Bruce Bartlett held senior policy roles in the Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Paul. He is the author of “The Benefit and the Burden: Tax Reform – Why We Need It and What It Will Take.”

The issue of Mitt Romney’s taxes continues to be a political liability for him. A NBC News/Wall Street Journal poll last month found that 36 percent of registered voters have a more negative opinion of him because of the issue, up from 27 percent in January, compared with 6 percent who have a more positive view.

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As I have discussed previously, the two years of returns Mr. Romney has been willing to release, for 2010 and 2011, show that he paid much lower effective federal income tax rates in both years than his running mate, Representative Paul D. Ryan, whose income was 85 percent to 90 percent lower than Mr. Romney’s in those years.

A key reason for Mr. Romney’s low tax rate is that a very substantial amount of his income comes from capital gains – 51 percent in 2011 and 58 percent in 2010. Capital gains, no matter how large, are taxed at a maximum rate of 15 percent, whereas wage income can be taxed as much as 35 percent by the income tax plus taxes for Medicare and Social Security. The latter two are not assessed on capital gains.

Significantly, much of Mr. Romney’s capital gains income achieved this treatment through a special tax loophole called carried interest. According to recently released documents, executives at Bain Capital, where Mr. Romney made the bulk of his estimated $250 million fortune, saved $200 million in federal income taxes and another $20 million in Medicare taxes because of the carried interest loophole.

The way the loophole works relates to the peculiar method in which money managers are compensated. Typically, they receive a fee of 2 percent of the gross assets under management, much of which comes from employee pension funds, plus 20 percent of any increase in value.

Thus, on $1 billion of assets the managers would automatically get $20 million that would be taxed as ordinary income. If the assets increased 10 percent to $1.1 billion, they would get another $20 million. For tax purposes, this additional $20 million would be treated as a capital gain and taxed at 15 percent.

The theory is that the money managers effectively become part owners of the assets they manage as a result of the fee structure. Critics contend that the distinction between the 2 percent and 20 percent fees is purely artificial — that in reality all their compensation should be treated as ordinary income and taxed as such.

Among the sharpest critics of carried interest is Victor Fleischer, a law professor at the University of Colorado. In a Sept. 4 post on DealBook, he explains that the New York attorney general’s office is looking into the issue, seeking to determine whether money managers have been illegally converting their 2 percent management fees into lower-taxed capital gains.

The New York Times recently commented in an editorial that while the carried interest loophole is unjustified, the core problem is lower tax rates on capital gains generally. Said The Times, “As long as income from investments is taxed at a lower rate than income from work, there will be no stopping the search for ways, legal or otherwise, to pay the lower rate.”

The view that capital gains should be treated as ordinary income for tax purposes is one that is widely shared by liberal tax reformers. They got their wish, briefly, from 1987 to 1990 because Ronald Reagan agreed to raise the tax rate on capital gains to 28 percent from 20 percent in return for a reduction in the top rate on ordinary income to 28 percent from 50 percent, as part of the Tax Reform Act of 1986.

There are three big problems, however, with taxing capital gains at the same rate as ordinary income. First, even if that were the case, capital gains would still be treated more beneficially, because the taxes only apply to realized gains. Those that are unrealized would remain untaxed. Investors needing cash could simply borrow against their assets to minimize their taxes, rather than selling and realizing a capital gain.

To equalize the taxation of capital gains and ordinary income, it would be necessary to tax unrealized gains. In theory, all increases in net wealth should be taxed annually, according to the economists Robert M. Haig and Henry C. Simons. But a 1920 Supreme Court case, Eisner v. Macomber, held that only realized gains could be taxed.

As long as a taxpayer decides when or if to realize gains for tax purposes, that is a very valuable loophole even if gains are taxed at the same rate as ordinary income. For one thing, a taxpayer can easily match gains with losses to avoid having net taxable gains. And, of course, capital gains would still avoid the 15.3 percent payroll tax, which applies only to wage income.

Second, there is a problem with inflation insofar as capital gains are concerned. Many academic studies have shown that a considerable portion of realized capital gains simply represent inflation, rather than real increases in purchasing power.

While theoretically capital gains could be indexed for inflation, it would be very complicated. For one thing, it is not clear what the appropriate price index should be. For another, there is the problem of also indexing losses. Historically, Congress has felt that simply excluding a certain percentage of capital gains from taxation was a better way to compensate for inflation.

Third, it is a fact of life that those with great wealth are the principal beneficiaries of the capital gains tax preference, and they exercise influence in our political system far out of proportion to their numbers. They will pressure both parties relentlessly to restore a lower tax rate on capital gains and eventually they will be successful. Keep in mind that two Democratic presidents, Jimmy Carter and Bill Clinton, signed cuts in the capital gains rate into law.

In short, it is a pipe dream to believe that eliminating the capital gains preference is the key to fixing the carried interest loophole. It can and should be addressed by treating carried interest as ordinary income, without requiring that all capital gains be taxed as ordinary income.

Article source: http://economix.blogs.nytimes.com/2012/09/11/mitt-romney-carried-interest-and-capital-gains/?partner=rss&emc=rss