Mitt Romney inspires a look at how tax rules help high earners

It’s certainly not his goal, but when Mitt Romney releases his income tax returns Tuesday, he is likely to show how wealthy people grow even wealthier with the help of the U.S. tax code.

The multimillionaire presidential hopeful has estimated that he pays about 15% of his income in taxes, less than many middle-class Americans and far less than the maximum 35% rate applied to ordinary income.

Romney’s returns are expected to show that his taxes are so low because of the steady reduction in capital gains rates over the last three decades.

He probably also has been helped by a reduction in taxes on stock dividend payments, which occurred during President George W. Bush’s administration. And in earlier years, the former head of Bain Capital gained from preferential treatment given to managers of elite investment partnerships such as private equity funds and hedge funds.

Altogether, experts say, Romney’s taxes are likely to demonstrate how ultra-rich Americans benefit from rules that most other Americans can’t take advantage of because they simply don’t earn enough.


“If you can earn your income from these tax-preferred sources, then you’re way ahead of the rest of us,” said Roberton Williams, a senior fellow at the Tax Policy Center in Washington.

Romney’s tax rate has stoked an intensifying debate about income inequality and fairness.

Critics say the tax code has helped widen income and wealth gaps between the richest Americans and everyone else. Aside from allowing high earners to keep more of their income, the disparity in effect adds to the burden on middle-income people.

“The wealthy are able to take advantage of tax breaks in ways that are not available to the rest of the population,” said Brad Borden, a tax-law professor at Brooklyn Law School. “They get wealthier and shift a larger burden of taxation onto the rest of the population, making it more difficult for those outside of the upper echelon to save and get ahead.”

Defenders of the tax code say the system encourages rich people to make investments, which pays off for society as companies expand and add jobs. They also say the capital gains rate should be as low as it is because of the chance that an investment will lose money.

“You want to encourage people to take what is basically a risky approach with their money in order to encourage investment in the economy,” said Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at Dartmouth’s Tuck School of Business.

Capital gains tax applies when an asset owned for more than a year, such as a home, stock or mutual fund, is sold for more than the price at which it was bought.

It has existed since the federal income tax was introduced in 1913. It has, on average, accounted for 5.2% of all federal income tax since World War II, according to a 2010 study by the Congressional Research Service.

The capital gains rate has fallen over the last three decades after reaching a high of about 40% under President Carter.

The tax cuts signed into law by President Bush in 2003 helped push the capital gains rate down to 15% in 2010. That compares to a rate on normal income of 35%.

Many middle- and upper-middle-class Americans who own stocks or mutual funds qualify for lower capital gains rates. But for most people, capital gains represent a very small portion of their overall income, data show.

The richest one-fifth of Americans accounted for 93% of all the realized capital gains and dividend payments last year, according to estimates from the Tax Policy Center. Two-thirds of that went to the top 1%, and 47% went to the richest 0.1%.

“It’s such a small percentage of our income,” Borden said. “The benefit to the vast majority of the population is insignificant. It may be a few hundred dollars a year.”

People with large holdings of stocks or mutual funds that invest in stocks also have benefited from a reduced rate on dividend payments. The 2003 tax revamp set the rate at 15%. Dividends previously were taxed as ordinary income.

A 2011 report from the Congressional Research Service said the drop in the capital gains tax has contributed to the rise in income inequality in the U.S. in recent decades.

The controversy over Romney’s taxes stems partially from a specific type of capital gain that Romney earned during his years at Bain Capital.

Private equity managers earn money when the investments they make on behalf of institutions and wealthy clients increase in value. Traditionally, the managers have taken 20% of this profit, which is known as carried interest. Many hedge funds and real estate managers work under similar arrangements.

Although carried interest always has been taxed at the same rate as other capital gains, there has been a push in recent years to tax it as ordinary income. The logic is that carried interest is essentially income that private equity managers earn in their jobs — in other words, normal earnings.

The House supported a revamp in 2007, but it was rejected by the Senate. Since then, the Obama administration has continued to push for the change, saying last year that it would help raise $18 billion over a decade.

The push to close the so-called carried interest loophole has also won the support of several business leaders, including entertainment mogul Rupert Murdoch, investment guru Warren Buffett and New York Mayor Michael Bloomberg.

But aggressive lobbying by the private equity industry, hedge funds and real estate investors has helped stave off the change.

“To raise taxes on investment would discourage the risk-taking required to start, grow and save companies,” said Steve Judge, interim president of the Private Equity Growth Capital Council.