The Federal Debt Bomb

Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery. - Charles Dickens

While everyone has been cheering the market gains so far this year, the European debt crisis which fueled last year's volatility is still very much on the minds of the financial markets. The recent calm has been largely driven by the bailouts of European borrowers and banks. All of this has been made possible by a debt market awash in cheap money. These bargain rates have also greatly helped the world's biggest borrower, the U.S.

Over the last several years, the United States has been quietly benefiting from historically low interest rates. These ultra-low rates have masked a budgetary challenge to service this debt in the future. The issue deserves more attention as the nation will be stuck paying the bill when rates inevitably rise.

First, a couple facts: The U.S. Treasury currently has $10.8 trillion in outstanding publicly-held debt, and more than $8 trillion of it must be repaid within the next seven years. More than $5.5 trillion falls due within the next three years.

This relatively short-term debt due is no accident. Like a consumer opting for a low teaser rate, the government has structured its debt to keep the current interest payments low. This is a political temptation for every administration because it means lower budget deficits on its watch.

The government has added close to $5 trillion in debt in the last four years alone. To keep the interest payments low, it much prefers to finance all of this at a rate of 0.3% in two-year notes than at 2% in 10-year notes. Even though the federal debt has soared during those years, the net federal interest payments are lower than they were in 2007. In nominal dollars, the interest payments are even less than they were in 1997 when public debt was a mere $3.8 trillion. This year the debt is expected to reach a whopping $11.58 trillion.

These low rates have disguised the magnitude of the debt threat that is building for future taxpayers. The Congressional Budget Office (CBO), for example, forecasts that in the period 2014-2017, the average rates on three-month Treasury bills will rise to 2% from less than 0.1% today. The CBO expects average rates on 10-year Treasury notes to climb to 3.8%, from 2.03% now. The CBO adds that every 100 basis-point rise in government borrowing costs over the next decade will trigger almost $1 trillion in additional interest expense, which of course will be paid with yet more borrowing.

As of January 2012, taking into account all the various notes and bonds issued by the federal government to the public, the U.S. is paying an average interest rate of 2.24%. The government expects to spend in the neighborhood of $225 billion this year on those interest payments.

That may seem like a large sum, and it is, but consider what happens if rates quickly rise back toward their historical norms. As recently as early 2007 the government was paying 5% on its debt, which is the average of the last two decades, though rates could always go higher of course. During the 1990s, the average was well above 6%.

If the government had to pay the 5% rate that it was offering before the financial crisis on today's debt, the annual interest payments would be $535 billion, twice CBO's projection for total federal spending on Medicaid this year. If the government had to pay 6% on its debt, the annual interest payments of $642 billion would surpass total federal spending on Medicare, currently $484 billion.

There has been far too little talk of the impact on our federal budget when (not if) interest rates normalize. These numbers will only get worse with the one point something trillion dollar deficits that are currently being run up every year. The situation has become so extreme at this point that even if all the tax increases being discussed were enacted, they wouldn't even cover half of these higher interest payments - let alone reduce the deficits.

The Treasury Department says it's aware of this risk and has stated that it is making changes to its debt structure. In the past year and a half, the Treasury Department has reduced the debt maturing in three years from 55% to 52%, but the short term outstanding debt is still far too and the move to rebalance the maturities far too slow.

The Fed has been buying its own debt in the open market through its "Operation Twist". In addition to greatly increasing the money supply, it is also purchasing 30 year bonds in part to keep longer term rates down. Eventually this will have to end. When it does, rates will start to rise to historically normal levels. The question remains, how quickly will the debt bomb go off after that?

We've seen what the future looks like - Europe. Crushing debt loads greatly reduce economic growth and employment. They also force a nation to be beholden to their creditors. In our case, that is looking more and more like the communist Chinese.

Are You Audit Worthy?

Since we are currently in the midst of tax season, I figured a tax-related article would be appropriate this month. And what could possibly be a more fun topic than tax audits? I think it goes without saying that our government is hurting for cash right now. Increasing tax revenue is always the first place the government looks to help balance the books. This year the IRS is focusing on ways to collect more money without actually raising taxes.

On a positive note, the number of tax filers that gets audited is very low. In 2011, only 1.11% of total individual tax returns filed were audited. But business owners who file Schedule C Forms were audited at a rate of slightly more than 4 percent. High-income taxpayers are also a target; for those earning more than $200,000 in 2010, the audit rate was 3.1 percent, and for taxpayers earning more than $1 million, it was 8.1 percent.

The IRS has three computer systems that use different types of analysis to determine which tax returns to audit. The Discriminant Function System gives each return a score based on the likelihood that it is accurate. It is believed that deductions and exemptions carry the biggest weights but the actual formula used is top secret. The Unreported Income Discriminant Function scores people based on their expense to income ratio. High expenses relative to income raise suspicion that there may be unreported income. The Information Returns Processing System stores information reported from third parties such as employers, banks and brokerage firms (W-2s and 1099s for example). The IRS also uses non computer related analysis as well.

Now that you have a general idea of some items that may raise suspicion from the IRS, let’s take a look at some specific red flags increase risk of an audit.

First off, make sure your return does not contain any mathematical errors. Even a simple mistake can cause the IRS to take a second look at your return and determine that it should be audited. Similarly listing incorrect basic information such as mistyping your Social Security number can also trigger an audit.

Another common culprit is high itemized deductions that exceed the typical IRS ranges for your income group. The IRS does not publicize these target ranges but it does release statistics that show the average amount of deductions claimed according to reported income.

Deducting automobile expenses is one of the biggest and most commonly audited items. It is crucial that those using a personal car for business keep a meticulous daily log of business mileage that includes odometer readings, dates, locations and meeting details.

Home office deductions are another flag raiser. If you work at home intermittently, it’s best to forego this deduction. The rules are very complex and you should consult a tax expert to determine if you qualify.

Another eyebrow raiser to the IRS is large charitable contributions relative to income level.

While there are certainly other red flags, I’ll conclude with the new 1099-K that the IRS plans to use this year to take a closer look at online income from E-bay and other auction sites. While I highly doubt any of you will receive one of these 1099s, I thought you would find it interesting. This 1099-K is the result of a new law that requires payment settlement companies (such as PayPal) to report amounts received by merchants to the IRS. For now this only applies to merchants who receive over $20,000 in payments or over 200 transactions.

If you ever become one of the unlikely (and unlucky) recipients of an IRS audit, you will be notified by mail and the letter you receive will specify they type of audit they will conduct, either a correspondence audit, an office audit or a field audit. In a correspondence audit, the IRS sends you a letter that asks for more information about certain items on your return and you respond by sending the appropriate documentation. This is the most common type of audit. During an office audit, you are required to go to your local IRS office to meet with an auditor. The IRS determines the time and the particular documents that you need to bring. If you have kept detailed records and can back up your tax files, you can go and take care of it yourself. If not, you may want to hire a professional. Lastly, during a field audit, the IRS agent makes a visit to your home or business to perform the review. This is the least common and is only used if the individual or business being audited earned well over $100,000.

To conclude, it is important to note that the IRS has 3 years from the date you filed to collect extra tax. They have 6 years to collect if the taxpayer didn’t report more than ¼ of his or her income. And for those who evade tax or file fraudulent returns, there is no statute of limitations and an audit can take place at any time.

By keeping complete and detailed records, you can greatly lessen your risks and stress should the IRS decide to take a closer look at your tax files. If you think the IRS may question a large tax deduction or tax credit, you may even want to attach an explanation to your tax return when you file it. While it may be impossible to avoid all of the red flags, it is beneficial to at least know what they are.