This week, as we all organize our W-2s & 1099s and field phone calls from accountants who are still in a good mood, we talk a little taxes.

Here’s a preview of the exciting territory we’re going to cover:

• How tax rates shift across the income spectrum.
• How much does the average household make and do you satisfy the criteria for wealthy?  (some of you will be surprised!)
• Who’s really shouldering the majority of the tax burden.
• Who will have to pay even more in taxes?
• Are Democrats and Republicans really that divided on the subject of taxes?

Wealth and taxes are touchy subjects, so I’m sure this will send some of you into frothy rants.  Let me hear it at Feedback@TheDraconian.com.  I’d love to share some interesting reader perspectives in next week’s letter.

A (very) brief history of the income tax

The U.S. has a progressive tax system, which means that the more money you make, the more taxes you pay.  This is true not just in an absolute sense, but also a relative sense.  Unless you’re a really crafty bugger, you’ll pay a higher percentage of your income on taxes if you make $150,000 per year than if you make $30,000 per year.

This is the system we have today and have had since Woodrow Wilson reinstated the federal income tax in 1913.  Under that legislation, pretty much everybody paid a marginal income tax rate of only 1% with the wealthiest ($10+ million per year in today’s dollars) paying as high as 7%.  How great would that be, huh?  And before that, there wasn’t even an income tax at all!  Most of the government’s revenue came from tariffs on imports.

That would change in a hurry, however.  By 1919 the U.S. had a war to pay for and at that point there were 57 different tax brackets.  The top marginal rate was 73%.  Again, most people paid only about 4% of their income in taxes, but that was a quadrupling from what it was earlier in the decade.  Those rates came way down during the 1920’s, but by the time the next world war was on us, citizens were called upon to pay even more of their income in taxes.  In 1945, most people paid between 25-35% of their income in taxes, and income above $200,000 was taxed at a mind-boggling rate of 94%.  I made the mistake of looking at some of these historical income tax tables late one evening.  It gave me nightmares.

I know a lot of you high-earners out there are losing sleep over Obama’s planned rollback of the Bush tax cuts, but maybe this will put things into a perspective.  A bracket of 39% isn’t so bad in a historical context.  And for all you others out there crying that the rich should pay for everything, keep in mind that folks in your bracket were paying about twice as much in taxes as you are today.  During times of past crisis, all of our nation’s citizens had to step up and make sacrifices.

In the 1940s, we were on a gold standard so we couldn’t just print or borrow money to pay for things.  If the government wanted to spend money, its people had to pay for it.  Today it’s a little more complicated.

OK.  A lot more complicated.

Who pays what

Here’s where we are today:

This charts the total effective tax rate for various income groups.  It includes all the federal taxes that individuals pay: income taxes, Social Security & Medicare, and excise taxes.

The Bush tax cuts developed a reputation for unfairly benefitting the rich, but the middle class and poor were helped out even more.  Given the economic and political environment we find ourselves in today, I think it’s easy to argue that, in retrospect, maybe those tax cuts weren’t such a great idea.  Do we feel like we’re all in a better place today because of them?  Did they make our lives and our nation better?  Think about how great a tax cut of that magnitude would be in this current environment.  Or how much real stimulus revenue of that magnitude could support.  But all that ammo was spent to get one man elected and launch our nation into a lost decade of decadence.

Am I wealthy?

You’re probably wondering which bucket you fall into, so here’s how those quintiles above break down in terms of income:

A lot of you guys probably didn’t realize your household was in the highest or second-highest quintile.  Those are households, too, so if you’re making $50,000 and your spouse is making $50,000, congratulations, you guys meet the statistical definition for “wealthy.”  Or at least the wealthiest quintile.  Do you feel wealthy?

Wealth can be a touchy subject, and there isn’t as much public discussion about it as there probably should be.  Think for a moment about what would make you feel wealthy.

I had this conversation with many people during the middle financial crisis, and I listened to a lot of interesting, heartfelt responses.  Wealth is a very personal thing to define, though common threads with those I talked to were an ability to satisfy basic needs without any worry and the ability to afford a modicum of luxury.  I found it had less to do with money and more to do with security, comfort, and freedom.  I count myself lucky to know and have known people who are technically in the lower and middle quintiles but consider themselves wealthy.  And I’m also glad I know many others, well into the highest quintile who do not consider themselves wealthy.  Perspective is a valuable asset, the reason I court diversity in my body of friends and colleagues.

Back to statistics, care to venture a guess what kind of income places you in the top 5% of wage earners?  That eeevil top 5%, the extremely “rich” that needs to pick up the slack, “pay their fair share”, and shoulder an even greater portion of our collective income tax burden?

$180,000.

Don’t get me wrong, if this is you, you’re doing well, but it’s probably not what you thought of when you think of those that are richer than 95% of the rest of us.

Let’s break it down.  $180k gross is about $126k net under average assumptions.  Us lucky Nevadans don’t have to pay state income tax, so for most of you that “top 5% paycheck” is closer to $110-115k.  That’s about $9,500 per month.  That should responsibly support a $450,000 house, a nice SUV and a sedan.  It’ll pay for utilities and school supplies for your kids and maybe a nice vacation or two per year.  You can eat out when you want, but certainly not all the time.  If you have no other financial obligations in life like a business to feed or a wayward sibling to support, you might also be able to squirrel away a few thousand dollars to invest.  Odds are, if this is you, you probably aren’t even maxing out your and your spouse’s IRA contributions.

Is it the good life?  You bet.  But it’s not a mansion-on-the-golf-course and a membership-at-the-club rich.  And obviously, if you live in a major metropolitan area like New York City or a state like California, that $180k doesn’t get you quite as far.  That might be “middle class” in some locales.

Again, that’s household income.  So maybe you pull down a decent living in finance, and your wife works for the state.  Maybe your wife is an attorney and you run a small computer business.  Maybe you’re a doctor.  You’ve got loans and a house and a car, and a wife that takes care of the kids who, before you know it, will be on their way off to college.  Do you feel really rich?  Do you feel like you’re not paying your fair share?  What do you say to those who demand you contribute even more of your hard-earned income to keep the nation solvent?

If this is you, how do you feel about those that both earn and pay less than you do?

And what if this is not you?  What if you struggle from paycheck to paycheck?  Your family budget probably can’t handle more taxes.  How do you feel about this guy living the good life, but who is probably also living right at or very close to his means?  Do you tell him to sell his house for something more modest and swap his SUV for an economy car?  Does he have an equal right to demand that you lease a smaller apartment and trade that Camry in for a used Kia?

These are very personal questions.  There are no right answers.  But they’re important considerations when it comes to macroeconomic policy, something that’s ultimately funded by a nation of diverse individuals.

Who’s really shouldering the tax burden?

The rich.  Mostly.

But you knew that.

We can have debate about whether or not this should be the case in the another venue.  Is it the responsibility of the rich to shoulder a larger burden, to pay for most of the cost of benefits that are consumed primarily by others, many of whom pay nothing to enjoy them?  Or is it the responsibility of each of us, regardless of our level of income, to pay an equal relative share of the benefits that we all enjoy together?  This is a classic debate and I have heard good arguments for both schools of thought.  But as I said, that’s a conversation for another forum.  Today we’re just going to focus on facts, on what is.

The fact is that those who make more money pay for a bigger share of our country’s expenses.  They do it in absolute terms and they do it in relative terms.

I know we’re only talking about income taxes here, and tax revenue does come from other sources.  But it’s not a lot.

Taxes on corporations make up about 10% of federal revenue, and excise taxes on stuff like gasoline and cigarettes account for less than 5%.  Most of it is income tax and social insurance tax, which is based on income.  The government gets most of its money from taxing its individual citizens.

Here’s the nitty gritty of who pays what:

Unless you’re a data hound like me, your eyes probably just glazed over.  Hopefully you weren’t reading this in bed.

It’s a lot to digest, I know.

Don’t worry, I’ll give you the juicy bits:

Those of you with an adjusted gross income of $100,000 per year or more, which is about 16% of all tax returns received by the IRS, account for nearly three-quarters of all the income tax revenue generated.  Those of you making less than $50,000 per year, which is about about half of all returns that get filed, account for only 10% of total income tax receipts.

You’ve probably heard that the top 5% of wage earners account for about half of all the income tax revenue that gets collected, and this is true.  But did you know that those of you that make more than $10,000,000 per year, a scant 0.017% of all returns, account for nearly 10% of all the income tax revenue that gets collected?

Despite the fact that a relatively small percentage of higher-earning individuals pay for the overwhelming majority of total tax revenue, it apparently isn’t enough:

Gallup has been asking this question for a while now, and apparently, most people think that the wealthy have never paid their fair share:

It’s hard for the wealthy to complain about this (you know, ‘cause they’re wealthy), but this makes me wonder just how much is enough? It’s an interesting question to meditate on.

Here’s a chart of the highest marginal income tax rate:

Before Reagan took office and slashed taxes – a historically correct moment at which to lower taxes, I should add – the average top marginal rate for most of the century was 79%.

I wonder if middle class folks in the early 1950’s – a time when the top marginal rate was 92% – still felt that the wealthy weren’t paying their fair share.  I wish I had some pre-1980 polling data.  (feedback@thedraconian.com if you guys ever find any neat data sets – I eat this stuff up.)

Anyway, today the top bracket is 35% and set to revert back to 39.6% in 2011.  I’d be shocked if that isn’t even substantially higher by 2020.  This is an easy, politically palatable way to raise revenue, especially in this era of stark partisanship:

The current administration has already decided that curbing spending is not an option for the decade to come.  Therefore, the government needs to look at new ways to generate revenue to prevent these deficits from spiraling too far out of control.  If you think that large deficits and a large debt-to-GDP ratio are things we shouldn’t be concerned about, you haven’t read Reinhart & Rogoff’s This Time is Different: Eight Centuries of Financial Folly.  I’ve been talking about this book since last year, and today, everywhere I turn I hear another sophisticated voice in the industry talking about it as well.  This is a seminal book.  Just don’t read it late at night.

The bottom line is that we’re in a real pickle and the menu of politically feasible solutions is slim.  Higher marginal rates is one, and I think a VAT (value added tax), which I covered in our Predictions for 2010, is another.  2010 is too soon to see either of those materialize, but I think this is the year that the dialog picks up, especially if economic growth strengthens.

Now that we’ve covered what’s happening on the income side of Uncle Sam’s statement of operations, it’s time to take a look at what’s happening on the expense side.

I want to spend this entire issue recapping what we’ve seen in the markets the last two weeks.  There have been some major moves, the likes of which we haven’t seen since last March.  I know I promised you guys a big newsletter on taxes and also something fun, but that’s going to have to wait for a week or two.  We can revisit those topics when the markets chill out a little bit.

But first, a few quick administrative items.

Thank you very much to all those who participated in our referral promotion!  I’ve contacted each of the three winners personally and your $50 P.F. Chang’s gift cards are in the mail.  I’ve had fun with this and look forward to doing something else like this later in the year or if we have another great quarter.

When we launched The Draconian back in July we had about 20 subscribers and about 40 visits per month on the website.  In January the website topped 400 unique visits for the month and over 400 additional subscribers via email.  It’s been very exciting watching our readership grow.

Those of you who have been on the list for a while will notice a few upgrades in the form of an improved layout, and also some links to various social networks.  Our Facebook fan page has been a nice success, but I’m still scratching my head about Twitter.  Please let me know if any of you have suggestions on how we could utilize that service in a way you would find useful (Feedback@TheDraconian.com goes straight to my inbox).

And for all the new faces this year, welcome aboard!  You can read a little bit about this newsletter here.

Our goal with each issue is threefold:

1. Informative – We’ll recap the most significant market events of the week, everything important you’ll need to know to sound really smart at your next cocktail party.
2. Actionable – We’ll help you interpret market action and develop investing strategies, many of which we and other professional fund managers actually use ourselves.  Not only will you sound informed, but your golf foursome will be impressed with your clever methods for profiting in the markets.
3. Entertaining – Market news sites and investing blogs are a dime a dozen, but hardly any are well written and fun to read.  Education is a lifelong process.  We try and make learning enjoyable for kids, so why can’t adult professionals have a little fun with it too?

Many of you know that our real business is not actually newsletter writing.  It’s investment management.  We’ve managed a family of hedge funds for 25 years and our firm’s trading heritage extends back into the mid-1960s.  While we have learned a thing or two about investing and alternative strategies over the years, we primarily consider ourselves students of the markets.  These markets are great teachers and have something fascinating to say every day if you know how to listen.  The Draconian is a place where we can make sense of it all and add a little more sophistication to our investment portfolios.

We don’t charge anything for The Draconian.  We don’t run any ads.  We’re 100% spam-free.  And we don’t sell your email address to anybody.  As you can see, there’s a pretty good reason our business isn’t newsletter writing.  I seem to remember something from my economics classes at UCLA about businesses needing to make money?  It’s sort of hazy, though.

On to the markets…

Market Recap

You’ll remember from our 10 Predictions for 2010 newsletter that our basic macro thesis for this year is that it will be a reminder that things are tougher out there than a lot of us were thinking during the last half of 2009.

Stocks have sold off relentlessly since mid-January when Greece slapped most of last year’s complacency out of the market in a matter of days.  Things are going from bad to worse over there and suddenly “contagion” is a buzzword once again.  It feels like I’ve been talking about Greece and the troubles in the Eurozone forever, and it looks like we officially raised that red flag in the nick of time.

Greece and its troubled cousins in the Eurozone have given the markets fits.  If there’s one thing that markets hate, it’s uncertainty, and right now nobody has any idea what to expect.  Will they default?  Will they get bailed out by the Germans or the IMF?  Will they really buck up and slash that deficit from 12% to 3% of GDP?!

Mohammed El-Erian, in his inimitable, ever-so-eloquent fashion, described it as “a huge game of chicken, whereby the Greeks are waiting for help from the outside and donors are waiting for Greece to take a step forward.”  Earlier this week STRATFOR weighed in on the subject with a deeper analysis.  That article is worth your time, if for no other reason than to see how all the pieces fit together on the geopolitical chessboard that is the European Union.

After this morning’s EU meeting it does sound like there will be some vague backing if necessary and vague action on the Greeks’ part.  The markets are usually reliable places to go to get a true read on things, and stocks in Europe didn’t move much on this news.  That could confirm that nothing has changed, but it could also mean that the real problem is bigger than Greece.

Scary thought, huh?

All eyes on the Euro

Look, Europe is what bears watching right now.  So pay attention to it.  Soon, for better or for worse, the world will get some clarity on the situation and we’ll all be able to envision which way this thing is going to go.  In the meantime, I’m comfortable avoiding the whole mess altogether.  Greek bonds at 6%?  That’s for smarter, gutsier folks than me.

During times like this when it’s so difficult to analyze the fundamentals it can help to have a basic understanding of technical analysis.  The medium term trend in the Euro completely broke down during the end of last year, so if you’re a disciplined market technician, you’ve avoided most of the pain in 2010.

Where’s it going from here?

I listen to my Bloomberg podcasts every afternoon while walking the dog, and last week there was a fantastic interview with Sophia Drossos, former chief Federal Reserve FX dealer and Morgan Stanley’s head of foreign exchange research.  She’s calling for 124 on the Euro by the end of the year.  Now that it’s broken through support around 140, a retest of 2008’s lows is certainly in play.  Being short the Euro is a very trendy trade right now with a lot of hedge funds.

Remember, the Euro isn’t a currency, it’s an experiment.  Never before has the world seen a unified currency of this size without a corresponding political union.  Unlike most nations who have control of both their currencies and their budgets, the European countries’ monetary policies are divorced from their fiscal policies.  If someone like Greece borrows money and runs huge deficits, currency debauchment isn’t a possible solution.  The only ways out are straight-up default or a few years of the good-old fashioned doctrine of “spend less than you make.”

If you guys think you have a hard time doing that in your own lives, be glad your household isn’t run by politicians.

What’s on deck

What to watch for after we get clarity in Europe?  It’s our belief that there are three things to keep your eyes peeled for in the coming months.  Full detail is available here, in our Market Weather Forecast, but here’s the recap:

1. The cessation of the Fed purchase program. What happens when the Fed stops buying all these mortgage backed securities?
2. Obama sets a firm course for policy. Will he stimulate, spend, and try and create jobs?  Or will he make some tough sacrifices to address the exploding debt and deficits?
3. Bernanke gives some guidance on rates. Are rates going to stay low and risk inflating new bubbles?  Or will higher rates choke the recovery?

Folks, these are major macroeconomic storms that are brewing and will move things one way or another.  It won’t happen all at once; the resolution of these factors that will affect the markets over the course of months, perhaps even a year or more.

Gold and the three phases of bull markets

I’ve been dead wrong on gold so far.  It’s taken a 15% dive from its high of $1226/oz.

I still think that it’s a prime candidate to bubble at some point in the next year or two.  Gold is expensive now in both nominal and real terms, but it’s nowhere close to where it could be if more serious speculation grabs hold.

Remember that epic bull markets move in three distinct phases and have exhibited a similar pattern for centuries.

The first phase is begins when the asset in question is hated almost universally.  In this nadir of public pessimism, selling pressure is finally exhausted and if the asset hasn’t been written off as a viable investment it’s been forgotten altogether.  It’s when the asset’s fundamentals are dirt cheap and only the hardest of the hardcore – the true believers –  are the ones who are buying or holding a position.

The second phase is where things start to warm up a little.  It’s when savvy professionals and sophisticated fund managers begin building their positions and the medium-term trend starts moving up.  This is the phase where fundamental valuations are still pretty good and investors get a little more excited about no longer having to fight such negative price action.

The third phase is the speculative blow-off.  This is the phase where the public really gets involved.  It’s the phase where you see ads on TV and you bump into people at the mall talking about what they think asset is going to do.  It’s the phase where prices soar to previously-unimagined heights and all sorts of analysts crawl out of the woodwork to justify fundamentals which have become ridiculously expensive.  We went through this with dot-com stocks in 2001, real estate in 2005, and crude oil in 2008.

In gold, we’re probably transitioning into this third phase.  Some of the more sophisticated individual investors that I know have been asking me about gold for several months now.  I see plenty of ads for gold in print and on Bloomberg, but I don’t think it has yet become a major part of the zeitgeist.

On top of all that, I know a lot of hedge funds who are incredibly bullish on gold right, not just about its prospects for this year, but the entire coming decade.

Anyway, our view is that you should always own gold because it’s different and investments that are truly different are the ones that can add the most value in diversifying your portfolio.  Gold should always be 5-10% of your investment portfolio and the best way to do it is to own some coins and leave ‘em parked in the safe deposit box.  The most fun (though least efficient) way to get exposure is by buying a little jewelry.  Your wife will thank you which will improve your quality of life.  But the easiest and most efficient way to do it is through GLD or another gold ETF or mutual fund.

Sell bonds?

Nassim Nicholas Taleb has a knack for making headlines.  Last week he said that “every single human being” should short U.S. Treasuries.  To a certain extent, I agree.

Let me clarify: I don’t like Treasuries one bit here.  Institutional investors might like them – or need them – but for guys like you and me they don’t make a whole lot of sense.  However, I do not think that guys like you and me should actively be shorting Treasuries.  We are perfectly well served simply avoiding them.

Keep in mind that I’ve been hearing people in the industry talk about the “get short bonds” trade for a long, long time.  After all, we’ve had such low rates for so long, how on earth could they get any lower?  The idea of trying to play rising rates (by shorting bonds) isn’t quite as long in the tooth as the “short Japan” trade, and hasn’t claimed the lives of quite as many traders.  But it wouldn’t surprise me a bit if things don’t work out quite the way everybody seems to think they will.  More often than not, when everybody thinks that one particular investment outcome is certain to materialize and everybody piles in on the same side of the trade, everybody goes home disappointed.  But that could just be the contrarian in me talking.

I’m on record pretty much since day one of this newsletter that if you’re looking to add some risk-free sovereign debt as a long-term allocation in your portfolio, TIPS (Treasury Inflation Protected Securities) are the better way to go.  After all, one of the biggest reasons investors hate bonds right now is that they think that some heavy duty inflationary pressures are lurking a few years out.  The bond market is not confirming these fears right now, which means there is opportunity in holding TIPS if inflation fears heat up.

As for corporate bonds, they’ve been dynamite over the last year and I and many others are wondering aloud “is the party over?”

The answer is “yes, the party is over.”

The last twelve months have been the best for bonds in a generation or two and that isn’t going to repeat this year.

Bonds might be back to being boring again, but they do need to be a part of your portfolio.  You all know our very cautious outlook for 2010, so stick with less volatile, higher quality names and you’re probably better off avoiding the longer end of the yield curve giving the economic and inflationary risks.

Don’t worry, at some point in the coming decade we’ll find ourselves – once again – in a situation where it seems like the economic world is coming to end.  It probably won’t be as bad as what we saw in 2008, but it’ll be bad enough to scare plenty of investors out of higher-yielding debt.  That’ll be the time to load the boat with corporate bonds trading at irrational discounts.

Investors that are starving for yield can also take a look at dividend stocks.

Next week

Kyle’s got the second part of his latest Trade School article set to run next Thursday.  After that we’ll talk a little taxes and show you who makes what and who pays what.  I’ve been swimming through mountains of IRS and BEA data and have fished out the interesting bits.  You might be surprised where you fall on the tax spectrum and how much you make and pay relative to your fellow Americans.

See you next Thursday!