Mitt Romney’s release of his 2011 tax returns has prompted another paroxysm of protests from the Left, and mild embarrassment across the rest of the political spectrum, since he pays a surprisingly low tax rate of 14 percent. After the announcement, Obama’s deputy campaign manager, Stephanie Cutter, argued that “people like Mitt Romney pay a lower tax rate than many middle-class families because of a set of complex loopholes and tax shelters only available to those at the top.” Conservatives have tacitly agreed with that argument by saying that their pro-growth tax-reform proposals would do away with many of these methods of lowering tax obligations. But loopholes and shelters are not why Mitt Romney pays a 14 percent tax rate — and his tax returns deserve not embarrassment but a stout defense.
Quite simply: Even if our income-tax system were substantially reformed with pro-growth aims, Mitt Romney would and should still pay a much lower tax rate than many Americans less wealthy than he.
Why? Because Romney draws his income from capital, not a salary, and it is sensible that we tax the former at a lower rate than the latter. This may offend liberals’ sense of fairness, and annoy conservatives who draw high salaries, but the fact that Romney pays just 13 or 14 percent in income taxes is actually a rare virtue of our tax code rather than a defect.
Economists on the right and the left, from Greg Mankiw to Thomas Piketty and Emmanuel Saez, agree that capital gains should be taxed at a lower rate than earned income. The explanation for lower rates on capital gains is simple: Earned income is taxed the year it is earned, and then the recipient can spend or save it. If he saves it, interest and dividends are taxed again, as are realized gains from appreciation, providing a powerful disincentive to investing. Capital income is taxed twice: when its principal is earned, at either corporate or individual income-tax rates, and then when the investment is disposed of, at the capital-gains rate.
There are a range of theoretical arguments to the effect that the ideal tax system should not tax capital at all. In fact, that lion of the Left, Joseph Stiglitz, authored a 1976 paper with A. B. Atkinson in which they laid out such an argument; however, this relies on investors’ having an infinite time horizon, which, even given the inheritability of wealth, they obviously do not. An infinite or very long time horizon makes any taxes on capital prohibitive; more realistic assumptions suggest that we should tax capital without too much discouragement of saving — that is, there should be a “gap” between capital and ordinary rates, as Piketty and Saez put it. (It is also worth noting here that the United States’ long-term capital-gains rate for the bottom two tax brackets is zero; Romney proposes making it 0 percent for all taxpayers with income under $200,000. What was that about loopholes for the rich?)
More specifically, in the U.S. tax system, corporations pay income taxes on their earnings, and then those profits either are paid out to shareholders as dividends (which are taxed at the same rate as capital gains) or accumulate in cash reserves, raising the company’s value, a capital gain. Exactly how the two rates — the 35 percent corporate rate and the 15 percent capital-gains/dividend rate — add up is a complicated question. It is not a simple matter of an arithmetic 44.75 percent, as some eagerly suggest, since “tax incidence” does not fall entirely on the shareholder. However, just as one stab at it, the CBO estimates that the average combined federal tax rate for the top 0.01 percent (who receive the vast majority of their income in the form of capital gains) is about 30 percent, and they implicitly pay about 14 percent of their income in corporate taxes. Thus, despite the appearance of a low statutory capital-gains rate, the investor class seems to pay its “fair share” (the middle quintile’s combined tax rate is 14 percent).
It is also important to note, as we discuss how to close the deficit, that capital-gains taxes are notoriously susceptible to the Laffer curve: Because individuals exercise control over when to realize capital gains, hikes in these rates yield very little revenue. A Democratic proposal, then, to tax people like Mitt Romney at higher rates, or just raise the capital-gains rate overall, is likely to constrict the economy and investment activity while raising little revenue. (Meanwhile, cuts in capital-gains rates result in much less revenue loss than cuts in taxation of earned income.)
All of this is subject to one key caveat: It is arguable that Mitt Romney personally should actually be paying a higher overall rate than he is, because some of his income that is classified as capital gains is more like ordinary income. Romney’s income comes from two main sources: his investments in Bain Capital funds and various other alternative investments, bonds, and equities, and his share of certain Bain carried-interest pools, negotiated as part of his retirement deal as a principal of Bain. Carried interest is the share of a fund’s appreciation which managers receive as compensation, usually about 20 percent, and though they usually risk only a nominal amount in the fund, that compensation is treated not like other management fees, as earned income, but as capital gains. Thus, Romney paid just a 15 percent rate on his 2011 carried-interest earnings, which the campaign estimated in January amounted to $5.4 million (out of his $13.7 million total income for the year). Romney’s substantial charitable contributions reduce his taxable income significantly, so he wouldn’t pay quite the top 35 percent rate on his carried interest were it taxed as ordinary income, but he would pay substantially more than he does now. Of course, the millions of dollars of other capital-gains and dividend income Romney reaps are justly taxed at a lower rate than earned income.
This treatment is a true “loophole,” with few defenders besides the hedge-fund and private-equity managers themselves (and indeed, it is a rare manager who will privately defend it on principle). Carried interest is clearly paid compensation, not returns on capital, and thus should be taxed as such. Changing its tax treatment, as I have written, would raise real concerns and would also be difficult to implement, but it is a worthy long-term goal to which even the Wall Street Journal has agreed.
This side issue, however, doesn’t alter the fundamental lesson to be learned from Romney’s tax returns, which even liberals must admit: Capital income is and should be taxed at a lower rate than earned income, and that, not unfairness in our tax system, is why Mitt Romney pays a low tax rate. There are many flaws in America’s tax system that need to be fixed; the marriage penalty and the partially uncompensated cost of raising children are two of them. The preferential treatment of capital gains is not.
— Patrick Brennan is a William F. Buckley Fellow at the National Review Institute.