reached military retirement age they are likely to be making far more income.  When my father retired from the Air Force his civilian pay was one third of his Vietnam buddies in the same profession due to lack of seniority.  His civilian retirement pay was non-existent and his life time earnings were half of what his buddies that got out after their Vietnam tour.

So military retirees get a little touchy when they start hearing about plans to cut their taxable “deferred income” after they have already retired (or are close to retirement) and are trying to get their kids through college. That 20-year promise was used to justify the working conditions to their families and in soldier’s and their leadership’s mind.

I also think the government’s recent “solution” to the “lack of efficiency” in the military retirement system will cause other problems down the road that could not be understood nor was considered by the corporate-culture advisers.

Military pensions have held steady compared to GDP since they began paying in the 40s. Calls to cut military and federal benefits usually come with a lot of mis/dis-information from those wanting part of these same income streams.

One wonders if the budget hawk yahoos take into account the loss of tax revenue at the federal and state level when they tell us how much money they are saving the government with pension cuts. It is not just income taxes, it is reduced spending from what I call fiscal braking – especially once the economic multiplier effect is placed in reverse.

Pension Crisis is Now

Today many state and private pension funds are captured by the central bank distorted financial markets. Long-term future returns baked-into-the-cake are below 2% compared to pensions assumptions of 6-8%.

I doubt the Treasury and Federal Reserve will bail out these pension funds like they did the mismanaged too-large-to-fail banks after the next crash exposes the pension crisis. They easily could and partially should since they helped create the problem. And the future economy will depend on it.

Instead I expect that after the transfer of wealth (currently hidden on the books) is consummated by the next financial crisis they will once again go after military and federal pensions to match the destruction monetary and fiscal policies created in the private sector and states.

The Competition

The Top 1% in net worth globally passed the bottom 99% around 2016 about the same time as elections were being lost by establishment politicians – social tensions are running high for some reason?  At the same time many voters have been convinced that lowering taxes (on the rich) is the answer to all our economic problems.  I don’t think so.

Look closely at the chart.  That is 99% not 90% or 80%.

We aren’t winning.  The guys with the lawyers, lobbyist and comrades infiltrating the top policy-making positions of the government agencies are. Americans are being distracted by partisan divisions while the financial elites have their way.

The real slide in wealth in the US corresponds with the shift in the tax load from corporations to the bottom 90% of income earners through higher payroll taxes in the late 70s and 80s under the disguise of creating a surplus.  Add to that twenty-percent of US manufacturing jobs moved overseas and 80% were lost to automation.

Trump can not bring the jobs back but he does not have to cut taxes on the top 1%.  Regardless of the sales pitches you hear, the top 3% or so capture 147% of the tax cuts in the latest plan.  Yes, 147%!  That means the other 97% pay more taxes in aggregate. That comes from working the numbers backwards in who gets the cuts, not the promises of lower taxes to the middle class.

18 October share

Unfunded Obligations

When scare tactics discuss unfunded obligations, they add up 80 years of social obligations and present the net present value as current debt.  These obligations were never meant to be “funded”, they were designed to be pay-as-you-go like the military budget, etc.  Imagine presenting the next 80 years of the military budget as an unfunded obligation.

A little debt monetization could get us over the baby-boomer social security hump if wall street would not keep absorbing the benefit of the US having the world’s reserve currency. It is hard to compete with wall street on future income streams when Americans are unaware they are even competing.

The Model?

Most of the fiscal crisis’s we see today at the state and federal government level are due to lowering taxes in the past based on supply-side myths. Business Insider gives us a glimpse of what is to come at the federal level in their recent article, Kansas Republicans scrapped the state’s disastrous tax cuts that look a lot like Trump’s plan.  Here is an excerpt:

But ask some Kansans and you’ll learn how that kind of tax cut could have serious unintended consequences.

Instead of spurring business investment and job creation, researchers from a number of institutions say it turned more into a “tax avoidance” program. A lot of white-collar workers like law partners, accountants, and doctors stopped taking salaries and instead started claiming the profits of the business. For them, state income tax essentially went from a maximum of 4.6% to nothing. This has led to the ongoing budget crisis.

“Kansas has been an unmitigated budgetary disaster,” Dr Lori McMillan, a tax-law professor at Washburn University, told Business Insider. “It was a very messy, blunt club when a scalpel was needed.”

The economic growth from the tax cuts never materialized. Kansas was saddled with an almost instantaneous budget hole, leaving schools and pensions drastically underfunded. Infrastructure repairs were put on hold. And to deal with a $700 million drop in revenue — almost twice what was predicted — Kansas raised its sales tax, hurting all residents, but especially lower income Kansans.

The current Republican tax plan is another blunt club. The economic growth from tax cuts never materialized under Reagan’s tax cuts either.  Lower federal taxes have not lead to higher economic growth as the propaganda research would have you to believe unless the Fed monetizes the debt to avoid crowding out private debt by increases in government debt.

Raising  the effective tax rate on the upper 10% today will not impact the economy (financial markets are not the economy), but it would go along way to solve some of the problems created by pushing supply-side economics too far.

It is amazing to me that anyone would push the same disaster on the Federal tax system as Kansas is going through.  But there it is in the Republican tax plan as a way to lower taxes on the wealthy from 39% to 25% through a new pass-through rate on pass-through taxed entities. Oh the loop holes this will create.  Along with it will come cuts to veteran, military and federal benefits when tax revenue does not materialize from economic growth.

Middle Class Tax Cuts Are Easy

Most small business owners do not pay an effective federal rate anywhere near 39%.  Let’s remember, the wealthy get a big tax break on income above $127,000 since that is currently the upper limit of the (deduction-less) 12.4% in payroll taxes. Small business owners don’t get this high income tax break.

incomes bottom 50

That 39% high tax rate was designed to keep those with very high incomes overall effective tax rate close to the middle class total taxes with payroll taxes included. And lowering taxes on the top 3% means cutting taxes on the largest source of income gains in the last 30 years.  This is the reason we hear so much talk of budget cutting and unfunded liabilities is because the math of tax cuts does not add up.  It can’t.

Remember tax reform is always about who pays more and it isn’t the guys with the lawyers and lobbyist.  Or the guys in the White House advising the President today as I discuss in The Goldman Sachs’ White house Update: Pre-Stock Market Crash.  Yes Mr. Treasury Secretary, the rich pay most of the federal income tax but what you fail to mention is they now make most of the income.

 


 

So how does this relate to investing today? Simple, the extreme positive sentiment on tax reform on top of years of monetary stimulus has driven financial assets to historical highs relative to the market’s economic underpinnings.  More of the same is going to be very disappointing to those jumping in near the top. Fiscal braking is certainly not the answer.

Timing the market top is a separate issue.  When we see the most risk-sensitive investors start to pull money off the table, it will be time to sit on the sidelines. Until then, the melt-up continues.

 


 

TSP & Vanguard Smart Investor