Let me tell you how it will be,
There’s one for you, nineteen for me,
‘Cause I’m the Taxman,
Yeah, I’m the Taxman.

For those of you who weren’t around in the 60s, the above lyrics are from “Taxman,” the opening track of the Beatles’ 1966 Revolver album. The song was a protest against the whopping 95% marginal tax rate inflicted on the UK’s top earners. The song also touched a nerve in the United States, where top marginal rates were 70%.

At first blush, today’s top rate of 35% appears to be a bargain. It’s not. Nobody really paid 70%. Back in the 60s and 70s, there were a great many deductions individual investors could take. Under the cover of tax code simplification, Congress eliminated all but a few of those deductions in 1986. The trade-off? The top tax rate was reduced to “just” 28%.

At the time, cynics suggested that all Congress really wanted to do was eliminate deductions. And that the real purpose of the Tax Reform Act of 1986 was to leave the taxpayer defenseless when higher tax rates were re-imposed down the road. Their words were prophetic.

Since 1986, the top tax bracket crept up to 39.6% by 2000. The Bush tax cuts in 2001 dropped the max to 35% and reduced taxes for all Americans. When those cuts expire in 2011, it will amount to a tax increase across the board for the 60% of citizens who pay taxes. In addition:

• Capital gains taxes will go up to 20% from 15%.
• Dividends will be taxed as ordinary income – up from 15% today.
• The death tax will be back with lower exemptions.

Back to the 60s?

What will happen, tax-wise, after 2011 is not difficult to ferret out. Consider:

• This year’s federal deficit is in excess of $1.5 trillion, which is more than the total national debt for the first 200 years of our country.
• The Congressional Budget Office projects that the federal debt will increase to $17.1 trillion over the next decade.
• Government debt will reach 76.5% of GDP by 2019.
• The U.S. is fighting two wars.
• Many states are facing massive deficits.

So with deficits rising and little or no political appetite for reining in spending, how do we get out of the box? It seems to me we can count on two things. First, count on higher inflation so the government can pay off its debts with cheaper dollars. And second, count on higher taxes.

Nancy Pelosi’s Face

When it comes to raising taxes, never underestimate the creativity of our representatives in Washington. A recent addition to the Senate health care bill is a proposed 5% tax on elective surgery. That would include breast implants, eye lifts, face lifts, hair transplants, and even Botox injections, to name but a few. This tax will raise an estimated $5.8 billion over 10 years. So who cares if Nancy Pelosi has to pay a little bit more to smooth out her forehead?

It’s not really about the tax, it’s about the principle. The American Medical Association says this tax would be the first federal levy on a medical procedure. As the Arabian proverb goes, “When the nose of the camel is in the tent, the rest of the camel is not far behind.” If this tax flies, who knows what will be taxed next?

What is clear is that our government continues to view the U.S. taxpayer as an ATM. And just as the banks are “fee-ing” us to death, we can expect to be nickel-and-dimed to death by the tax code.

What to Do Now?

Before inflation comes back in a big way, you have to consider commodities to be an essential part of your portfolio. In his Resource Windfall Speculator newsletter, IDE’s Rusty McDougal has identified a number of terrific inflation-fighting stocks.

You also need to have some gold in your portfolio. Yes, gold is off from its highs. Every bull market takes a breather. Look to buy gold on the dips.

Having the right corporate bonds makes sense too. Steve McDonald’s approach almost never locks you in until a bond matures. With the active strategy he adopts in The Bond Trader, he has been able to generate returns far in excess of a bond’s coupon rate.

Unless you own your own business, there’s really not a lot you can do to minimize your taxes. That said, here are some suggestions:

• Convert your IRA to a Roth IRA. You’ll pay taxes on the conversion, but after that all withdrawals are tax-free. And considering where tax rates are headed, it may make sense for you.
• Take out a home equity loan. (The interest is tax deductible.) Use it to pay off your credit card balances and consumer loans.
• Consider municipal bonds. Municipal bonds throw off tax-free interest. And if you live in a high-tax state, bonds issued in your state may also be exempt from state tax.
• Sell your losers. We’ve been saying this for months, but now is definitely the time to upgrade your portfolio. Sell your losers and book the tax losses.
• Give away appreciated securities. If you are so minded, consider donating appreciated securities to your favorite charity. In most cases, you will get a full deduction for the value of the securities and not have to pay any capital gains tax.
• Max out your 401(k).
• Contribute to an IRA.

As the sun sets on the Bush tax cuts next year, your tax strategy will become more important than ever. That said, I’ll leave you with the final stanza of “Taxman”:

Now my advice for those who die,
Declare the pennies on your eyes,
‘Cause I’m the Taxman,
Yeah, I’m the Taxman.
And you’re working for no-one but me.

Invest Safely,

Bob Irish
Investment Director
Investor’s Daily Edge