Mitt Romney's Marvelously Unburdened Income

Presentations like Romney and the Burden of Double Taxation, by John Berlau and Trey Kovacs in the op-ed page of the Wall Street Journal on January 24th, have suggested that it is wrong to conclude that Governor Romney's effective tax rate in 2010 was 13.9%, as widely reported. Instead, they argue, his true tax rate was "as much as 44.75%." And the Editorial Board of the Wall Street Journal repeated this argument in an editorial on January 27th (The Buffett Ruse). They all reach this conclusion by arguing that Romney suffers the burden of double taxation on his considerable income in the form of capital gains and dividend income.

This argument is wrong, for multiple reasons.

A preliminary note about the Romneys' 13.9% effective tax rate. That number represents the Romneys' actual tax liability for 2010 divided by their "adjusted gross incomes" (AGI), as reported on their tax return. AGI is not in fact a terribly accurate measure of economic income for someone whose principal sources of income come from investments, as opposed to wages, because taxpayers can choose when to realize their gains from investments, by timing their sales. In fact affluent Americans regularly engage in "loss harvesting," in which they sell investments that have declined in value, while letting their winners ride along into the next tax year. Moreover, if a taxpayer makes a charitable contribution with appreciated investment securities, the built-in gain on those securities is never taxed, and the taxpayer nonetheless gets a full fair market value deduction for the contribution, unreduced by the capital gains taxes that were avoided.

So a powerful case can be made that, if all the facts were known, the Romneys' true effective tax rate for 2010 might have been much lower than the 13.9% reported rate. This point of course is not unique to the Romneys: it applies with equal force to Warren Buffett or to any other American with very large investments.

The 13.9% effective tax rate that the Romneys paid in 2010 (measured against their AGI) includes all payroll taxes (technically, in their case, self-employment taxes) to which they were subject. How does that rate compare with the taxes paid by other Americans? The nonpartisan Staff of the Joint Committee on Taxation answered that question in a 2010 publication (their publication JCX-19-10, Table 11, available at www.jct.gov). Americans with "expanded incomes" (a significantly broader category than AGI) of $40,000 to $50,000 had an all-in federal tax burden of 14.5% in 2010, so the Romneys, with their $22 million of income, did a bit better in the tax burden category than the average American wage-earning family in the $40,000 to $50,000 range.

But should Romney be treated as also suffering a substantial indirect tax cost, in the form of the corporate taxes paid by the companies in which he has invested? Economists do something superficially analogous to this when they determine the total federal taxes that burden wage-earning Americans: there, almost every economist agrees that working Americans pay not only the payroll taxes withheld from them, but also the "employer's half" of payroll taxes, because employers reduce the wages paid to employees to reflect this additional cost of hiring them. Why should not a similar argument lead one to conclude that Romney has suffered not only the 15% individual tax levied on capital gains and dividends, but also the 35% corporate income tax?

The principal reason to reject this false analogy is that Romney's investments generally are not burdened by a significant corporate tax expense.

First, the investment funds in which Romney and other affluent Americans invest are not themselves taxpayers: instead, those funds are organized as partnerships (which are "pass-through" vehicles for tax purposes, so only their partners are taxed on their profits) or as offshore corporations beyond the reach of the corporate income tax. That means that the only level where corporate tax might be relevant is at the level of the portfolio companies in which those funds invest -- for example, Staples, or Domino Pizza, or similar companies that Bain Capital investment funds acquired as private equity (PE) investments.

Second, the whole point of PE deals is to wipe out the corporate tax liability of portfolio companies with interest expense from new borrowings at the operating company level -- that's the leverage that drives the high returns to PE funds from successful deals. While details are lacking, it's reasonably clear to everyone that the principal source of Mr. Romney's wealth has been the returns generated by the PE deals in which he has participated for many years. (Indeed, the Romneys' 2010 tax return reveals that even as late as 2010 the Romneys were awarded new "carried interests" in new Bain Capital investment fund deals, apparently as part of his separation agreement from Bain 10 years earlier.)

So in all these PE investments, there generally is no double tax at all. But dividends received from those portfolio companies still qualify for the 15% tax rate, even though the premise of that low rate was precisely to mitigate double taxation!

Going further, one can plausibly view the "stock" in PE deals as really the economic equivalent of options. If things go even reasonably well, the option-like stock earns huge returns. If things go badly, the option premium-like investment expires worthless (along with the company). But no one talks about the double tax on options!

Third, at least some PE portfolio companies are turned into nontaxable operating partnerships. You can see circumstantial evidence of that on the Romney returns -- this is the probable explanation, for example, for the very large "passive activity losses" that the Romney's have accumulated (that is, their share of tax losses from some operating partnerships). So no double tax there. And yet, the Romneys will enjoy capital gains taxed at 15% when those interests in operating partnerships are sold!

Fourth, what about unrelated non-PE investments that the Romneys may have acquired, in big public US companies? Even there the 44.75% tax rate story falls apart. The real life effective tax rates enjoyed by most publicly-held US multinational firms in which the Romneys might have invested are far below the statutory rate, and the more multinational the firm, the lower that all-in (federal and foreign) tax rate is likely to be. (For more details on the intersection of U.S. corporate tax burdens and foreign tax planning, see Stateless Income, 9 Florida Tax Rev. 699 (2011).)

So for all the above reasons, the assumption that there is a 35% corporate tax being paid on Romney's investments is not consistent with the reality of how his portfolio was created, or the actual tax rates enjoyed by the most sophisticated U.S. public companies. But regardless of the effective tax rates imposed on Romney's portfolio investments, it is an entirely separate leap of faith to attribute that corporate tax burden to Mr. Romney in his capacity as a shareholder. Economists refer to this as the question of corporate tax "incidence." The corporate income tax ultimately burdens one or more groups of human beings, but which ones? Tax burdens can be shifted from the apparent taxpayer to others, through lower wages or higher prices. The federal gasoline excise tax, for example, is nominally collected from gasoline wholesalers, not retailers or consumers, but if you look at the details at the pump next time you fill up you'll see that the tax has been tacked onto your cost for gasoline.

While economists are virtually unanimous that the incidence of the "employer's half" of payroll taxes falls on employees (in the form of lower cash wages), there is no consensus at all as to who ultimately bears the corporate income tax. The principal candidates are all owners of capital (not just shareholders), through market mechanisms that bring returns in different investment markets back into a relative equilibrium when one form of capital is nominally subject to tax, or employees, on the theory that a corporation must yield returns that are set by the world market for capital, and high corporate income taxes reduce investment in that country, which leads to lower wages.

The corporate tax incidence debate is endless, and certainly can't be resolved here. But it is ironic, to put it kindly, that the Wall Street Journal's op-ed pages have featured a consistent slant on this debate, by featuring economists who urgently argue the need to reduce the corporate income tax rate, on the theory that the corporate tax actually burdens labor income. Now the same editorial board has turned around and published a piece that argues that shareholders alone suffer the burden of the corporate income tax. Whatever the ultimate resolution of the academic debate (which has gone on for decades), no one seriously thinks that shareholders alone suffer the incidence of the corporate income tax.

Finally, the capital gains tax is poorly targeted along most any margin. If the aim is the relief of double taxation, then we should go back to the 2001-03 arguments about some sort of true imputation type result, where shareholder relief is contingent on actual corporate tax payments. And we should ask why sales of partnership interests, or for that matter sales of appreciated US Treasury bonds, give rise to capital gains, where by definition there is no double taxation. These are the sorts of larger questions that the Romney tax returns should encourage us to debate.