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Controversy over Romney’s Taxes Underlines the Need for Broad Reform

The controversy over Mitt Romney’s tax returns underlines the need for broad reform of the U.S. tax system.  Much commentary has focused on the low average tax rate that this wealthy candidate for president enjoys, thanks in large part to low rates on capital gains.

The political issue raised by Romney’s taxes is simple: should the rich pay a larger share of the cost of government, or, are they being justly rewarded for their role as job creators? The economic issues are more complex: Does it make sense to treat capital gains differently from other forms of income? How do capital gains taxes interact with the rest of the tax system?

The blogosphere is awash with commentary on the political aspects of the question. (See here for samples from the left and the right.) This post will tackle the economic aspects, under the headings of three economic arguments often advanced in favor of lenient tax treatment of capital gains.

1. Capital gains are not income

One argument for lenient tax treatment is that capital gains are not income, but rather, only a reflection of the transfer of control of an existing asset. If we want assets to come under the control of those who can put them to best use, we should erect no barriers to their purchase and sale. Tax income if you will—wages, interest, rents, profits—but not ownership transfers.

This might be a persuasive argument if it were possible to distinguish cleanly between income and capital gains, but it is not. Consider the following example: I make a contract with my wife to supply 2,000 hours of labor over the coming year for a payment of $2,000. She can, if she wants, call on me to use those hours mowing the lawn and making lasagna for dinner. Instead, she can treat the contract as an asset (which it clearly is) and sell it to the local university. The university happily pays her, say, $60,000 for the right to command 2,000 hours of my time as a lecturer. Come April 15, she reports a basis of $2,000 on the sale of the contract and a capital gain of $58,000. I report labor income of $2,000. If capital gains are preferentially taxed, it’s a pretty neat way to reduce the total taxes on our joint return, no? At the same time, it moves my labor to a higher-valued use, and I can still mow the lawn in my spare time.

Although the teaching contract example is fanciful, the real world is full of situations where a business can choose to structure a transaction to make it look like income or to make it look like a capital gain. A corporation can pay dividends to its shareholders or retain earnings and allow the market price of its shares to appreciate. It can pay executives high salaries or give them stock options structured to produce equivalent capital gains. The examples are endless.

One of the most controversial ploys is the carried interest rule, which allows hedge fund and private equity managers to structure the income they receive for their services in a form that qualifies for taxation as capital gains. It appears likely that Mitt Romney is among those who have taken advantage of the carried interest rule.

Even some commentators who are otherwise enthusiastic about lenient taxation of capital gains draw the line at carried interest. For example, David Frum, who forthrightly asserts that “the lower tax rate for capital gains is good policy,” writes that

The person entitled to the lower capital gains rate is the owner of the capital asset. But the US financial industry benefits from rules that allow non-owners the same benefit as owners: This is the famous “carried interest rule.” It’s utterly unjustifiable. If you’re investing with other people’s money, what you are earning is income—and it should be taxed as such.

Even if tax avoidance strategies that convert ordinary income to capital gains were economically costless, they would still violate the principle that good tax rules should treat like as like, keep the tax base broad, and keep rates low for everyone. But the situation is worse than that. Very often, tax avoidance requires more than just waving an accountant’s wand over something a firm would do anyway in the normal course of business. Instead, structuring transactions to take advantage of specific tax rules often requires changing actual business practices—the choice of financing methods, the timing of investments, even entry into whole lines of business that would be unattractive except for their tax advantages.

For example, suppose a private equity group is weighing the pros and cons of a risky leveraged buyout of a failing company. Is it worth throwing good money after bad in the hopes of turning the company around, or at least papering over its problems long enough to resell it? Or would it be better just to liquidate the company and sell off its assets piecemeal? The lower the tax rate on capital gains from the buyout,  the more tempting it is to take the risk, even if the before-tax return on some other, more highly taxed venture would be a more productive use for the capital. In such cases, lenient treatment of capital gains does not, as its defenders claim, encourage the transfer of assets to their highest value uses. Instead, risks transferring them to uses that have lower real values, offset by tax benefits. Doing so creates deadweight losses for the economy as a whole.

2. We need low capital gains taxes to offset the effects of inflation

A second justification for low tax rates on capital gains is that we need them to avoid taxing “phantom” capital gains produced by inflation. This argument has an element of truth. In times of inflation, owners of assets may be subject to taxes on nominal gains even when real asset values do not increase. You buy shares at $100 and sell them for $120 a couple years later, after prices have risen 10 percent. If you pay 30 percent tax as ordinary income on the $20 nominal gain, your tax rate on the $10 real gain is 60 percent. Cutting the rate on capital gains to 15 percent, while leaving the tax rate on ordinary income at 30 percent, would only level the playing field. Right?

Not really. There are two flaws in this argument.

First, any arbitrary rule like a fixed lower tax rate or an exclusion of a portion of capital gains can only crudely approximate the necessary adjustment for inflation. The 15 percent rate that works out right in the example we just gave becomes too low a rate if inflation slows, or too high a rate if it accelerates. Furthermore, the rate that just levels the playing field for a person whose ordinary income falls in one tax bracket will be too high or too low for others in different brackets.

A more nuanced approach would be to index the basis on which capital gains are calculated to reflect inflation between the date of purchase and the date of sale. That would avoid the taxation of phantom capital gains, but it would not avoid a second, equally serious problem.

The second problem is that other forms of investment income, too, are subject to phantom taxation when there is inflation. Suppose you are subject to a 30 percent tax rate on interest income that you earn from a bond with a 5 percent coupon that you own during a period of zero inflation. If inflation later rises to 5 percent, and the same borrower then offers a 10 percent coupon rate on similar, newly issued bonds, your real income before tax is unchanged. The trouble is, you have to pay 30 percent tax on the full 10 percent nominal interest, which comes to 60 percent on the 5 percent real interest that remains after you subtract the effect of inflation.

The situation is similar for income from the common stock of a firm that has constant real profit, of which it pays a constant share as dividends. Faster inflation increases the real effective rate of taxation on the dividends.

A helpful 1990 paper from the Congressional Budget Office explores the problem in detail. The paper confirms that faster inflation raises the effective tax rate on investment income, but it points out that the effect is inherently smaller for capital gains than for dividend or interest income. Attacking the problem of phantom capital gains in isolation by whatever means—a preferential capital gains rate, an exclusion, or indexation –only widens the gap between the way inflation affects capital gains and the way it affects dividends and interest. Doing so increases the attractiveness of tax avoidance strategies that involve inefficient business practices.

The ideal solution to distortions caused by inflation would be to index the entire tax system. Indexation would have to cover not only all forms of investment income, but also taxation of ordinary income, real estate, inheritance, and everything else. But trying to remove the effect of inflation on capital gains taxes separately is likely to make things worse, not better.

3. We need low capital gains taxes to avoid double taxation of corporate profits

Avoidance of double taxation of corporate profits is a third common argument in defense of lenient tax treatment of capital gains. As Chris Edwards puts it in a recent post on Cato@Liberty, “Corporate profits are taxed at the business level and then again at the individual level by taxes on dividends and capital gains. Providing a lower rate for dividends and gains at the individual level is one way to partly alleviate the distortion.”

Yes, it is one way to partly alleviate the distortion—one way, and a bad way. A much better way would be to fix the flaws in corporate taxes that are the source of the problem rather than apply a Band-Aid  to capital gains.

What would fixing the U.S. corporate tax involve? I’ll reserve a full discussion the subject for a future post, but briefly, it would mean two things.

First, it would mean getting rid of the numerous loopholes in the corporate tax system that allow some corporations to escape taxation of their altogether while those unlucky enough not to qualify for the same loopholes pay the second highest rate in the world, after Japan. Income derived from companies that do not pay corporate taxes does not need to be shielded from double taxation.

Second, it would mean further reducing the double-taxation problem by substantially lowering the corporate tax rate while taxing capital gains as ordinary income. That was a key element of the Simpson-Bowles tax reform package advanced in December 2010, which proposed a comprehensive reform of the corporate tax with a single rate in the range of 23 to 29 percent along with taxation of capital gains at the ordinary income rate.

A recent paper in the Virginia Tax Review by Rosanne Altshuler, Benjamin H. Harris, and Eric Toder explores the logic of the Simpson-Bowles proposal in detail. In the authors’ view, “there may be both efficiency gains and increases in progressivity from shifting taxes on corporate equity income from the corporate to the shareholder level.” The distributional effects are admittedly hard to estimate, since they depend on the complex issue of how the corporate tax is divided between capital and labor and also on the extent to which corporate taxes distort international locational decisions. The case for efficiency gains is much more robust. It holds up even if capital bears the entire burden of the corporate tax.

The bottom line

The bottom line is that proper policy design depends on more than whether capital gains taxes can affect business decisions. Of course they can. So do taxes on ordinary income, payroll taxes, sales taxes, property taxes and most other taxes. But it is a non sequitur to say that capital gains taxes affect business decisions, therefore they should be as low as we can make them. Instead, we should properly consider capital gains in the context of the tax system as a whole:

  • Taxing capital gains at lower rates than other forms of investment income does not encourage investment in general so much as it encourages structuring investment decisions in ways that avoid taxes, even if they are less efficient.
  • A separate regime for capital gains taxes is likely to increase the degree to which inflation erodes the equity and efficiency of the tax system.
  • When we consider corporate income taxes and capital gains taxes jointly, a strong case emerges for revenue-neutral reform that taxes capital gains as ordinary income while lowering the corporate tax rate.

And what does all this have to do with Mitt Romney’s tax returns? Jack Blum, a Washington lawyer and tax authority hit the nail on the head when he recently told ABC News that “his personal finances are a poster child of what’s wrong with the American tax system.”

4 Responses to “Controversy over Romney’s Taxes Underlines the Need for Broad Reform”

Earl GrinolsJanuary 26th, 2012 at 2:07 pm

Or, the nation could repeal the16th Amendment and the income tax, institute a consumption tax (in form of VAT, but other varieties are possible), and eliminate the vagaries above while reaping 4-6% higher national income in the long run, according to most estimates. This also has the advantage of helping the little guy accumulate wealth and fully prevents the rich guys from avoiding taxes when they consume.

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