By Patrick Brennan @ National Review (September 26, 2012)
Quite simply: Even if our income-tax system were substantially reformed with pro-growth aims, Mitt Romney would and should still pay a much lower tax rate than many Americans less wealthy than he.
Why? Because Romney draws his income from capital, not a salary, and it is sensible that we tax the former at a lower rate than the latter. This may offend liberals’ sense of fairness, and annoy conservatives who draw high salaries, but the fact that Romney pays just 13 or 14 percent in income taxes is actually a rare virtue of our tax code rather than a defect.
Economists on the right and the left, from Greg Mankiw to Thomas Piketty and Emmanuel Saez, agree that capital gains should be taxed at a lower rate than earned income. The explanation for lower rates on capital gains is simple: Earned income is taxed the year it is earned, and then the recipient can spend or save it. If he saves it, interest and dividends are taxed again, as are realized gains from appreciation, providing a powerful disincentive to investing. Capital income is taxed twice: when its principal is earned, at either corporate or individual income-tax rates, and then when the investment is disposed of, at the capital-gains rate.
More specifically, in the U.S. tax system, corporations pay income taxes on their earnings, and then those profits either are paid out to shareholders as dividends (which are taxed at the same rate as capital gains) or accumulate in cash reserves, raising the company’s value, a capital gain. Exactly how the two rates — the 35 percent corporate rate and the 15 percent capital-gains/dividend rate — add up is a complicated question. It is not a simple matter of an arithmetic 44.75 percent, as some eagerly suggest, since “tax incidence” does not fall entirely on the shareholder. However, just as one stab at it, the CBO estimates that the average combined federal tax rate for the top 0.01 percent (who receive the vast majority of their income in the form of capital gains) is about 30 percent, and they implicitly pay about 14 percent of their income in corporate taxes. Thus, despite the appearance of a low statutory capital-gains rate, the investor class seems to pay its “fair share” (the middle quintile’s combined tax rate is 14 percent).
It is also important to note, as we discuss how to close the deficit, that capital-gains taxes are notoriously susceptible to the Laffer curve: Because individuals exercise control over when to realize capital gains, hikes in these rates yield very little revenue. A Democratic proposal, then, to tax people like Mitt Romney at higher rates, or just raise the capital-gains rate overall, is likely to constrict the economy and investment activity while raising little revenue. (Meanwhile, cuts in capital-gains rates result in much less revenue loss than cuts in taxation of earned income.)
This side issue, however, doesn’t alter the fundamental lesson to be learned from Romney’s tax returns, which even liberals must admit: Capital income is and should be taxed at a lower rate than earned income, and that, not unfairness in our tax system, is why Mitt Romney pays a low tax rate. There are many flaws in America’s tax system that need to be fixed; the marriage penalty and the partially uncompensated cost of raising children are two of them. The preferential treatment of capital gains is not.