Romney's Carried Interest and Capital Gains Rates Generally

As most everybody knows by now, Mitt Romney, the GOP nominee for president, refuses to release anything other than the 2010 tax return we’ve seen (and sometime soon, it is promised, the 2011 return).  Without more tax returns–and more complete return-related information–Romney is basically telling voters they have no right to know how he invests and earns his vast wealth. 

It just ain’t so. 

First, voters have a valid interest in knowning how Romney invests his great wealth.  Passive investments, “hobby” investments, treatment of his later years at Bain Capital, treatment of his “retirement” income from Bain–all of those are of valid interest.  Then there is the question whether Romney has consistently held a lot of his wealth offshore during many years? And did he report his offshore accounts and income as he was supposed to, back in the days before Birkenfeld opened the crack in Swiss banking secrecy, or did he end up participating in the IRS amnesty program in order to avoid criminal prosecution for his failure to file FBARs?  We surely have a valid interest in those questions and more about the way Romney’s wealth is held.

Second, voters have a valid interest in knowing (and understanding) how Romney acquired his great wealth.  Yes, he was born into a well-to-do household and that gave him an incredible leg up on every American who is not born into the lap of wealth, even before he received his inheritance  from his father’s estate(which he purportedly contributed to charity).  But he claims to have a wealth of business expertise that will allow him to be a good president, and that rests on his role at Bain Capital.  But there he is caught up in the rarified world of equity fund managers–people who, through an interpretation of the Code, not through a specific provision providing for it, claim that their “carried interest” compensation income can be treated as capital gains rather than as ordinary income.  As a result, they pay a very low rate of tax.  And their “job” is to buy  out firms, almost always by leveraging them up so they can use other people’s money to make the acquisition, and not infrequently by running them into bankruptcy, resulting in Mitt Romney getting to fire people (he said he enjoys it).

Bruce Bartlett, a veteran GOP economic adviser, even agrees with the majority of tax experts who have come out against the “carried interest” loophole and argues that it “can and should be addressed by treating carried interest as ordinary income.”  See Economix- Bruce Bartlett, Mitt Romney, Carried Interest and Capital Gains, New York Times (Sept. 11, 2012).

Bartlett is correct that we can and should address the ridiculous carried interest loophole–it is well past the time that Congress should have acted to quit favoring the richest folk amongst us with preferential treatment of the compensation they receive for their asset-management activities.

But Bartlett is wrong about whether the effort to fix capital gains problems should stop there.  He argues against eliminating the capital gains preference with three well-hashed and relatively weak arguments.  Let me give you his arguments, and my responses, here.

1. First, he says, even if you got rid of the preferential rate, you wouldn’t have completely eliminated the preference for capital gains in the Code, since gains aren’t recognized until they are “realized”–meaning that the taxpayer has the ability to choose to dispose of a capital asset at the timing that suits him.  Gains can be deferred.  Losses can be accelerated.  (And they still avoid the payroll taxes that apply to wage income). 

The point is true but nonetheless not an argument against eliminating the preferential rate.  Congress is not likely to require mark-to-market rules, but it could easily write rules that make  monetization-without-taxation schemes  unworkable.  (One monetization scheme that has been often employed by wealthy taxpayer is to use shares as collateral for a loan, enjoy the money during life, and let the beneficiaires inherit the shares at stepped up basis and then sell them to pay off the loan–no cost in life; no cost to the beneficiary either.)  Another thing Congress could do to help prevent the “cherry-picking” of loss recognition-without-gain-recognition is to repeal the identification provision that allows taxpayers to pick out which of a bunch of identical shares (except for basis) they are selling.  Require all sales to be taken from all groups of shares.

The fact that eliminating the preferential rate for capital gains doesn’t eliminate all the tax advantages that the wealthy will be able to enjoy from holding the vast majority of the financial assets doesn’t mean that we should at least eliminate that significant advantage!

2. Second, he brings up the old saw about inflation and the fact that in times of significant inflation, the gain calculated as the different between current value and original cost basis will represent in part a “phantom” inflationary gain.  Indexing for inflation would be an administrative nightmare (that would invite wealthy taxpayer manipulation of the data, just as already happens with inflated bases).

The answer here is really “so what.”  If we concede that taxpayers will still benefit–especially compared to ordinary income earners on whom taxes are withheld as the income is earned throughout the year–from having capital gains assets for which they can control the timing of taxation through the realization requirement, we should be quite willing to have a “rough justice” tradeoff the other way with whatever inflationary gains (or losses) may be represented.  This is especially true when one considers that the financial assets held mostly by the wealthy also give enormous other economic benefits during the time they are held–prestige, influence, and power are not to be ignored.   Further, the tax-free consumption power attained through monetization with loans (in circumstances in which it wouldn’t be treated as a constructive sale, and depending on whether Congress would act to make monetization with no taxation impossible through elimination of the step up in basis on monetized assets) is another significant advantage.

3. The third reason given by Bartlett for not eliminating the capital gains preference is that it will be hard–people who get most of the capital gains preference are people of great wealth who “exercise influence in our political system far out of proportion to their numbers.” 

This is a practical reality, but it is not a reason for deciding to retain the preference.  It is, rather, a reason for Republican and Democratic economists to speak up courageously and call for the repeal of the preference from the Code.  It is a reason for all of us to take the actions and policies of politicians favoring wealthy owners of capital into account in our votes.  It is a reason to think twice about electing a ticket (Romney-Ryan) in which both parties grew up in the upper middle class, have always had plenty of money, and don’t have much understanding of what it is like to be down and out in America today.  It is a reason to find progressives who understand the problem of a tax code that preferences the wealthy plutocrats and corporate owners.