Bracket Creep

Romney has acknowledged that he probably pays close to 15% of his income in taxes.  Here’s what to look for in the returns tomorrow.

1.  Carried Interest

As detailed in this NYT story, Romney continues to receive income from his days at Bain Capital.  His financial disclosure forms suggest that his payout came mostly in the form of interests in a wide variety of Bain funds, including private equity funds, mezzanine funds, and hedge funds.  Many of those distributions are in the form of carried interest, or a percentage of the profits that Bain receives in exchange for managing assets.  Because much of the profits allocated to Bain are capital gain, the income is mostly taxed at the long-term capital gains rate.  Some of the income may be dividend income, also taxed at 15%, and some of the income may be interest income taxed at 35%.

From an economic point of view, even the 15% rate overstates his tax liability.  There is a deferral benefit that’s hidden.  While the economic value of his investments have increased over time, he is only taxed on realized investments–that is, when Bain actually sells investments.  The longer that income is deferred, the lower the tax rate (from an economic point of view).  By contrast, if he had sold his founder’s equity in Bain back in 1999, he would have paid tax back then.

Of course, the only thing we’ll see on the return is a reporting of capital gains, not whether it was received in exchange for services provided in the past.

2.  Reinvested capital; Cayman Islands

It is common for investment fund managers to invest some of their own cash alongside other investors.  Some of Romney’s investments are true investments in Bain funds, not just carried interest received in exchange for services.  In many cases, however, private equity and hedge fund managers use cash from carried interest (or “incentive fee”) allocations to reinvest, pre-tax, in related investment funds.  The use of a Cayman Islands affiliate facilitates this tax deferral strategy.  While Congress enacted section 457A in 2008 in an attempt to shut down this deferral strategy, transition rules ensure that many of Romney’s investments in the Cayman Islands are grandfathered in and have never been taxed in the U.S.

Unlike most investments, then, Romney is using pre-tax money to make his investment — that is, his compensation was transformed into investment holdings without having paid tax on it.  Most of us can do this in our IRAs, but only up to $5,000 or less.  The Cayman islands deferral strategy is like an unlimited IRA.  If Romney ends up giving away the money to charity or bequesting it to heirs, no one will have ever paid any income tax on it.

The tax benefit of the deferral will not show up on Romney’s tax return for the same reason that the tax benefit of your IRA doesn’t show up in your effective tax rate: the income that is sheltered reduces your AGI, and it will be taxed later, if at all.  For this reason Romney’s reported effective tax rate is lower than his actual effective tax rate from an economic point of view.

The Romney campaign has denied that any tax benefit flows from the Cayman entities.  What about tax deferral benefits?  What is the non-tax purpose of the entities?  I recognize that the entities also help foreign investors and tax-exempt investors avoid paying tax on U.S. business income, something that’s not necessarily abusive of U.S. tax policy.  But that doesn’t mean that Romney isn’t helped too by deferring his income offshore.

3.  IRA

Romney has packed an awful lot of investments into his IRA.  Presumably, he was able to do so by rolling over a qualified retirement plan from Bain Capital, and the magic of pre-tax compounding and Bain’s impressive investment record has ballooned the IRA into the $100 million range.  How many people in the country have an 8 or 9 figure IRA?

4.  Charitable contributions

Romney makes considerable charitable contributions to the Mormon church and other organizations.  These contributions generally reduce his taxable income.  From an economic perspective, it’s as if a portion of his tax liability is instead re-directed from the public fisc to the Mormon church.  It’s like a government matching grant program, and the donor chooses the recipient.  There is nothing unusual about this arrangement, although one might question whether it’s good tax policy.  (See Miranda Fleischer, Generous to a Fault? Fair Shares and Charitable Giving, Minn L Rev 2008.)

5.  Speaking fees

Romney will have some ordinary income from speaking fees (although “not much”).  This income would be taxed at 35%, but it is probably offset by his charitable contributions.

6.  Something unexpected?

I doubt there will be any big surprises.  Romney has acknowledged that his tax rate is close to 15%.  I expect that the actual release of the returns will be anticlimactic.

If there are any surprises, I’ll try to post something here, or on twitter.

7.  Why this matters

We shouldn’t lose sight of why this matters in the first place.  We live in a country with two tax regimes, one for the sophisticated, rich, and well-advised, and another for the rest of us.  People who manage money for a living often enjoy a 15% tax rate, and they can often defer their tax liability through offshore vehicles or huge retirement plans and IRAs.  The rest of us pay up to a 35% tax on wages, plus considerable state and local taxes, plus a payroll tax.

That Romney personally paid tax to the government at a low rate as a percentage of his economic income is no surprise to those of us who study tax policy.  What we don’t know, and what really matters, is whether he thinks the status quo is good tax policy or not, and why.  Congress has tried to change the tax treatment of carried interest four times, but lobbying by the private equity industry, including Bain, has successfully blocked the effort.  We can continue to raise ordinary income taxes and payroll taxes, or we can broaden the tax base by closing loopholes and changing the structure of how we tax businesses and individuals.  Do we want a tax system that favors Wall St or Main St?

Reasonable people can differ about the size of government and how we should finance it.  But this is not a discussion that should be held in “quiet rooms.”  It should be held in the open.

Further reading:

Victor Fleischer, Two and Twenty: Taxing Partnership Profits in Private Equity Funds (NYU Law Review 2008)