The main reason the rich pay so little is that most of their income takes the form of capital gains, which are taxed at a maximum rate of 15 percent, far below the maximum on wages and salaries. So the question is whether capital gains — three-quarters of which go to the top 1 percent of the income distribution — warrant such special treatment.
Defenders of low taxes on the rich mainly make two arguments: that low taxes on capital gains are a time-honored principle, and that they are needed to promote economic growth and job creation. Both claims are false.
When you hear about the low, low taxes of people like Mr. Romney, what you need to know is that it wasn’t always thus — and the days when the superrich paid much higher taxes weren’t that long ago. Back in 1986, Ronald Reagan — yes, Ronald Reagan — signed a tax reform equalizing top rates on earned income and capital gains at 28 percent. The rate rose further, to more than 29 percent, during Bill Clinton’s first term.
Low capital gains taxes date only from 1997, when Mr. Clinton struck a deal with Republicans in Congress in which he cut taxes on the rich in return for creation of the Children’s Health Insurance Program. And today’s ultralow rates — the lowest since the days of Herbert Hoover — date only from 2003, when former President George W. Bush rammed both a tax cut on capital gains and a tax cut on dividends through Congress, something he achieved by exploiting the illusion of triumph in Iraq.
Correspondingly, the low-tax status of the very rich is also a recent development. During Mr. Clinton’s first term, the top 400 taxpayers paid close to 30 percent of their income in federal taxes, and even after his tax deal they paid substantially more than they have since the 2003 cut.
So it's a good time to get a little wonky and ask why capital gains and carried interest are taxed at only 15 percent, while ordinary labor income is taxed at rates as high as 35 percent. If you're the cynical sort, you think the answer is simple: Rich people make lots of their money via capital gains and carried interest, and the Republican Party is dedicated to making the lives of rich people easy and prosperous. So they've made sure those tax rates are low.
Maybe so. But there's an official, noncynical answer too: Capital gains are profits from investments, and a high level of investment is good for the economy. Low tax rates on capital gains encourage investment and therefore benefit the entire economy.
But is this true? If it were, you'd expect to see some kind of long-term correlation between capital gains rates and the total amount of capital gains income. The lower the rates, the more the income. Let's roll the tape:
Do you see a correlation? I don't. What you see is two things. First, when people know rates are about to go up, they sell their assets quickly to beat the tax man and take advantage of the current rates. You can see that in 1968 and 1986. Second, capital gains skyrocket during investment booms. You can see that during the dot-com bubble of the late '90s and the housing bubble of the aughts. When you remove those artifacts, there's pretty much nothing left. No matter what the tax rate is, the level of capital gains pokes along at about the same rate.
As the Congressional Research Service concluded in a study a couple of years ago, capital gains tax cuts "are unlikely to have much effect on the long-term level of output or the path to the long-run level of output (i.e., economic growth)."
So what about carried interest? What's that all about? Carried interest is a feature of the way partnerships are taxed, and private equity funds are essentially partnerships. In a partnership, it's frequently the case that one person puts up the money and another person manages the business. Both partners get equity in the enterprise: The former gets ordinary, garden variety equity and the latter gets "sweat equity." When the enterprise is sold off (hopefully at a profit), both are taxed at capital gains rates.
Bain Capital acted as a managing partner in most of its transactions, so this was a pretty good deal for them. After all, most of us who work as managers, even if our pay comes in the form of a bonus that's based on the profitability of the company, have to pay ordinary income tax rates. That's because this kind of work is known as "labor." But if you manage a private equity fund, that exact same kind of work is defined as sweat equity and gets taxed at capital gains rates.
This is pretty hard to defend. If it walks like a duck and quacks like a duck, it's a duck. Except in this one case, where it's sweat equity. There's really not much justification for it.
So this is where we end up. Mitt Romney pays low tax rates on his capital gains because this is supposed to encourage him to invest his money. But it turns out that it doesn't. And he pays low tax rates on his carried interest because his job of managing companies that other people own was conveniently redefined as sweat equity and therefore treated as capital gains. It's a nice deal for the rich, who get nearly all of the benefit of these policies, but neither of them is really defensible. It's one thing for Mitt Romney to have gotten wealthy running Bain Capital. Good for him. But he ought to pay the same taxes on his earnings as the rest of us.Oh, and none of these earnings are subject to taxation for Social Security. And if the capital gains come from stocks and bonds (except for those purchased in initial offerings), they're not coming from investments, they're coming from gambling.