Wednesday, September 12, 2012
A key reason for Mr. Romney’s low tax rate is that a very substantial amount of his income comes from capital gains – 51% in 2011 and 58% in 2010. Capital gains, no matter how large, are taxed at a maximum rate of 15%, whereas wage income can be taxed as much as 35% by the income tax plus taxes for Medicare and Social Security. The latter two are not assessed on capital gains.
The New York Times recently commented in an editorial that while the carried interest loophole is unjustified, the core problem is lower tax rates on capital gains generally. Said The Times, “As long as income from investments is taxed at a lower rate than income from work, there will be no stopping the search for ways, legal or otherwise, to pay the lower rate.”
The view that capital gains should be treated as ordinary income for tax purposes is one that is widely shared by liberal tax reformers. They got their wish, briefly, from 1987 to 1990 because Ronald Reagan agreed to raise the tax rate on capital gains to 28% from 20% in return for a reduction in the top rate on ordinary income to 28% from 50%, as part of the Tax Reform Act of 1986.
There are three big problems, however, with taxing capital gains at the same rate as ordinary income.
First, even if that were the case, capital gains would still be treated more beneficially, because the taxes only apply to realized gains. ...
Second, there is a problem with inflation insofar as capital gains are concerned. Many academic studies have shown that a considerable portion of realized capital gains simply represent inflation, rather than real increases in purchasing power. ...
Third, it is a fact of life that those with great wealth are the principal beneficiaries of the capital gains tax preference, and they exercise influence in our political system far out of proportion to their numbers. ...
[I]t is a pipe dream to believe that eliminating the capital gains preference is the key to fixing the carried interest loophole. It can and should be addressed by treating carried interest as ordinary income, without requiring that all capital gains be taxed as ordinary income.