When the media reported that Mitt Romney's total tax rate was 15 percent, some people were mad at Romney for taking advantage of the tax code. But others were mad at the media for getting it wrong.
Mitt Romney's tax rate was not 15 percent, this group said. It was more like 50 percent because Romney's income is doubled taxed. He derives the vast majority of his income from corporate investments, which are taxed first under the 35 percent corporate income tax rate and second under the 15 percent rate for capital gains.
"There are two levels of taxation in capital gains," Romney explained succinctly to Larry Kudlow on CNBC. "One at the corporate level, which is a 35 percent rate, and another at the individual level, which has been 15 percent. So combined, it's about a 50 percent tax."
The IRS, corroborated by some smart people, says that Mitt Romney's real tax rate is 15 percent. Yet Mitt Romney himself, corroborated by other smart people, claims that his real tax rate is more like 50 percent.
The Misery and the Mystery Double Taxation
To understand Romney's argument you have to understand something called double taxation. The standard argument against double taxation goes like this. Let's say you own stock in Derek Inc., which earned $100 in 2011 (sorry, I'm not a very good company). I'm taxed at the corporate rate of 35 percent. Out of the $65 that remains, I offer a dividend to thank you for investing in me. That dividend is taxed, again, at 15 percent. That is double taxation. It brings the total tax on your kind investment to a total of 44.75 percent. That sounds outrageously high.
But like Derek Inc., this standard argument against double taxation is only theoretically plausible and mostly mythological. The vast majority of companies pay far less than 35 percent of their income in taxes. GE paid practically nothing in 2011. Google paid about 22 percent. Out of 280 companies in a study by Citizens for Tax Justice, more than 250 had a tax rate under 35 percent.
Another way to see why the toll of double taxation is often far less than 44.47 percent, ask yourself a simple question: Why would I buy a stock in a company? Maybe it's that the company is making money. But maybe it's also because the company has potential. "If an oil company discovers a huge new oil field, its value will increase substantially well before any additional oil is extracted from the ground and sold at a profit," the Tax Policy Center's Eric Toder explained. If you sell that oil company's stock right after it shoots up, much of your capital gain isn't double taxed because it represents the hope for future income.
Back to Romney. Private-equity firms like Bain Capital buy, fix, and sell companies whose profit comes after restructuring. The money that private-equity firms get from selling winners reflect the market's expectation that the newly buffed companies will perform well in the future. That's one reason why "the tax burden on private-equity partners [such as Romney] is a lot closer to 15 percent than to the 44.8 percent figure," Toder says.
The Tax Code We Deserve
If I've convinced you that double taxation is no big deal, then ... I've failed. Double taxation does matter. But not for the reason that Romney is paying too much to Washington.
Of the four economists I spoke with for this article, all four criticized the spirit of double taxation and the way we tax investments. Collectively, they identified three problems.
Problem 1: The gap between investment and income taxes gives smart people a reason to spend lots of valuable time hiding their money. "When you have a 15 percent rate on capital gains and 35 percent rate on earned income for the wealthy, you create huge incentives for tax sheltering," said Len Burman, a professor at Syracuse University and a renowned expert on capital-gains taxes. "The people who invent all these tax schemes are really smart. They could better spend their time making stuff."
Problem 2: The gap between investment income and earned income makes the tax code revert to regressivity at the top. Millionaires made $258 billion of the $261 billion of net gains reported on tax returns in 2010--97 percent of the of the total. That's neither an inherently good thing nor a bad thing. It's just the kind of stat that makes you see that the tax code isn't as progressive as the marginal rates make it look.
Problem 3: Double taxation is a symbol of our confusing tax code, and we could change it if we thought more holistically about the flow of money. "The double taxation of corporate income is not something that makes sense," said Alan Viard, an economist with the right-of-center American Enterprise Institute. "The better treatment is to not have a firm level tax and tax the income at the individual level. You would have to tax the gains from publicly traded stock as they accrue."
Seth Hanlon an economist with the left-of-center Center for American Progress said nearly the exact same thing. "The best way to deal with this would be to integrate the corporate and individual income taxes," he said. "Basically, shareholders would pay tax on income as it accrues, rather than when they sell an asset."
So, that's the deal with double taxation. It exists. It's not as bad as it sounds. But it's much worse than it should be.
Nota Bene from the economists:
Hanlon on the benefits of private equity: "The other aspect that seems especially ironic in the private-equity context is that the use of debt can lower or zero out the company's tax bill. So some of the gain for the PE investors and managers might result directly from the reduction in tax at the corporate level."
Viard on the clear case for a lower dividend tax rate: "The sole argument for the dividend rate was to offset that double taxation. The cap gains and dividends offset is better than nothing. But it's not ideal."
Burman on how corporate taxes affect a new company: "You know that future income will be taxed and that affects the value of future expected profits. It does suggest that anticipated dividends aren't really double taxed because the value of the company already reflects the expected future taxes. I think this is the basis of the new view of dividends."