The news that Mitt Romney earns most of his income in the form of capital gains is really no surprise. That is one of the attractions of being in a business like Bain Capital. If your corporate restructuring works out well, you can earn millions or tens of millions of dollars and pay a flat 15 percent tax rate on it. (You also avoid the 2.9 percent Medicare tax that would apply if the income were treated as regular compensation.) By all accounts, the Bain deals worked out very well indeed, which is why Governor Romney has been able to spend so much time running for office rather than working for a living.
The teachable moment has stimulated a lively debate about whether this is fair and whether lower capital gains tax rates are good or bad for the economy. To many conservatives, it s a matter of faith that the tax rate on capital gains should be lower than ordinary rates, or even zero. They believe that lower tax rates encourage risk-taking and entrepreneurship, offset the double taxation of corporate profits (since they re taxed at both the corporate and individual level), offset the double taxation of savings, and provide a rough adjustment for the fact that part of capital gains are simply inflation. Moreover, they argue that taxing capital gains at higher rates would be counter-productive because people would just stop selling assets with gains and Treasury revenues would fall.
Most of these rationales for low taxes on people like Mitt Romney are wrong or overstated, and they miss a key point: taxing capital gains at much lower rates than other income creates a ginormous loophole that leads to a tremendous amount of inefficient tax shelter activity. Virtually every individual income tax shelter is devoted to converting fully taxed income into capital gains. If you can transform $10 million of wages into gains, you can save over $2 million. With that kind of payoff, there is a whole industry devoted to inventing schemes to generate current deductions to shelter the wages and ultimately recoup it years later as lightly taxed gains. These shelter schemes entail inefficiency for at least two reasons. First, the investments that work in tax shelter plans are often very inefficient the kinds of projects that would never attract capital in a rational world. Second, the people who put these schemes together are very intelligent and absent the capital gains windfall might actually do socially productive work like, say, producing American products that people around the world would like to buy.
And, of course, the low tax rates on capital gains make Mr. Romney s line of work much more attractive than work that pays actual wages. (Yes, I know that some of Romney s income at Bain would have been taxed at ordinary rates, but the lion s share of compensation on private equity deals is taxed as capital gains, which is a very sweet deal.) It s not clear why the tax code should subsidize hedge fund managers and private equity over other lines of work.
Janet Novack , the richest 400 taxpayers income over $110 million earned 13.1% of capital gains.
In normal years, capital gains are distributed a bit more widely, but the fact is that most people earning under $200,000 don t have much wealth outside their house and retirement accounts and thus get little or no benefit from the generous tax break on capital gains. The vast majority of gains go to people with very high incomes.
If you re interested in more about the capital gains debate, you might check my book, The Labyrinth of Capital Gains Tax Policy: A Guide for the Perplexed, out of the library. It was published in 1999 so doesn t reflect the latest tax rates, but the analysis is right.
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