How are the super-rich like Romney different from the rest of us? They pay taxes at a lower rate.

The belated disclosure of his 2010 tax return by Republican presidential candidate Mitt Romney confirms the public speculation which forced its disclosure, that Romney and his wife do in fact pay income tax on his enormous income of nearly $22 million in 2010 at a lower rate than many middle-income taxpayers. Their federal income tax of less than $3 million amounted to an effective tax rate of only 13.8%, although the top federal income tax rate of 35% was supposed to apply to taxable incomes in excess of $379,150 in 2010.

Estimated taxes for 2009, disclosed on the 2010 return, suggest that in earlier years Romney may have paid significantly less tax on significantly more income, but we will never know unless Romney decides to release tax returns for earlier years.

How are the Romneys, and other super-rich Americans like them, able to pay taxes at a lower rate than middle and upper-middle income Americans? The main reason is that our current tax system taxes income from capital more favorably and at a lower rate than income earned through labor. Most Americans earn most of their income through labor. Such ordinary income is taxed at ordinary rates topping out at 35%. In comparison, the Romneys reported no income from wages at all in 2010, and almost all their income came from capital gains and dividends received from corporate stock. Such income from capital is taxed at a top rate of 15%.

Many of the super-rich, including the Romneys, have been able to characterize the compensation they receive for services rendered as capital gains and dividends through a device called “carried interest” by which their compensation is determined as a percentage of partnership capital gains and dividends. Legislation is pending in Congress to properly characterize such carried interest as ordinary income for services. But such legislation has been and is vigorously opposed by Republicans including Romney.

I think the Obama administration could and should unilaterally and retroactively declare such “carried interest” to be ordinary income for services and direct the Internal Revenue Service to tax it accordingly. But that would unleash a political firestorm from the super-rich, and the administration has shown no interest at all in administratively applying the basic tax principle that “substance prevails over form” to carried interest.

What possible justification can there be for treating income from capital more favorably than earned income from labor? There are many theories, none of which I find very convincing. There’s the theory that because capital gains and dividends come from the success of corporations which themselves are subject to tax, taxing such capital gains and dividends as ordinary income would amount to double taxation of the same income. The flaw in that argument is that the capital gains preference does not depend on any corporation actually paying any tax, and many corporations are able to minimize their tax obligations or even reduce them to zero. Some are not even subject to U.S. income tax on activities outside the U.S.

Another argument is that capital gains shouldn’t be treated like ordinary income because part of the gain accruing over time is due to inflation. But that ignores the fact that any taxes due on capital gains are payable in inflated dollars.

Some claim taxing capital gains as ordinary would distort the marketplace by locking-in investments that would produce gains upon sale. But that ignores the marketplace distortion that results from sophisticated taxpayers preferring to engage in activity generating capital gains rather than ordinary income. See carried interest.

Some claim that a preference for income from capital over income from labor is just the normal functioning of a capitalist economic system, a kind of “Golden Rule” under which those that have the gold make the rules. And it’s apparently true that most capitalist economic systems do seem to have some kind of tax preference for investment income. But the American tax system goes to an extreme, as analysts have noted who tried to estimate what the Romneys would have paid on their income in other countries.

It should also be noted that besides minimizing their federal income tax, the Romneys minimized the payroll tax for Social Security and Medicare which working Americans see deducted on their pay stubs. Payroll taxes claim about 6% of the income of the median American taxpayer who earns just over $50,000. Mitt Romney and his wife managed to pay just one-tenth of 1% of their income in payroll taxes by reporting zero wages.

And are we likely to elect a President like Romney who keeps his lightly-taxed savings in a bank in Switzerland and in trusts in tax havens like the Cayman Islands and Bermuda, rather than invested in the United States? Or will we prefer someone like President Obama or Newt Gingrich, both of whom pay a significantly higher effective income tax rate than Romney on income which is only a small fraction of Romney’s?

Gingrich, it should be noted, thinks the super-rich like Romney pay too much in tax, and wants to further reduce the tax on capital gains and dividends, virtually eliminating Romney’s federal income tax liability. So Romney could win even if he loses!

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