You can’t write about tax rates these days without getting shelled by those who feel their favourite Presidential candidate is being attacked by whatever you say.That’s too bad, because it hinders the ability to have a reasoned discussion about taxes, which is a discussion this country desperately needs to have.
(Almost no non-partisan economist thinks our budget deficit can be solved by cutting spending alone. Taxes will almost certainly eventually have to go up. The question is by how much and on who and when. And that’s a debate we need to have in as cool-headed a way as possible.)
Anyway, anytime one points out that Mitt Romney pays a very low tax rate for a citizen who makes as much money has he does, one quickly hears from Romney supporters who say, effectively, the following:
You idiot. Don’t you understand the difference between taxes on “ordinary income” and taxes on “capital gains”? Mitt Romney already paid taxes on his ordinary income–at normal ordinary income rates! Now you want to tax him twice–by making him pay the same taxes on his capital gains!!!
(Some Mitt Romney supporters are much more polite when making this argument, which is much appreciated.)
To answer the question, yes, I do understand the difference between taxes on ordinary income and taxes on capital gains. And I understand the rationale for having the two tax rates be different (to provide an incentive for investors to risk their capital and thus help build businesses that employ people). And I actually agree with that rationale. I don’t think we can afford to have the difference between the two tax rates be as big as it is, but I agree with the rationale.
But here’s the thing…
Romney’s supporters are almost certainly wrong when they assert that Romney “already paid taxes on his ordinary income” and that now he’s just risking his “capital.”
This is because Mitt Romney has almost certainly taken advantage of one of the most outrageous tax loopholes in our entire tax code: The “carried interest” tax exemption.
This loophole allows money managers to structure the performance fees they are paid as “capital gains” instead of as ordinary income.
The loophole therefore allows money managers to avoid paying ordinary income taxes on their performance fees and then make much bigger bets than they would be able to make if they actually had to pay taxes on their earnings. When the money managers use very sophisticated tax shelters, it also allows them to defer paying taxes for years (if not decades)–and then only pay low long-term capital gains rates instead of ordinary income rates.
Although we don’t know for certain that that’s what Mitt Romney has done (because he won’t release his tax returns), it seems highly likely that this is what he has done. And, in fact, the obvious unfairness of this tax loophole seems like one big reason he won’t release his returns.
To be clear:
Taking advantage of the “carried interest” tax loophole is not illegal or wrong. Romney has done what any smart tax-minimising person in his position would have done.
But the loophole itself is outrageous.
And the existence of the loophole means that Mitt Romney has almost certainly not “already paid taxes on his ordinary income.”
Rather, Mitt Romney has probably figured out ways to make sure that many of the fees he was paid for managing clients’ money at Bain were directed into future Bain investments before he paid taxes on them. These Bain investment then presumably did extraordinarily well, and Romney’s pre-tax ordinary income compounded tax free. And now, presumably, Romney is paying himself “dividends” or “long-term capital gains distributions” out of these Bain funds, which means that not only his original fee income but his pre-tax investment gains are being taxed at vastly lower long-term capital gains tax rates.
If Mitt Romney had actually paid ordinary income taxes on his fee income and then bet his after-tax income on future Bain investments, those who support today’s low rates on long-term capital gains would be justified in saying this is perfectly defensible, fair, and acceptable.
But Romney almost certainly didn’t.
Rather, Romney almost certainly took advantage of an outrageous tax loophole to take home tens or hundreds of millions more dollars than he would have if he had paid ordinary income tax rates.
So the Mitt Romney supporters who suggest that he paid these rates, unfortunately, appear to be delusional.
Examples are helpful, so let’s put some numbers on this:
- Let’s say Mitt Romney was paid $1 million a year in the 1980 in annual performance fees for managing clients’ money (likely way too low).
- Let’s say the all-in “ordinary income” tax rate at the time he earned this income was 50% and that today’s long-term all-in capital gains rate is 20%.
- Let’s say that Mitt Romney’s investments in Bain funds accrued at a 15% annual rate from 1990 to now.
If Mitt Romney had had to pay ordinary income on his fees in the 1980s, he would have netted (after state/local taxes, Social Security, Medicare, etc.) about $500,000 a year, or about $5 million for the decade.
If Romney then subsequently invested this $5 million in Bain funds in 1990 and it accrued at a 15% annual rate (likely low), he would now have $108 million in the Bain funds. He could then withdraw a bit of this every year and pay long-term capital gains taxes of 20% on the gains.
That’s not bad. Lots of people would be happy with that!
But that’s not likely what Romney did.
Rather, Romney probably found ways to invoke the “carried interest” exemption and steer the whole $1 million of fees per year into the Bain funds, for a total of $10 million invested.
At the same 15% compound growth rate, the total of $10 million invested in 1990 would now be worth $216 million–twice as much!
That’s really not bad!
Especially because, thanks to the carried interest tax exemption, Romney will never have to pay “ordinary income” tax rates on any of that money. Rather, it will all be treated as long-term capital gains or dividends.
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