How To Survive Tax Hikes and Spending Cuts

The coming transformation of government could upend the way we live.

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First there will be talk. Lots of it. Washington lawmakers will spend most of this year, and probably next, jawboning about how the federal government needs to cut spending, get its finances under control, and—you didn't hear this from me—raise taxes, eventually.

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Often inside the Beltway, bluster is all there is. But not this time. The national debt has become so huge that action must follow. Conservatives want to slash government spending before considering a single penny in tax hikes. Liberals want to tax the rich, and tax them some more, before touching the money that goes to the needy. But neither approach alone will come close to solving the problem, and the vast majority of Americans who have enjoyed relatively low taxes for the last decade will have to pay the piper. "It's inevitable that some change will have to occur in both directions," says Clint Stretch, managing principal at Deloitte Tax. "That will impact people who think of themselves as middle class."

There's no dispute over what the problem is. The federal deficit this year will hit a record $1.5 trillion, thanks to the extension of the Bush tax cuts at the end of 2010 and other measures in that bill meant to boost the weak economy. The overall national debt is about $14 trillion, roughly equal to the nation's entire GDP. There will be a big brouhaha this spring over raising the "debt ceiling" so that the government can keep borrowing, which will happen despite lots of fulminating over why it shouldn't. At the current pace, America's debt will hit Grecian levels in a decade or so, and trouble could come sooner if global investors start to lose confidence in Uncle Sam's ability to pay back its debt. If that happens, Washington's interest costs would rise, forcing even deeper spending cuts and bigger tax increases than might otherwise be necessary. Stagnation or even a prolonged recession are possible.

There are plenty of ideas about what to do. Defense, Medicare, Medicaid, and Social Security account for about 60 percent of all government spending, so that's where the money is, for those looking to cut. Medicare and other healthcare programs in particular threaten to bankrupt the government, since healthcare costs are rising so steeply. The tax code is another problem, with a complex hodgepodge of deductions, exemptions, and loopholes that narrow the tax base and gunk up the economy.

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At least three budget-cutting commissions have produced detailed plans recently for reforming the tax code, cutting spending, and making the government solvent once again. Real action might not happen until 2013—after the next presidential election—but it's not too early to plan for what's coming. Here are 10 ways to get started:

Become less dependent on government. A huge fight is coming over exactly what government spending needs to be cut, but the government is so deeply in hock that practically every category of spending is vulnerable. That could affect anybody who works for the government directly—since pay and benefit cuts and staff reductions are likely—plus millions of others who work for defense or government contractors. Budget hawks would love to cut farm subsidies, earmarks, and other giveaways that sounds like Beltway boondoggles, but that money also supports jobs in lawmakers' home districts. Cuts in "discretionary" spending could affect funding for hundreds of things like highways, arts and humanities projects, university research, and community development. It would be wise to know if your job is dependent on government funding—including state or local support—and to develop backup plans if it is.

Live well below your means. Remember: Those tax cuts that were extended at the end of 2010 will expire at the end of 2012, and there's a good chance they won't get extended again—amounting to a de facto tax hike for most taxpayers. On average, those "temporary" tax cuts reduced income tax rates by about three percentage points. So to do prudent planning, run your monthly budget assuming the higher tax rates are in effect, and make sure you don't come up short. Also think about the possible impact of even higher taxes—especially on capital gains and dividends, if you're lucky enough to worry about that—if Washington should happen to get serious about balancing the budget. Under one deficit-reduction proposal, led by Pete Domenici and Alice Rivlin, tax changes would lower the average person's after-tax income by 4.3 percent. Other proposals would rely more heavily on spending cuts to balance the budget, but there's almost no way to get the job done without some tax increases on the middle class. Plan for that or pay the consequences.

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Get used to controlling your own medical costs. The skyrocketing cost of healthcare is a huge strain on many families, and it's also the government's most-unmanageable expense. Virtually all serious budget-cutting proposals include provisions for lowering the government's exposure to healthcare costs, such as raising premiums and co-pays for Medicare patients, providing fewer benefits to wealthier enrollees, cutting Medicaid benefits for the poor, and taxing the value of employer-provided health insurance as if it's income, instead of exempting it. Any such changes would probably be phased in gradually, to lessen the impact. But a recurring theme is the need to pass more of the cost of healthcare on to consumers, forcing people to comparison-shop the way they do for other services and drive down prices. That's hard to do right now, since healthcare isn't priced transparently, the way most other things are. But smart healthcare shoppers should get in the habit of paying attention to cost and seeking the best deals—even for care that's covered by insurance. Some day soon, it might not be.

Don't expect a free ride forever. Nearly half of all U.S. households pay no federal income tax, even though the majority of those households include workers with paying jobs. That's largely because of credits that effectively reduce the tax rate for some low-income earners to zero. One goal of tax reform, if it happens, will probably be to expand the tax base, so that more people pay taxes. That could happen through a reduction in popular measures like the child-care tax credit and earned-income tax credit, or a slightly higher bottom income-tax bracket, or both. Low earners who have evaded taxes, in essence, will be asked to kick in something.

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Expect less from your home. Government giveaways don't just go to well-connected fat cats. One of the biggest subsidies of all is the tax deduction for the interest paid on residential mortgages, which many homeowners take advantage of. Since this tax break costs the government a hefty $80 billion a year, it's likely to be curtailed, at a minimum. One possibility is the elimination of the interest deduction for home-equity loans, currently available on loans of up to $100,000. Washington could also eliminate the deduction for second homes, and cap the amount of the deduction available for a primary residence. One idea gaining credence is eliminating the mortgage-interest deduction completely, and replacing it with a credit that would benefit more people—but most likely raise the after-tax cost to homeowners with more expensive properties. One upside: The credit would be calculated ahead of time and simply lower the borrower's monthly payment, without requiring taxpayers to itemize the deduction and wait till tax time for the benefit.

Buy a more efficient car. President Obama's debt-reduction panel, led by Erskine Bowles and Alan Simpson, recommends a 15-cent hike in the federal tax on gasoline, to help reduce the deficit. Strapped states could raise gas taxes too, and the idea is also backed by green-energy advocates who feel the best way to promote new forms of energy is to raises taxes on the old forms—namely, fossil fuels. It's also likely that gas prices will continue to rise on their own, as the global economy heats up. In anticipation of costlier gas, carmakers have been rolling out an impressive lineup of high-quality cars that also get good mileage, whether they're budget cars or luxury makes. Amping up your mileage the next time you upgrade your wheels can't hurt, and could save a bundle down the road.

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Get used to spending less. The Domenici-Rivlin plan calls for a 6.5 percent national sales tax, also known as a value-added tax, that would be phased in over two years. This kind of tax would raise lots of money quickly, but it would also make goods and services more expensive for nearly all consumers. Conservatives oppose a national sales tax on the grounds that it would simply give the government a huge new pool of money to spend inefficiently—yet most other developed countries have one. If Congress ever passed such a tax, it would probably be combined with a reduction in income tax rates, to make it more palatable. There could also be a tax credit for low-income workers, who would be paying more for food, clothes, and other staples. Still, most consumers would probably have to cut back on purchases to compensate for the added sales tax.

Save more. One of the few things not likely to be taxed or penalized in the future is more savings. In fact, many economists believe that new policies that encourage saving while discouraging spending—through a national sales tax combined with lower income tax rates, for example—would boost economic growth, since more national savings makes more money available for the kind of private investment that generates high returns. Many consumers need to save more anyway, to make up for wealth they've lost through plunging home values. And a bigger cash cushion would help consumers cover higher taxes or rising costs for government services. One thing to watch out for: possible limits on the amount of income that can be placed in tax-deferred retirement accounts like IRAs or 401(k) plans, which some budget-cutters have proposed.

Adopt healthier habits. Sin taxes are in—again. The Domenici-Rivlin plan proposes new taxes on alcohol, soda, and other sugary beverages linked to obesity, which, if enacted, could come on top of similar new state and local taxes. And states routinely hike cigarette taxes when they need new revenue. Unhealthy habits are likely to get more expensive than ever.

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Plan to work longer. To keep Social Security solvent, it's likely that the federal retirement age—which now ranges from 65 to 67, depending on when you were born—is likely to go up. And there could be other incentives, like steeper penalties for claiming retirements benefit early, intended to make people work longer. Policymakers say such changes are likely to be gradual, so they don't freak out millions of aging baby boomers. But changes in the federal retirement age could also lead to changes in the way unions, pension plans, and private companies treat retirement. Plus, many Americans lack sufficient savings and are poorly prepared for retirement anyway. Planning ahead of time for a side career, consulting practice, or part-time work in your 60s and 70s could prevent you from lowering your living standards or making other painful changes as you get older. And if you complain about it now, you might just get it out of your system by the time you actually retire.

Twitter: @rickjnewman