Buffett, Romney, and Taxes

It's election season, and with it comes the obligatory discussion – or, more often, heated debate -- about taxes.

The signs are everywhere. In Tuesday's State of the Union speech, President Obama invited Warren Buffett's secretary, Debbie Bosanek, to showcase what he sees as inequities in the tax system: "Right now, because of loopholes and shelters in the tax code, a quarter of all millionaires pay lower tax rates than millions of middle-class households. Right now, Warren Buffett pays a lower tax rate than his secretary."

Buffett himself is stirring the tax pot, too. Responding to criticism that if he feels taxes on the rich are too low (an argument he's made before), he can donate money to the IRS, Buffett offered to match Sen. Mitch McConnell three-to-one on any donations made to lower the deficit. When he found out that Rep. Scott Rigell already donates 15% of his salary -- about $25,000 a year -- to pay down the debt, Buffett allegedly agreed to write a check to the Treasury for $49,000 (the amount Rigell donated over the last two years).

Then there's Mitt Romney. After releasing his tax returns for 2010 and an estimate of 2011, a small bit of hell broke loose. On more than $20 million of income, Romney paid an effective federal tax rate of just 13.9%. People haven't been this outraged at a presidential candidate's taxes since … John Kerry revealed his 13% tax rate in 2004.

What should you make of it all?

It's impossible to write a complete examination of the tax code in one short article. And you're bound to offend many when talking about this stuff, so I (sort of) apologize in advance. But after listening to the tax debates this week, I think there are two points to keep in mind.

One argument we heard a lot this week is that Mitt Romney's tax rate is lower than many working-class Americans. Indeed, that was the thrust of Warren Buffett's criticism of the tax code.

But dig into the numbers, and it's not so clear. The top tax rate on earned income is currently 35%, but it kicks in only on income over $388,350. Since all income earned below that level is taxed at a lower rate, and deductions lower the amount taxed even more, very few people have an effective federal tax rate close to 35% -- even those with high incomes. In fact, Romney's 14% tax rate still puts him in the top quintile of taxpayers:

Source: Tax Policy Center. The year 2006 used because it was a non-recession year.

Still, frustration about Romney's tax rate, is, I think, valid. A lot of the reason why Romney's -- and many of the nation's wealthiest's – rates are relatively low is thanks to a loophole given to private equity and hedge fund managers that allows fees earned from managing other people's money to be taxed as capital gains, rather than as ordinary income.

Here's how it works. If I gave you $100 to manage and agree to pay you 20% of the profits as a fee, and you double my money, you would earn $20. In most businesses, this money would be taxed as ordinary income (up to 35%), since it's a fee for service. But for private equity and hedge fund managers, it's considered a capital gain, where the tax rate maxes out at 15%. As Bloomberg explained:

The private-equity industry argues unconvincingly that the capital-gains rate is appropriate for managers such as Romney because they put their own money at risk. Opponents of the carried-interest tax break point out, correctly, that private-equity managers are eligible for that low rate on profit just for managing other people’s money, regardless of whether they themselves have any skin in the game. It's worth noting that workers in other financial sectors -- investment bankers and portfolio managers -- pay ordinary rates on their income, even though they perform essentially the same service for their clients.

The loophole, called "carried interest," is contentious virtually everywhere except in private-equity boardrooms. Bloomberg recently asked 1,200 of its financial clients if the carried-interest loophole was defensible. Two-thirds said it was "unjustified." On Wednesday, the Wall Street Journal reported, "If elected president, Mitt Romney might consider ending a tax break that helped the former Massachusetts governor accumulate his fortune, an aide suggested Tuesday," referring to carried interest. Last week, News Corp. chairman Rupert Murdoch tweeted: "Carried interest tax racket. Billions over many years. Why and where has Obama been?" With the exception of private equity managers themselves, few seem to be able to argue rationally that taxing carried interest as a capital gain makes sense.

Tax rates do matter, of course, and everyone should want the lowest taxes possible that pay for the services people demand. But another point frequently made lately is that raising taxes at all -- such as returning to 1990s tax levels on higher-income earners -- will spoil economic growth and undermine business investment.

That might happen. But the link between taxes and the strength of the economy may not be so black and white. When tax rates were brought up last year, Buffett made an interesting point:

I have worked with investors for 60 years and I have yet to see anyone -- not even when capital gains rates were 39.9 percent in 1976-77 -- shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off. And to those who argue that higher rates hurt job creation, I would note that a net of nearly 40 million jobs was added between 1980 and 2000. You know what's happened since then: lower tax rates and far lower job creation.

Dig into the numbers, and you might see what he means. For example, consider job growth over the last half-century at various tax rates:

Sources: Tax Policy Center, Federal Reserve, author's calculations.

The same goes when looking at capital gains taxes and real (inflation-adjusted) gross private investment growth:  

Sources: Tax Policy Center, Federal Reserve, author's calculations.

If there is a link between tax rates and economic growth, you might actually conclude that higher taxes are consistent with higher growth. That's silly, and no rational person should make that argument. Correlation is not causation. Instead, I think what the numbers show are that tax rates are less important in determining economic growth than some give them credit for. They aren't the magical knobs that, when tweaked, can dictate the path of the economy. Other variables -- such as the ideas of entrepreneurs, the confidence of consumers, the stability of the financial system, the status of other global economies, demographics of the labor force, the savings rate, and productivity, to name a few -- seem far more important. A tax cut when rates are extremely high will likely give growth a boost. But the idea that going back to 1990s tax levels for a small subset of taxpayers will sink the economy? That's a different argument, and one that history isn't terribly kind to.

This isn't a call to raise taxes. I think some tax rates, particularly corporate taxes, should be dramatically lower, since shifting business to a low-tax haven is so easy for large corporations to do. But these debates are more useful when you have as much information and context as possible. Does Mitt Romney pay a lower tax rate than most middle-class Americans? No. Would ending a few of the tax code's more flagrant inequities derail economic growth? History shows it probably would not.  

Disagree? Let me know why below.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.