Charles Dharapak / AP
Republican presidential candidate, former Massachusetts Gov. Mitt Romney campaigns at Andrews Field House at Wofford College in Spartanburg, S.C., Wednesday, Jan. 18, 2012.
Mitt Romney’s estimate that he pays a 15 percent effective tax rate has suddenly become the dominant theme in the Republican campaign. While Romney has rekindled the long-running argument over tax fairness and whether investment income ought to be taxed at a lower rate than salary and wage income, it isn’t surprising that his effective tax rate is what it is – since much of his income is from investments and the tax code has long provided a preferential lower rate for them.
Romney’s focus on his taxes has also revived a debate which Congress had in 2007 over whether the specific type of income he gets from his years at Bain Capital -- a kind of investment income called “carried interest” -- ought to be taxed at the lower capital gains rate of 15 percent, or the higher tax rate on earned income, which for the highest income taxpayers is 35 percent.
If Romney, or anyone else, made $500,000 a year from a salary, he’d be taxed at a top marginal rate of 35 percent (scheduled to go up to 39.6 percent next year), but if he made that money in the form of capital gains and dividends he’d be taxed at 15 percent.
The case against taxing “carried interest” at the lower capital gains rate was made in a Senate Finance Committee hearing in 2007 by Joseph Bankman, a professor of law and business at Stanford Law School.
“We ought to have the same rate of tax apply across different occupations or investments,” Bankman told the committee. “The relative profitability of different professions, or investments, ought to be dictated by the market, not the tax law.”
He contended that the tax code’s treatment of investment fund managers “distorts career choice” and “is also unfair: why should fund managers get a lower tax rate than executives or scientists?”
But investment industry advocates pointed to the long-standing policy of Congress -- dating back to the 1920s and continuing under both Democratic and Republican Congresses and presidents -- of taxing the gains made from sale of stocks or other assets at a lower rate than wage and salary income as a way to spur investment, help launch new companies, and create private-sector jobs.
Kate Mitchell, a venture capital investor from Foster City, Calif., told the committee that she and others who run investment funds invest both their wealth and time (“sweat equity”) finding businesses to start, run, or revive.
She said it was both smart and fair policy to “reward investors of sweat equity with the same long-term capital gain tax benefits that investors of financial equity receive. Both will only succeed if the business builds in value -- so both are subject to the same entrepreneurial risk … .”
In 2007, when the Democrats controlled the House, Rep. Sander Levin, D-Mich., proposed to treat “carried interest” as ordinary income and have it taxed at rates up to 35 percent. Levin’s proposal was passed by the House four times, but never acted on by the Senate. Levin said Wednesday he would reintroduce that bill.
In 2010, Senate Finance Committee chairman Max Baucus, D-Mont., introduced a bill to tax carried interest as ordinary income, but it did not pass the upper chamber.
There was a brief period after enactment of the 1986 Tax Reform Act when capital gains income and salary income for the highest income people were taxed at the same top income tax rate of 28 percent. But when Congress increased income tax rates in 1991, it kept the lower capital gains tax rate and then cut it to 20 percent in 1997 and to 15 percent in 2003.
Although the details of Romney’s income and the taxes he pays won’t be clear until April when he has promised to release his tax return for 2011, Democrats argue that Romney’s tax rate is unfairly low, and that a person who earns perhaps millions of dollars from carried interest ought to pay at a higher effective rate than 15 percent.
But if it is 15 percent, how does Romney’s tax rate compare with that of other Americans?
Romney’s 15 percent effective income tax rate is lower than that of most wealthy people, but higher than the effective income tax rate that most taxpayers pay.
According to the Internal Revenue Service, in 2009, the most recent year for which data is available, two-thirds of all income tax returns reported adjusted gross income of under $50,000. In other words, nearly 93 million of the 140 million income tax returns reported adjusted gross income of less than $50,000.
That means those taxpayers paid at the 10 percent statutory income tax rate or the 15 percent tax rate, or owed no tax at all.
For married couples filing jointly, if their taxable income is not over $17,000, the law says they must pay at a rate of 10 percent.
If their taxable income is over $17,000, but not over $69,000, they must pay $1,700 in income tax, plus 15 percent of the amount of income over $17,000.
The 25 percent income tax rate does not apply until a married couple has taxable income over $69,000 -- and the vast majority of Americans don't.
(The higher rates, 28 percent, 33 percent and 35 percent, apply at even higher income levels.) But the effective tax rate, which the Congressional Budget Office defines as “the share of their income that people pay in (federal) taxes,” is lower than the statutory rate because exemptions, credits and deductions reduce tax liability.
The IRS Statistics of Income data for 2009 show that for all 140 million tax returns, income tax paid as a percentage of adjusted gross income, was 11.4 percent.
About 3.9 million tax returns reported adjusted gross incomes of $200,000 or more. Those tax filers, on average, paid at an effective tax rate of 22 percent.
Those with between $50,000 and $200,000 in adjusted gross income paid, on average, about 9 percent of their AGI in income taxes.
The tax filers with under $50,000 in adjusted gross income paid at an average effective tax rate of about 3 percent.
(This IRS data doesn’t include the state and local taxes that people pay.)
A person such as Romney who gets his income mostly or entirely from capital gains, dividends or “carried interest” does not face what the carpenter or barista faces: the Social Security and Medicare payroll tax, which is normally 7.65 percent. But in 2009 more than 27 million tax filers got the Earned Income Tax Credit which offset the payroll tax burden and was worth nearly $60 billion to those taxpayers -- on average, nearly $2,200 per tax return.
The IRS Statistics of Income data isn’t perfect because as the Congressional Budget Office noted in 2005, “people, particularly those at the bottom of the (income) distribution, move onto and off the tax rolls from year to year,” so that the data “poorly represent the entire population over time and cannot consistently provide information on low-income taxpayers.”
But the IRS data does cover all 140 million income tax filers and does allow comparisons to be made between different groups. Exactly where Romney falls in the tax distribution will be interesting to see in April when he releases his tax return for 2011.