Financial Literacy

During many social gatherings in Connecticut these days, there is a likelihood that at some point the conversation will turn to: outrageously-high property taxes, falling real estate prices, and moving out of the state. Why is there such an exodus from this formerly successful and wealthy state?

According to locals, below are some of the commonly mentioned reasons (in no particular order):

• State politicians spend too much buying votes and hiring people – growing state and local staff 6 times faster than the population.
• Foreign immigrants are overwhelming the state’s budget, reducing money for counties and townships. So property taxes have continued to ratchet upward (Norfolk alone went up 14.5%).
• Hedge funds, who had moved their trading desks from Wall Street to Connecticut, all left when CT started specifically targeting them with high tax increases.
• Large insurers have left the state to find a more business-friendly climate.
• Increasing gun control laws drove out their most well-known manufacturers, Remington and Colt, plus several smaller firearms manufacturers.
• Otis Elevator and Carrier Air Conditioning moved their headquarters from CT to FL.
• GE moved its headquarters out of CT to Boston.

What Connecticut is facing today:

• Worst economic growth in the country.
• Huge state budget deficits.
• Underfunded state government pensions.
• Among the worst business climates in the country for number of taxes and their high rates.
• The highest gasoline tax in New England.
• Even the average cable bill has a $12 tax.
• The worst probate court system in the country, incentivizing retirees to leave.
• Net emigration from the state for the last 5 years, and it is increasing.
• Many of the ritzy homes in Greenwich are for sale as wealthy residents flee to TX and FL with no income tax and far lower property taxes. But no wealthy are moving in to purchase real estate, so expensive real estate lies empty and languishes on the market.

Similar discussions about “moving to another state” due to “how horrible the government is here” are also commonplace in Chicago, San Francisco, and Seattle. It is best to continually evaluate state and local governments on how they affect your career and personal finances before these predictable cascades occur. 

Argentina has been chronic debt-defaulter and currency hyper-inflator for a long time. Last year, they offered 100-year bonds at an attractive interest rate and sold billions of them. Less than a year later, they are teetering on default of these bonds and all kinds of money managers around the world are caught with catastrophic losses. How did this happen?

Since 2008, interest rates around the world have been artificially lowered to boost economies. (For example, the U.S. Federal Reserve’s Fed Funds Rate 48-year average is 5.64%, but today you can see in the chart that they are 1.75%). Now, over 10 years later, short-term interest rates are still near zero and many government bonds in Europe are being issued with a negative interest rate. As a result, professional investors at pension funds, endowment funds, insurance companies, and other financial institutions have been desperate to find a speck of return to meet their payment obligations. Without normalized interest rates, they are in colossal financial trouble. Hence, when a 3^rd-rate country run by socialists known for hyper-inflating their currency and defaulting offers a bond with a decent interest rate – even the professional managers lose all sobriety and recklessly jump on some Argentine bonds.

One of the many consequences of these prolonged artificially low interest rates is struggling pension funds. From the states of Illinois and Connecticut to the country of Netherlands, pension benefits are becoming imperiled. For example,

• Netherlands is forced to buy zero-interest government bonds so they now must either raise their pension contributions by 30% or reduce the pension payouts.
• The maximum Full-Retirement pension in the UK is capped today at a pitiful $10,354 per year.
• Connecticut state pensions are only 46% funded
• Illinois state pensions are only 38% funded

As these troubled fund managers panic for growth, they are more inclined to gamble on foolish investments, like Argentine bonds, that just lead to more losses. Artificially lowered interest rates have been transferring trillions in wealth from savers (individual and corporate) to the largest borrowers – government treasuries, banks, and corporate borrowers. It is a horrible environment for safe investing for a reasonable return and I expect more trouble for institutions that rely upon bonds and savings instruments in their business model.

The state of Illinois is in all kinds of financial trouble. For example, they haven’t had a balanced budget in 19 years, the worst credit rating among states, plus sales and income taxes are high and rising. As a result, Illinois residents are currently leaving the state at a rate of 1 every 4.5 minutes. According to a poll by NPR Illinois and the University of Illinois, Springfield: 61% of Illinoisians recently thought about moving out of the state. Their number one reason for considering moving to another state = high taxes. And the number two reason = getting away from the Illinois state government and its policies.

What are the financial problems with Illinois?

• State and city pensions are in death spirals
• Deficits are large and growing
• By most fiscal measures, Illinois is rated at or near the bottom among U.S. states

Chicago is even in worse financial shape than the state so in the last few years they have tripled every type of fee, charge, fine, and tax. Similarly, Illinois Governor JB Pritzker has a new list of tax increases that he hopes will syphon off an additional $7 billion from overtaxed residents. His budget proposals:

1. Progressive increase in income tax rates
2. Tax on managed care organizations
3. Tax sports gambling
4. Recreational cannabis tax
5. Retail tax hike
6. Video gambling tax hike
7. Cigarette tax hike
8. Plastic bag tax
9. E-cigarette tax
10. Gas tax hike
11. Vehicle registration tax hike
12. Ridesharing tax hike
13. Streaming video tax
14. Beer, wine, liquor tax hike
15. Video gaming terminal tax hike
16. Cap the exemption on trade-in property tax
17. Parking garage tax
18. Real estate transfer tax hike
19. Electric vehicle registration tax hike

Just awesome. These new taxes (that won’t put a dent in the deficits and underfunded pensions), are sure to attract new residents from other states and keep the currently overtaxed residents from fleeing.

However, Pritzker has other tax issues to defend… (Keep in mind that 4 of the last 10 Illinois governors have gone to prison). Now, Pritzker, his wife, and brother-in-law are under federal investigation for a scheme to defraud Cook County of $331,000 in property taxes. They temporarily removed toilets from a mansion they own before an inspection so that it would be erroneously classified as “Uninhabitable,” hence the media label: Toilet-Gate.  So the state is run by a tax cheat who is simultaneously attempting to raise those taxes.

No matter which country, culture, or time period, anytime someone’s total income tax rate approaches 40%, they scramble to lower it. High income earners in several states are now breaching that 40% barrier, and residents have begun taking action in 2019.

There are several high-tax state candidates, the usual suspects, such as Illinois, Connecticut, and New Jersey. But this is occurring in the largest numbers in the high-tax states of New York and California. New Yorkers are streaming into no-tax Florida and Californians are streaming into no-tax Texas. (Mansions in Florida have seen prices rise all year) For the high-income earners that are remaining where they are, they are moving billions of their investment dollars into tax-exempt bonds. This is the easiest way to reduce the tax bite until they get into more serious tax planning and moving their primary residence.

As for corporations, they have been abandoning high-tax states for several years. While California gets the most press about this, the states of Illinois and Connecticut are also facing this problem. Connecticut chased the hedge funds and trading desks back to New York City, and their insurance and banking companies to the Carolinas – even as far as Oklahoma (Oklahoma city is booming). Taxes are most everyone’s largest expense so it is critical to your financial stability and success to minimize your tax burdens. If you evaluate both your personal and business taxes, you too may be better off in a different state or jurisdiction.

Over 40 states have underfunded pensions for government employees. Instead of setting up reasonable obligations or switching to employee contribution funds like most companies, politicians look for the easy solution first and so they’ve started to fall for financial gimmicks. For readers that do not watch government finances, whenever Wall Street “comes to the rescue” to a government entity, it always ends in a larger and faster bankruptcy with taxpayers owing a lot more money. The latest Wall Street “solution” to underfunded government pensions is called Pension Bonds, and is sold as a “free fix without raising taxes.”

The pension bond method consists of raising money with bonds, say $1-to-10 billion, and placing that money into the pension to reduce its underfunded level. Then, the pension fund will “magically” earn so much more than any investment fund ever has. This new pension money will routinely earn unrealistic profits to not only make the bond payments, but make additional payments to reduce the underfunded amount of the pension. “Everybody wins” is the argument being pitched by the people selling this high-risk and unlikely arbitrage.

Pension bond programs are so likely to fail that the Government Finance Officers Association issued an advisory report warning against pension obligation bonds with 5 grave reasons; https://www.gfoa.org/pension-obligation-bonds But you cannot stop politicians from employing reckless ideas that leave everyone poorer. Local governments (like Houston and Muskegon) have already issued pension bonds. A couple states have jumped in while several are attempting to pass legislation to do it, such as Alaska, Illinois, California, Michigan, and Kansas.

What happens when the unrealistic investment returns do not materialize? Hence the term ‘pension bombs.’ The pension defaults on the bonds and the pension’s financial position becomes worse than if they hadn’t rolled the dice on this program. (This is what exacerbated Detroit’s financial position when a complicated Wall Street debt product went against them in 2009; it became a huge additional debt that helped force the city into bankruptcy in 2014). Per usual, the taxpayers end up with higher taxes to fund the mistakes of the politicians and their Wall Street buddies with their latest high-risk gimmick.

In the 70s, former U.S. Treasury Secretary, William Simon, said something like: Washington is like a train running at full throttle while officials are mindlessly partying it up in the caboose. In my opinion, those were the good old days of fiscal responsibility. Today, there are many budget-busting programs and departments, let alone colossal boondoggles like the transportation spending. To highlight what is happening today, for the fiscal month of February, here are some notable statistics:

$167 billion Total Federal Government Tax Receipts  

-$ 87 billion Social Security Spending                           

-$ 52 billion Medicare Spending

-$ 25 billion Interest on the Federal Debt

– – – – – –

$    3 billion remaining for ALL other federal spending

$231 billion in other federal spending in February

$234 billion in additional debt created in February

So, outside of entitlements and interest, the federal government spent 40% more that it took in, and this ratio will increase over the next 30 years as the Baby Boomer generation consumes an increasing amount of Social Security and Medicare. Yes, February results were a little more unfavorable than usual, but the trend of increasing entitlements and increasing borrowing will continue to degrade.

Note that the economy couldn’t be doing any better than today. What would happen if there were a severe or even slight recession? Tax receipts would fall and government spending needs would increase, and the federal debt of $22.2 trillion is already larger than the U.S. economy at $20.4 trillion.

To me, this financial calamity-in-the-making means one thing: soon, we will all be on our own for retirement. Either the government will be forced to dramatically reduce Medicare and Social Security benefits, or they will ignite a Venezuelan-style hyperinflation. If you are mostly on your own for retirement, then it is time to become diligent about saving money. If, at some point, the government goes down the inflationary money-printing path to “solve” the problem, then your savings need to avoid U.S. dollars and be held in:

• Inflation-adjusted securities
• Stronger currencies than the U.S. dollar or whichever currency is being inflated
• Physical assets such as real estate and possibly gold.

New York City has had some bankruptcy brinkmanship – in 1975 it was bailed out in the last second by the teacher’s pension, and in 1907 by Hetty Green (a wealthy millionaire who bailed the city out with a check). Today, the economy is performing spectacularly, and yet the State of New York and New York City are both running very large deficits. If both government entities are struggling in great economic times, how poorly will they perform if there is a recession? The combination of overspending and high taxes (of all types) is already prompting residents and businesses to flee the Empire State and NYC in droves for lower-tax locales. The resulting statistic highlights the problem: NYC’s long-term debt is $257 billion, or $82,600 per household.

Adding gasoline to the debt bonfire is NYC’s current Mayor Bill de Blasio. Whether de Blasio is calling himself a socialist, a communist, or a progressive – his policies are financial train wrecks. (We will not comment on the recent scandal of his wife being unable to account for $850 million in taxpayer money he gave her to run “Mental Health Anxiety programs.”)

• The current NYC budget deficit for 2019 is -$3.9 billion
• Since his election in 2014, he has run up city spending by 32%, now at $89.2 billion
• He added an additional $3 billion in new spending in that $89.2B
• He announced a new $100 million universal health care system
• He has hired an additional 33,000 public employees

The State of New York cannot help NYC because they are already struggling with their own budget deficit of -$2.3 billion. The state’s response to the deficit isn’t reducing spending or lowering taxes to sustainable levels, but to increase the numbers of income tax auditors to try to claw back some money from the wealthy residents that have already left the state. What is unpredictable is the number of residents leaving NYC to save money on taxes this year, not to mention the future. A few people emigrating from a state is normally not a big deal. But NYC has the highest income-tax rate in the country, and 50% of all taxes collected is from a tiny number of the wealthiest households. So if just 2 hedge fund zillionaires leave the state, it can have a catastrophic impact to the state’s budget. New Jersey, Maryland, and Connecticut discovered this exact phenomenon when they introduced a “millionaire’s tax,” and so many wealthy residents left the state that the government collected far less money than before the millionaire tax was introduced.

While the credit rating for New York City is Ok for now, the credit rating agencies are notoriously slow in responding to the deteriorating finances of government entities. I would not hold any bonds issued from states that have enormous unfunded pension obligations for state employees that they can never pay – such as New York, Illinois, California, Ohio, Connecticut, Massachusetts, Rhode Island, or New Jersey. I can anecdotally confirm the upper middle class fleeing the high-tax northeastern states: a relative who moved to Florida to reduce his taxes says he meets lots of new state residents on golf courses that have migrated from that list of northeastern states. The state of Florida has no income tax and low-property taxes. He tells me, just like him, their move was prompted by tax increases and they know exactly much they are saving in taxes per year from their move.

You may know that the State of Illinois has the lowest credit-rating of any state and is in a financial death-spiral from colossal state employee pension liabilities and over spending. For at least 8 years, Illinois has been very slow in paying suppliers of all kinds. From nursing-home patients, to prison guards trying to get bullets, to lottery winners, and even state income tax refunds – nobody gets paid within a reasonable period of time. According to an Illinois vendor survey, 40% wait 5 months for payment and 36% wait 6-12 months for payment. I know a Michigan dentist, who has two patients that work for the State of Illinois, and she says she won’t accept any more of them because she’d go bankrupt – it takes at least 8 months to get paid. 

Have there been any consequences for this structural habit of slow payment?

• To pay unpaid bills, the state ratcheted property taxes so high it resulted in the emigration of residents to other states.

• Legislators have received eviction notices for their district offices and had their phone lines cut off. Banks won’t lend to entities relying upon payments from the state.

• The state is slow to pay townships and cities, resulting in a “deadbeat” reputation across the entire state. Many suppliers insist upon payment upfront in advance of sending goods.

• Lending companies started cropping up 7 years ago, offering quick payments to Illinois vendors, but those payments are discounted, you receive less than what you are owed. Many more lenders are needed, but Illinois also has usury laws disallowing rates commensurate with high risk: loans to a government entity cannot exceed 6%.

• Non-profits and foundations have closed or are floundering, according to the CEO of the Illinois Donor’s Forum. Funds are generally raised from 3 entities (businesses, individuals, and the state), but corporations are leaving the state, individuals are struggling, the only one left is the state and they are not following through with their commitments.

• A lawsuit forced the State of Illinois to speed up Medicaid payments. Medicaid patients have doubled in the last 15 years, causing yet another financial strain on the state’s finances. 

• Availability of social services is diminishing: mental health services, food for homebound seniors, domestic violence centers, libraries, and state colleges are laying off staff and deferring maintenance.

On top of all of this, small businesses have been closing and medium/large companies have been moving out of the state. The only way to turn around Illinois’ gigantic deficits and unpaid bills is to:

1. Cut spending (which they’ve been unwilling to do in 20 years)

2. Cut state pension obligations (but that is illegal in Illinois)

3. Possibly increase taxes (but they are already so high that individuals and businesses have been fleeing the state).

New U.S. Congresswoman, Ocasio-Cortez would like a confiscatory tax rate of 70% for personal income above $10 million dollars to pay for her socialist government goals. Setting aside socialism, let’s examine two critical questions: will this tax plan work and how will taxpayers react?

The first question, will it work, we can already assess by many recent examples of this new income tax. The states of Maryland, New Jersey, Washington DC, and others have imposed a “millionaire tax” for their highest income earners in the last few years. What happened? The income taxes collected from their highest earners fell – it backfired for all of these states. The exact same result happened recently in France and Canada when their socialist presidents tried it (Hollande and Trudeau). Why does a higher marginal income tax rate mostly backfire? Anytime you increase someone’s opportunity cost, they go far out of their way in effort and money to avoid it. (For example, the anecdotal evidence from Maryland, D.C., and New Jersey was that many of their high-income earners had a second or third home in a lower taxation state, and they simply changed their declared domicile to that other state. If they didn’t have this option, they simply moved out of state, usually to Florida, and took their entourages of advisors with them).

Now the second question: How will taxpayers react? Let’s examine; who actually earns more than $10 million a year? Nearly all of them are business owners, aside from a few movie, music, and sports stars. How do they pay their income taxes? Each year, they sit down with their tax attorney, accounting firm, banker, insurance agent, investment broker, and other advisers to map out and coordinate the next 5 years of activities and tax laws. Together, they optimize the high-income earner’s financial situation and minimize their lifetime tax liabilities. Some top earners also consider the tax consequences for several generations of inheritance. As a business owner, they have many “levers” to manipulate:

1. How much salary they want to take
2. How much dividends and/or capital gains they want to take
3. How much deferred compensation they want to take
4. How much of one type of income they want to convert into another type of income
5. When to time spending and donations for tax deductions
6. How to increase depreciation or other IRS incentives to reduce taxes
7. Which tax credits do they want to select to reduce their taxes
8. And many more levers such as life-insurance arbitrage or captive insurance

I have attended one of these meetings and was rather shocked at the size of their tax-lowering menu that they can choose among. One of the options is to actually pay zero income taxes and there are two ways someone wealthy can achieve this within two or three years. First, purchase many apartment buildings (or commercial real estate) and the depreciation will drive your taxable income much lower, and if you want, all the way down to nothing. (One acquaintance started with 1 rental property and now has 6,300 units; he cannot remember the last time he paid income taxes to the state or federal government.)

The second method allowing a wealthy business owner to pay zero income taxes is to choose not to have any income and borrow all of the money that they spend. The high-income earner could change their salary and dividend withdrawals to zero, and let’s say they spend $5 million a year on their luxury lifestyle. They borrow $5 million, every year, for the rest of their life for spending money. The cumulative loans and interest are re-paid at their death from insurance policies and/or their pledged business assets. This is exactly how many earners in the top 0.01% already pay nothing in income tax all over the world. Because they don’t have any income, they just spend loaned money, perhaps from an offshore trust. If confiscation tax rates were enacted at the federal level, these strategies (and many, many others) would quickly become commonplace for incomes much lower than $10 million.

When a politician increases income tax rates, let’s say to grab an extra $2 million from someone very rich – they only see the new money that they can spend on pet projects. What these politicians ignore is that the taxpayer now has a $2 million incentive to lower his or her tax burden. Plus, they can spend $1.9 million of that money on tax experts to find a way to make that happen and still come out ahead. In my opinion, Congresswoman Ocasio-Cortez’s new 70% marginal tax rate, if enacted, would result in yet another taxation backfire for the socialists.

The city of Chicago has a $36 billion shortfall for their city employee pensions. Basically, Chicago’s 4 pensions are in a death spiral to insolvency. But not to worry, Mayor Rahm Emanuel and his crack team are on the case. His latest solution is: a city-owned gambling casino and legalizing recreational marijuana. This is even sillier that his prior pension solution ideas. So instead of dealing with financial reality in city budgeting, he wants to roll the dice on two tactics that won’t add up to anything of note.

1. Let’s see… a city that has never been able to manage its own budget is going to successfully manage a casino without breaking its budget as well? Chicago is one of the epicenters of government corruption, and he wants to introduce an additional trough of casino cash under the control of politicians? First consider that no city owns and runs businesses. Aside from legal reasons; they are not qualified or capable of neither running it; nor managing the company that does operate it on the city’s behalf. Already, they can’t successfully manage simple towing companies. Chicago city officials are already trying to find a loophole to get out of paying any state taxes on their new fictional casino, which would be an illegal advantage over other casinos in the area. Local casinos have already been experiencing a softening of the gambling market – so Chicago might be jumping in as the industry languishes. A new casino is planned just across the border in Wisconsin and Indiana is considering one too.

Presuming Chicago builds out and manages the greatest casino in the Midwest, it would earn $27 million per year. That is just 0.0135% of their annual pension bill, and not nearly large enough to slow the shortfall that continues to grow exponentially large reach year. So Chicago would need the profits from 92 casinos to make a tiniest dent in the pension problem. An average large casino costs $1-7 billion to build out. Let’s take the low end of $1 billion, times 92 casinos and so how is Chicago going to come up with an additional $92 billion when they cannot come close to making a $2 billion pension payment? They have no credit to borrow at a reasonable rate. To provide an idea of how many casinos 92 are, the entire city of Las Vegas has around 122 casinos.

2. How about that marijuana legalization? Well, what has Colorado’s experience been?

Tax revenue is up but there are plenty of deductions that have to be made:

• Colorado had to double their car insurance rates because of increased accidents from marijuana-impaired drivers.
• The Mexican drug cartels moved in, taking over the black market and growers for export to other states. So law enforcement is busier with illegal activity from more dangerous outlaws than when all marijuana was illegal.
• Emergency room visits from drug overdoses are up 300%, too many of these are children or teenagers that accidentally ate edible marijuana products like cookies and chocolates.

Presuming Chicago expertly rolls out the perfect balance of laws and regulations over legalized recreational marijuana, it could take in additional taxes of roughly $10-40 million per year in the first few years. Let’s be overly optimistic and say Chicago will take in $150 million a year in taxes. Chicago’s annual pension obligation requires an annual payment of $2 billion. So drowning the city in marijuana will only contribute a tiny 10% of the annual pension payment, and do absolutely nothing to catch-up with the escalating shortfall.

My 3-minute back-of-the-napkin analysis = Mayor Emanuel needs $2.00 per year just to slow pension solvency and his brilliant solution is to: start a casino that will earn 3 cents per year and new tax revenue from legalizing marijuana that may produce 4 cents. Reducing your $2.00 pension bill by 7 cents isn’t an idea worth the napkin it was written upon.