15 percent or not, tax policy favors the rich

Mitt Romney hasn't done anything wrong in paying a low tax rate. What’s wrong is the tax system itself—by favoring investment income, the excessive use of pass-throughs, and subsidizing debt financing.

By , Guest blogger

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    Republican presidential candidate and former Massachusetts Governor Mitt Romney speaks at a US-Cuba Democracy PAC event in Miami, Florida January 25, 2012. Romney isn't doing anything wrong by paying a low tax rate, but the tax code that allows him to do so is broken, Bernstein argues.
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The editorial page of the WSJ is at it again, torturing numbers until they confess to crimes they did not commit.  In this case, they’re claiming that Mitt Romney’s tax rate is a lot higher than the 15% he himself has acknowledged, and that his tax records confirm.  It’s a claim that requires considerable sleight of hand, as I’ll show.  But more importantly, when you actually start to look at the tax code that applies to rich folks like Gov Romney, with all their income from investments as opposed to earnings, you get a sense of just how tilted tax policy is in their favor.

The Journal’s main point is this:

One reason investment income is taxed at a lower rate than wage and salary income is because it is a double tax—profits are taxed once under the statutory 35% corporate tax rate and then again when they are paid out to individuals as dividends.

But this is almost certainly not the case with income from private equity firms like Bain Capital, because they are invariably set up as “pass throughs,” meaning that profits face only the individual rates of the owners, not the corporate rate.

Recommended: Six ways the rich really do get richer

What about the corporations in which the PE funds invest?  Don’t they pay the corporate rate and wouldn’t that be capitalized into their profits (which would be lower due to the corp tax)?  But that’s not how the PE guys roll.  They profit from buying and selling undervalued stock in the company, or for that matter, selling the undervalued company itself.  The corp rate doesn’t come into play in either scenario (Dan Shaviro makes these points here).

And to the extent that these companies are themselves pass-throughs, the corporate rate again doesn’t apply.  Based on Romney’s tax returns, it’s impossible to tell whether the capital gains he realized through these companies reflect corporate taxes at all (interestingly, Romney’s trustee actually made this point to the WSJ, which chose to ignore it).

Finally, remember this: PEs are masters of debt financing, and debt financing carries an effective tax rate of -6% because business interest can be deducted from your tax bill.  For the highly leveraged PE crowd, debt financing is a tax shelter for other liabilities they face, including any corporate income that might slip through the cracks…if I were the WSJ here, I’d crow that Romney’s tax rate is actually 9% (15-6)!

Let me be clear: I’m not saying Gov Romney did anything wrong here—though I am saying that without dealing with all of the issues above, the WSJ’s claims are clearly unfounded.  What’s wrong is the tax system itself—by favoring investment income, the excessive use of pass-throughs, and subsidizing debt financing, it’s even more distortionary and unfair than the WSJ editorial page.

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