Republican presidential nominee and former Massachusetts Gov. Mitt Romney… (Richard Ellis / Getty Images )
Under pressure to release his income tax returns, former Massachusetts Gov. Mitt Romney decided instead to disclose what percentage of his income he forks over to Washington. It turns out that Romney pays about 15% — less than the share paid by many California teachers, sales managers and others who earned far less than he did. The reason? His income "overwhelmingly" came from past investments, which are taxed at a lower rate than salary and wages. Romney's ability to pay a lower percentage than many taxpayers who aren't wealthy will only feed the concerns about widening income inequality in the United States. But this isn't a case of the rich playing by a different set of rules than everyone else. It's a case of the rules benefiting them far more than most.
The original, 1913 income tax code treated capital gains, dividends and interest the same as wages, but within a decade lawmakers had decided to give investments a break. They've gone back and forth ever since. The most recent change came as part of the Bush tax cuts, when Congress capped taxes on capital gains, dividends and interest at 15% for those in the mid- to upper-income brackets, and at 10% for those in lower brackets.
One rationale for the preferential rate is the desire to encourage investment in stocks and bonds, which provides companies with the capital they need to grow. Another is to recognize that investment income is different from wages — it's less predictable, more vulnerable to inflation and often generated by activities that have already been taxed.
Research shows, however, that the vast majority of the benefits of the tax break accrue to upper-income Americans. They're not only more capable of investing, but the tax break is considerably larger for someone in the 35% bracket than someone in the 15% or 25% bracket. That disparity might be justifiable if the preferential rates generated more investing, but it's not clear that they do. "Capital gains tax rate reductions appear to decrease public saving and may have little or no effect on private saving," a 2010 Congressional Research Service report concluded.
The preference for one type of income also encourages savvy earners to game the system, designing their compensation to look more like capital gains and less like wages. That's why private-equity managers — as Romney was before he entered politics — pay a 15% rate on most of their income, even though they don't have to invest their own money to generate those returns.
Whatever benefits it might provide to the economy, the break makes federal taxes less progressive and enables some high-income Americans to cut their tax bills in ways other taxpayers can't. A better approach would be to simplify the tax code and treat all forms of income equally, broadening the base and lowering rates. That's the approach taken by President Reagan and Congress when they overhauled the tax code in 1986, and it's worth repeating now.