An illustration of the problem with average tax rate calculations

In a couple of earlier posts, I've noted some of the conundrums posed by relying on effective or average tax rate computations, when used either for purposes of a Buffett rule (see here) or to assess Romney's degree of federal income tax burden (see here).

A fresh illustration comes from a recent Wall Street Journal blog posting, Laura Saunders' "What Was Mitt's Income in 2009?," available here.

Noting Romney's $4.8 million capital loss carryover to the 2010 tax year, along with other evidence (such as of estimated tax payments) on the 2010 return, Saunders cites Boston CPA Adam Gorlovsky-Schepp for the conclusion that "the Romneys’ 2009 adjusted gross income appears to have been about $6.47 million, with federal income tax of about $1.24 million," whereas "[i]n 2010 they paid nearly $3 million of tax on $21.6 million of income."

Saunders adds: "That would make their effective tax rate 19% in 2009, much higher than the nearly 14% rate they paid in 2010."

Ah, so Romney apparently paid a "fairer" tax rate in 2009 than 2010. Saunders doesn't say this, but may mean to imply that it is a logical conclusion.

Consider, however, that - unless tax planning incompetents were at the helm, which seems unlikely - Romney's 2009 capital losses must have reflected "loss harvesting," or systematically selling stocks that were worth less than their tax basis, while continuing to hold those that were appreciated. Now, despite the horrific stock market events of 2008 and 2009, it is entirely plausible that Romney's stock portfolio remained substantially appreciated on balance, given the massive overall stock market run-up over the two decades preceding 2008. There's certainly no reason to think it likely that he had purchased most of his stocks right at the end of the run-up, or just before the crash.

Given this set of issues, a tax rate computation that is based on Romney's adjusted gross income misses a large part of the picture. You have to think about economic income, not just taxable income, and about a long-term time horizon, not just the current year.