Rising debt may drive future higher taxes

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The Congressional Budget Office (CBO) recently released its latest analysis of the federal government’s finances. While the annual budget deficit will not rival levels realized during peak Covid years, the CBO reports a nearly $1.7 trillion deficit in 2023.

Unless Congress takes some policy action, budget deficits are expected to persist. In fact, government spending as a percentage of GDP (23.1%) easily outpaces revenue (17.5% of GDP).

Also, higher interest rates are driving an increase in the cost of servicing the existing debt. At some point, the debt trajectory will drive discussions on Capitol Hill to increase revenue (i.e., raise taxes), reduce certain government benefits, or, most likely, do both. Investors who have contemplated and planned for these potential risks will be better prepared to meet these headwinds in the future.

Here are some notable observations from the report:

Total debt continues to rise

Source: Congressional Budget Office, The Budget and Economic Outlook: 2024 to 2034, February 7, 2024.

Government debt as a percentage of the overall economy set a record in 1946, as debt held by the public reached 106% of GDP. Current CBO estimates suggest we will exceed that level beginning in 2028 and eventually reach 116% of GDP by 2034. This assumes that the Tax Cuts and Jobs Act (TCJA) expires as scheduled at the end of 2025. According to recent analysis, an extension of the TCJA through the end of 2033 would increase government outlays by $3.5 trillion. Given these circumstances, extending the current tax rates and provisions will be challenging regardless of which political party controls Congress.

Most government spending is on autopilot

Policymakers have generally considered cuts to entitlement programs as off-limits. Yet more than 70% of government spending is driven by a combination of large benefit programs like Social Security and Medicare, as well as interest costs on the existing debt. Social Security is the most expensive of these programs with an annual price tag of $1.3 trillion. (Medicare spending is roughly $1 trillion.) Due to rising interest rates, the cost of servicing existing debt is the fastest-growing spending component. For 2023, net interest cost to service the existing debt reached $649 billion, a 35% increase from last year.

Revenue is driven largely by individual taxes

Consequently, the government overwhelmingly relies on individual taxpayers to fund its operations. More than half of all government revenue comes from taxes on individuals (taxes on employment, capital gains, dividends, interest, etc.). Payroll taxes are also a major source of revenue, generally split by individual workers and their employers. Given these considerations, it is reasonable to suggest that individual taxpayers will bear a significant burden on any federal government attempts to raise revenue.

Planning for an uncertain future

Given the current state of government debt and looming solvency issues with major entitlement programs, it’s reasonable to conclude that revenue needs will lead to tax increases. Whether these will be limited to higher-income taxpayers remains to be seen. For example, many Biden administration proposals have proposed raising taxes on those with income levels exceeding $400,000. However, it may be challenging to generate enough revenue from this small segment of taxpayers.

As a result, many taxpayers may want to consider incremental steps to improve tax diversification. That is, owning assets across different tax buckets (taxable, tax-deferred, and tax-free). Partial Roth IRA conversions, backdoor Roth contributions, health savings accounts (HSAs), and other tax-favored strategies can help hedge the risk of higher taxes in the future. A professional advisor can help develop a personalized plan based on unique circumstances.

Source: Congressional Budget Office, The Budget and Economic Outlook: 2024 to 2034, February 8, 2024.

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