Mitt Romney's tax returns and the tax rate he paid on his income have been hot issues in the recent Republican primaries.
"What's the effective rate that I've been paying? It's probably closer to the 15 percent rate than anything because my last 10 years, my income comes overwhelmingly from investments," the GOP front-runner recently told reporters.
So why does a multimillionaire pay just 15 percent on his income? After all, the top income tax rate is 35 percent and many middle-class people pay over 20 percent.
It's because most of Romney's income came from investments, so it came in the form of dividends, or in the form of capital gains — that is the increase in the value of investments that he sold. They're both taxed at a lower rate than ordinary income — the salaries most of us make at the office or the factory. NPR's Audie Cornish discusses the debate over the special tax treatment that investors receive with NPR's John Ydstie.
So why the break for income earned from investments?
The theory has been that if you tax investment income at too high a rate, you'll discourage investment and crimp economic growth and job creation. But it's somewhat controversial, not least because most of the people who get to pay that lower rate are well-off.
In fact, 70 percent of the benefit goes to the top 1 percent of income earners. It's the rate paid by hedge fund managers and private equity managers, like Romney when he was at Bain Capital, though the rate was a bit higher back then. And it's the rate paid by investors like billionaire Warren Buffet. Buffet is quite famously appalled by the situation. He says it's not fair that he pays a lower rate on his massive income than his secretary pays on her middle-class salary.
So does it benefit the economy enough to justify this apparent lack of equity that troubles Buffet?
A number of economists say that there are no studies that prove that there's a benefit to the economy. They say it does make good sense though when it comes to taxing income from venture capital — income generated by increased value of new ventures and startups like when Apple and Microsoft were created a couple of decades ago.
Those companies created huge numbers of jobs and boosted the economy. But the problem is, Congress hasn't been able to limit the tax break to that group. And it turns out that venture capital income represents less than one-tenth of the income that enjoys this low 15 percent tax rate. If you sell stock in Ford or General Mills and make a profit you get the lower rate; if you sell real estate and make a profit, you get the lower rate. But that's basically just a change of ownership and doesn't make a big contribution to economic growth or job creation, but you get the lower rate anyway.
So economists seem to be saying that it doesn't make much sense that income from those kinds of activities is taxed at a lower rate than regular wages and salaries?
That's right. And, in fact, the difference between the 15 percent capital gains tax rate and the top 35 percent for ordinary income encourages people to create tax shelters that allow them to claim their income as capital gains. And those tax shelters produce a huge amount of inefficient economic activity — in the past things like investing in office buildings that stand empty or city people buying tractors. These days, it's much more complex but just as damaging to the economy, not to mention that you have very smart people creating these tax dodges when they could be inventing more useful things that do create jobs.
Is there any movement to change this in Washington?
There's talk of tax reform, but no critical mass building around this issue yet. President Obama's bipartisan deficit commission did recommend that the tax rate on investment income should be the same as for ordinary income. Of course, there's a lot of interest on the part of some very powerful people in keeping this low rate, so I wouldn't hold my breath.