The GOP frontrunner pays the same rate as many members of the middle-class. Here's why that matters.
Mitt Romney's private equity problem is taking a backseat today to Mitt Romney's tax problem. The GOP frontrunner acknowledged that his effective tax rate is around 15%, thanks to the tax code's preferential treatment of income from investments and private equity firms.
As Pat Garofalo explained for The Atlantic, a considerable portion of Romney's income comes from a retirement deal with Bain Capital that continues to pay him a small share of the firm's profits. The wonky term for this cool stream of money is "carried interest" -- the share of investor gains "carried" by the private equity or hedge fund manager.*
You might expect that Mitt's millions would be treated as earned income, because it represents gains from a service rendered by a private equity manager. Normally, that sort of money would be taxed at the top 35% marginal rate. Instead, the tax code treats Romney's retirement payout as carried interest -- investment income from a private equity firm shared among its managers. As a result, Romney pays Uncle Sam only 15% of his Bain Capital income.
In 2009, 15% was the average effective tax rate for households making between $75,000 and $100,000, in the middle quintile of U.S. families. That means Mitt Romney, a mega-millionaire, pays the tax rate as if his were a firmly middle class family, which would seem to pose a considerable political problem to a candidate fighting for middle class votes. To be clear, I don't think it's a moral problem. It's not like it's his fault, or anything. It's just the natural outcome of a tax system designed to give special treatment to investors -- and private equity managers, in particular.
Whether investment taxes should be preferential is a matter for debate. You can think of investment income from, say, a company's stock, as being taxed twice: first by the corporate income tax and second by the investment tax. That's a reason for capital gains taxes to be lower, and lower investment taxes theoretically means more savings and investment. On the other hand, the rich are more likely to invest, and if we want to protect a progressive tax code and raise enough money to fulfill our promises, taxing wealthy people's investment income as ordinary income in the 35% bracket would raise money we would otherwise have to borrow or cut.
Either way, private equity's "carried interest" loophole is not capital gains. Capital gains are income from your own investments. Carried interest is income from other people's investments. "If you manage money for a mutual fund or a public company, you pay regular income taxes," James Surowiecki explained in the New Yorker. "Do it for a private fund, and you pay capital gains." That's backward.
But don't expect Romney to hear much about carried interest from his fellow GOP presidential hopefuls. Under chief rival Newt Gingrich's tax plan, all investment income would be tax free and Romney's overall rate would fall quite near to zero.
*Bonus background from an explainer we wrote last year:
Private equity and hedge fund managers tend to get paid according to what's known as the principle of 2 and 20. They charge 2% annual fees for managing the portfolio of assets, and they collect 20% of the fund's annual profits.
There's nothing strange about this arrangement. It makes sense to align managers' financial interests with their clients'. There is something strange about the way the government taxes these revenue streams. The 2% fees are considered income, so they're taxed up to the 35% marginal rate. The 20% profit returns are considered capital gains, so they're taxed at the long-term capital gains rate of 15%.