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Large Numbers of Law - Romney's Taxes

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One of the reasons why the capital gains tax rate is lower is because capital has already been taxed once at the corporate level, as high as 35 percent.

That's Mitt Romney's defense of his low tax rate during his 60 Minutes interview with Scott Pelley. And he's wrong. He's not wrong that the corporate tax structure can result in double taxation, but he is wrong about why his own taxes are so low.

For those who haven't studied corporate income taxes, here's a quick primer on how they work. First thing to know is that corporate income taxes are not taxes on corporate income. That is, the corporation's revenues aren't taxed; instead we tax corporate profits. If we taxed revenues then companies with narrow profit margins would be quickly driven out of business.

Corporate tax rates range from 15-35%, and every major corporation is going to be big enough to be at the 35% rate. Marginal corporate tax rates work differently than marginal personal income tax rates. If you make $400,000 your marginal rate is 35%, but your effective rate is only 29.19%. The 35% rate only applies to the money in excess of $388k that you're earning, and the higher rate doesn't apply retroactively. With corporate taxes it does apply retroactively. Not immediately upon hitting the new rate (because then it'd sometimes make sense to be less profitable), but as you go up it starts to apply to a greater percentage of your profits until you hit an effective 35% rate.

That's just a little quirk of corporate taxation though, and not really relevant.

 

Since we're only taxing profits, taxes on a corporation might look something like this:

Goliath Corp has $50 million in revenues in 2011.

Goliath Corp also has $45 million in expenses, resulting in $5 million in profits.

That $5 million is taxed at 35%. Goliath pays $1,750,000 in taxes and has $3,250,000 left over in profits.

Goliath distributes that $3.25 million to its shareholders as dividends.

The shareholders now pay the capital gains rate of 15% on that $3.25 million. Another $487.500 in taxes is paid.

Total taxes paid are $2,237,500. The total taxes paid on Goliath's profits are 44.75%.

This is what Mitt Romney is describing. The 15% capital gains rate looks incredible low and disgustingly unfair to the working class, but once we look at taxes paid at both levels it starts to make a lot of sense, and the amount is much higher than the highest personal income tax rate.

 

What Romney gets wrong is that his income has not already been taxed at the corporate rate.

Remember, corporations are only taxed on their profits, not their revenues. This means that corporations can reduce their taxes by increasing their expenses. For instance, when Goliath Corp sees that it has an extra $5 million, it can pay its directors another $1 million in bonuses, spend $1 million buying heavy machinery for its manufacturing, spend $2 million on real estate investments, and the last $1 million buying stock in other companies.

Now Goliath has $50 million in revenues and $50 million in expenses. It's tax burden is $0. Of course, you might be wondering if it has $0 in profits then what money is going to the shareholders?

The answer is stock value.

When Goliath re-invests $4 million (the bonuses are an expense, but not a re-investment) its total value as a corporation goes up. It's stock was previously at $10 per share, now it's at $10.15.

A wealthy shareholder now sells 100,000 shares, realizes $15,000 in capital gains, and pays a 15% rate on that. They money has never been taxed at the corporate level and that 15% is all the taxes paid.

 

In 2011 Mitt Romney had $10.3 million in income that was taxed at the capital gains rate. $3.5 million was dividend income, taxed at both the corporate rate and the capital gains rate. The remaining $6.8 million was through share appreciation and taxed only once, at the 15% rate. Doing a little math here can tell us his actual rate (just on the investment stuff, excluding other sources of income).

To get $3.5 million in dividend income, the companies must have made $5.4 million in profits. They were then taxed 35% ($1.9 million), passed on the remaining $3.5 million to Romney, and he paid 15% ($525,000) on that. He also paid 15% ($1,020,000) on the other $6.8 million.

So, we're starting at the corporate level with $12.2 million, and by the time the company and Romney have both paid their taxes, a total of $3.4 million of taxes have been paid. That gives us an effective rate of 27.9%.

Had all the money been taxed just at the personal income rate, eliminating the corporate tax, the rate would have been 35%.

Had all the money been subject to double taxation at both the corporate and personal levels, the rate would have been 44.75%.

Instead, Mitt Romney sees his investments bring him $10.3 million and pays taxes at the same rate as someone earning $300,000 in wages.

[More Large Numbers of Law]


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