Tax Distortions

January 25th, 2012 at 5:37 pm

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.

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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11 comments in reply to "Tax Distortions"

  1. Ted Boettner says:

    Of course this violates the ‘free market theory” that taxation falls completely on wage earners or is passed onto to customers. It cannot all be double taxation if it reduces wages, it can only be double taxation if it falls shareholders. And if that’s true, state corporate income taxes take on a whole new meaning.

  2. Russ Abbott says:

    Two separate points.

    1. If the WSJ (or anyone else) wants to credit Romney (or anyone else) with the taxes paid by corporations, it should also credit him with the income of corporations. If not, who pays taxes on that income? But of course, people who makes this sort of claim also claim that “corporations are citizens,” which means that they should be taxes separately. Money transferred from one citizen to another is taxed whether the citizen from which it came paid taxes on it or not.

    2. A point no one is making is that Romney has behaved incredibly selfishly by investing in the Cayman Islands. Perhaps he can (legally) make more money for himself by doing so, but investing in the Cayman Islands does not create jobs in America. If Romney is really interested in being a job creator, he would invest here at home where his investments might do some good.

  3. Jean says:

    I still wonder if, in addition to all this favorable tax treatment the PEs are getting, we could attribute some percentage of the current unemployment problem to the buying and selling of companies where the goal is to make money and not to be a stakeholder?

  4. perplexed says:

    Maybe its time to recognize that corporate charters themselves are a government intervention in the “free market” and eliminate them. This will immediately solve this corporate tax issue and free the public from bearing this risk at such a deep discount. Surely Republicans will agree that this was not what was intended by allowing “market forces” to decide outcomes through the “invisible hand” of the marketplace. Corporate charters, far from creating “people,” were granted to provide limited liability to investors for the damage they cause in excess of their investment, and were supposed to be accompanied by some benefit to society as well, because these excess losses are borne by creditors (who are often other corporations) and, ultimately, the public at large. Its highly unlikely that the amount of corporate taxes actually collected provide adequate compensation to the public for the risks they assume, and business are free to buy insurance against the risks they face in the “free market” anyway; its not a form of welfare the government needs to provide any longer, especially at such a low cost. Our society has too many pressing and more important challenges to deal with in the face of drastically reduced revenues to continue this form of welfare to our oligarchs. In the case of the TBTF banks, not only does the public bear the risks beyond what the investors put up, but now they have to cover the losses suffered by the bank’s depositors, creditors, and investors as well. Its time to get these corporate welfare queens off the government payrolls and allow them to earn a paycheck by putting their own assets at risk instead of those of the public.

    For more on the subject see Dean Baker’s new book “The End of Loser Liberalism.” It removes much of the obfuscation our corporate welfare queens use to conceal how they profit by getting others to take risks while they take any gains generated by it (less a few dollars paid in taxes of course – quite a bargain by any standard, chump change really). Does anyone really think that if they could buy this kind of insurance cheaper in the open market that they wouldn’t already be doing it? Maybe we should find out how much we’re leaving on the table and at least start charging the “market” rate.

  5. Steve says:

    Reading this post made me remember a conversation I had many years ago with my former boss. We were discussing his rental properties and he bemoaned the fact that when he sold one, the money he made from the sale was taxed at 30% or some such number. He said that discouraged investment and the tax rate should be lower.

    My response was this: If the government targets wages more than wealth for tax revenue, there is no way for anyone who relies on their wages to gain wealth. I then told him there has to be a middle ground somewhere that allows a working guy like me to gain wealth or the whole premise of working hard and getting ahead was a lie. He didn’t have any answer to that and the conversation quickly turned to another topic.

    The more I think about it, the more I think I could have had that conversation with every Republican candidate and none of them would have had a good answer for me.

  6. Comma1 says:

    This is why I’m inclined to support a 35% flat tax, no deductions, no nothing. That’s it – 35%. I would include corporations too. If they are to have the rights of people, they must have the responsibilities(citizenship, criminal responsibility, etc., etc.) A flat tax, insures that Mr. Dudley-Do-Right-body-double pays the same as everyone else. One rate with zero deductions is transparent. Politically, it shreds Repubos.

    This is a Gordian Knot that should have been cut years ago. Handle the issue of progressivity when issuing benefits not when collecting taxes. This is a winner for progressives because it demands everyone contribute the same amount. Repubo economic theory is always attacking the phantom lazy (Cadillac welfare queens, etc.) This cuts that argument down, and this one argument is the keystone to all Repubo thought. It tells the voters there are no people gaming the system, we all pay 35%, there are no millionaires who are “masters of debt financing,” etc. It also provides progressives a new deal for America — equal burden, equal opportunity. Furthermore, it changes the discussions from cutting taxes (which 98% of people instinctively want) to which benefits do we cut (which leads to more nuanced conversation, and requires having real conversations about policy. Something that hasn’t happened in over a decade.

    • Roger says:

      The tax issue is not about amount but present and future ALLOCATION. If a meteor were to warp above the earth next year, and we had to build a mothership to leave the planet, the right tax rate would be 100%.

      Therefore, I find recent discussion of tax rate moot, as they are built upon assumptions held constant…when they really should be up for debate. For example, healthcare may not be so burdensome if everyone just ate their damn fruits and vegetables. They are not a panacea but, like vaccines, if enough people partake of the institution then the funding for the truly ill will make itself apparent.

      By the same token, we must see the government bill of receipt. Unfortunately, public policy 101 is that one man’s inefficiency is another man’s income.

  7. Tom Lum Forest says:

    I eagerly await the WSJ saying that all individual taxes should be abolished, and henceforth government revenues should be solely derived from corporate taxes.

  8. rjs says:

    even if one accepts that there is double taxation on capital gains, thats the way it should be…since the state exists to protect the elites, they should be paying more to sustain it than the slave class…

  9. Roger Larson says:

    How could Six Sigma be applied to the likes of the WSJ and Mitt Romney? That is a bit facetious, but may merit some input if you wish. But my conclusion is that if a supposed journal and CEO cannot deal with real numbers and the way it works, what business do they have being followed? Above and beyond the fact that government is not a business, did you catch Pawlenty going on about Lincoln in reply to Lawrence O’Donnell’s question in a similar regard? Not to mention dragging in Ronald Reagan with his union experience followed by his marriage into a new ideology. Martin Bashir also recently noted Republicans and their difficulties with irony? I don’t know if he was punning on I Ron Knee? But I have.

    BTW: The Republicans as well as maybe some Democrats associate themselves with Six Sigma, but the issue of the government not being a business must be at the foundation of the process, which would mean that the debate we are having about the dynamics of economics and politics is key. i.e. who would you rather have setting the ends and means for a more perfect union. Those with the foundation (speaking of Lincoln speaking of labor prior to capital) or those with the trickle down? GE, I did not mean to…

  10. Bud Meyers says:

    Capital gains tax is not a “double tax”. Corporate tax is a tax on corporate income, not personal income.

    If corporate executives no longer want to pay an “effective” 35% corporate tax from their corporate treasury (before paying themselves stock-options taxed at 15% for capital gains), they can always un-incorporate.