Tuesday, January 22, 2013

The Perverse Result of More Progressive Tax Rates

It's no secret that the two major US political parties are at odds over federal income tax rates. President Obama and leading Democrats have made clear that they intend to raise taxes again on higher income Americans. Leading Republicans have implied that they will not let this happen and they seek a flatter tax structure.

Holding two of the legs of the voting stool (presidency and Senate), the Democrats would appear to have the upper hand. Let's focus on how this affects retirement. Who wins?

I think it is very possible that this will produce a perverse result. Here is why. When marginal tax rates on the highest earners increase, with those increasing rates tend to come hand-in-hand the following behaviors among that group:

  • They save more on a tax-deferred basis
  • They spend less
  • They invest less
They are hoping that this is just part of a cycle and that their rates will come back down again soon. 

All this tends to point toward even further employer belt-tightening. This means smaller benefits and limited pay increases. The middle class is generally less able to withstand this because the people who fill that class just can't save as much. The highest earners, on the other hand, even if they can't make use of qualified plans have nonqualified plans in which to save on a tax-deferred basis. In essence, they will currently spend less and will have even more saved for retirement. At the same time, those who earn less than that will save less and have even more difficulty preparing for and saving for retirement.

I think this is just the opposite of what the Democrat Party intends. The result could be perverse indeed.

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