Monday, September 24, 2012

Should Romney pay a lower tax rate than the rest of us?

I have seen two lines of argument in the last couple of days, to the effect that Romney's low effective tax rate, compared to that of people much less affluent than he is, might actually be just fine.  But each is wrong in important ways.

The first is Romney's own argument, which he advanced here, to the effect that "one of the reasons why the capital gains tax rate is lower is because capital has already been taxed once at the corporate level, as high as thirty-five percent."

Those who have seen me direct a lot of snark at Romney in recent weeks (albeit in my view deservedly so) may be surprised to hear that I agree that, in principle, he has a point.  Only, I suspect that in practice the argument is incorrect as applied to him.

Suppose Romney holds Apple stock, and that Apple is generating huge profits, on which it pays U.S. tax at a 35 percent rate.  It never pays dividends, but when he sells his Apple stock he enjoys capital gains, by reason of these profits.  Then he has a point.  (A longer discussion might be needed if one raises the point that the incidence of the corporate tax may be shifted to workers - but then we have to raise similar questions regarding the true incidence of income taxes that are directly paid by the owners of proprietorships and partnerships.)

But consider the following:

(1) Often corporations are not actually taxed at anywhere close to a 35% rate on their actual economic profits. Apple, for example, is notorious for causing a lot of its global taxable income to show up in tax havens such as the Caymans and Bermuda. So I believe Apple faces a very low effective rate of tax. By the way, its financial statements overstate what it actually pays, since it declines to take any accounting credit for the deferral of US taxes by keeping profits abroad. (Most publicly traded companies, by contrast, are desperately eager to take maximum accounting credit for the game.) Obviously, Apple isn’t really the point here. But when big U.S. companies are in general paying tax at a very low rate, Romney’s point loses a lot of its force.

(2) How did Bain make money? To a large extent, by lowering target companies’ tax bills by loading them up with debt that generated huge interest deductions. As is well known, the US corporate income tax code creates a huge bias in favor of debt over equity, because interest payments (and indeed mere accruals of interest) are deductible while dividends aren’t. Given that very aggressive leverage was apparently a key element in Bain’s acquisition strategy, it’s a bit funny that Romney could say he is being taxed a second time, when to a large extent the cause of the profits that show up in his carried interest payouts is that he is reaping the benefit of the value increase that they achieved by reducing the target companies’ U.S. income tax liabilities.

(3) In any case where Bain made money OTHER than by increasing the target companies’ taxable profits, the profits that Romney is being taxed on may not actually have been taxed at the corporate level. E.g., suppose Bain buys a target company cheap and then sells it for a big profit. Suppose this was through smart trading rather than lowering the target company’s tax bill – i.e., suppose Bain recognized that it was undervalued. The trading profit, at the expense of other stock market investors, from buying low and selling high is totally distinct from the taxation of the target’s actual firm-level activities. In effect, Bain has won a side bet with other investors. There is nothing wrong with that, but the fact that some traders win and reap profits at the expense of other traders has nothing to do with the tax on Apple’s actual economic activity. No reason not to tax at 35% the work that smart traders do in making money by outsmarting the other traders.

In sum, for once Romney has made an argument that actually is intellectually defensible to a degree.  But I suspect that it would be very substantially rebutted if one looked at the companies that actually funded Romney's millions of dollars in Bain payouts.
                                                                                                                                                             OK, on to Dylan Mathews over at the Ezra Klein blog, who has a blog post with the admirably (but as it happens misguidedly) contrarian title: "Why Romney's tax rate should be low."  Noting that many economists believe that there should be zero taxation of capital income, he concludes that "the disagreement among economists isn’t about whether people like Romney are paying too little. It’s about whether or not they’re paying too much."

This is not quite correct.  What many economists, along with such fellow travelers from the tax policy world as me, often assert is that the "normal risk-free return to waiting" should be tax free.  (This is typically about 1 percent per year.)  Amounts that are labeled as investment returns or capital income should NOT be exempt, under this view, to the extent that they represent, for example, either extra-normal returns or labor income tha has been labeled by the tax system as capital income.

Mathews partly recognizes the labeling problem, noting that it is "hard, in practice, to distinguish wage and investment income. Romney is a great example of this. His income as head of Bain Capital counted, technically, as investment income, but he got it for doing a workaday job. A zero tax rate on investment income would provide a huge incentive to pretend wage income is investment income."   But the problem goes beyond labeling.  As I and many others have noted in writing about progressive consumption taxes (see, for example, my 2004 article here), the whole point of the progressive consumption tax exercise is roughly to match income tax progressivity without inefficiently discouraging saving.

The idea is NOT for Romney to pay less, but for his share of the tax burden (a) to be set appropriately given distributional goals that are independent of the choice of tax base, and (b) not to vary in present value terms by reason of how much of his vast wealth he chooses to save rather than invest in a given year.   To make the argument work, you must either (a) be willing to look at the infinite horizon (e.g., the taxation of Romney's great-great-grandchildren when they finally consume the last of his wealth), or (b) accept the view that taxes that are deferred indefinitely but that grow at a market interest rate, and thus do not lose present value by reason of being deferred, are as-if-paid.

But the point is not at all for people like Romney to pay lower tax rates than workers.  It is for people at his economic level who consume more to pay the same tax over time as people at his economic level who consume less.  This is an important distinction, easily missed in label-dominated debates about the existing income tax.


Unknown said...

What's "normal risk-free return to waiting"?

Daniel Shaviro said...

Sorry for the jargon. The pure time-based element of returns to investment, at the boring risk-free rate (such as that for Treasury bonds if considered risk-free and ignoring expected inflation). In theory, returns to capital have the pure time element, the risk premium, the actual risky outcome, the adjustment for expected inflation, and higher returns reflecting labor input, the availability of "rents," etc. The literature has shown that, in the abstract, a well-designed consumption tax differs from a well-designed income tax only in that just the latter taxes the pure return to time at the risk-free rate, which tells you that the systems are more similar than we thought. Key point in re. Romney is that a consumption tax can be just as progressive as an income tax (at least in theory), and that the main reasons for preferring a consumption tax have nothing to do with preferred distributional outcomes writ large. So disliking a tax on investment income doesn't actually mean that Romney should pay less over time.

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