Jan 25, 2012
kosmo - See all 772 of my articles
Mitt Romney has released income tax information, any many people are shocked that he paid an effective rate of just 13.9% in 2010. His opponent, Newt Gingrich, pays an effective rate of 30%! Is Romney doing something illegal?
The reason for Romney’s rate
The reason why Romney pays a far lower rate than Gingrich isn’t due to some strange loophole that Romney pays his lawyers to exploit. It’s simply due to the fact that capital gains are treated differently than ordinary income. While tax rates on ordinary income (wages, interest, etc) range from 5% to 35%, capital gains are taxed at 15% (although taxpayers in the 5% and 10% brackets pay their ordinary rate on capital gains).
This means that if I have a $1000 capital gain and Mitt Romney has a $1000 capital gain, we will both pay taxes of $150 on that income.
Mitt’s income is nearly all derived from investments. He doesn’t have a wage-earning job. While he does make a few bucks from book royalties, it pales in comparison to his investment earnings. Throw in some deductible charitable contributions, and Romney is able to chisel the 15% rate down to 13.9% without much work.
Why are capital gains taxed at a lower rate?
The basic idea behind a lower rate for capital gains is that this will encourage people to invest in capital assets (ownership of companies) instead of keeping their money in a mattress or a passbook savings account. There’s more risk in doing this, of course, so one way to balance the risk/reward is to allow profits to be taxed at a lower rate.
Is the capital gains rate too low?
In my opinion, yes. It seems absurd that a $500 capital gain and a $5 million capital gain would be taxed at the same rate, when $500 or ordinary income and $5 million of ordinary income would be taxed at different rates.
Do I think that capital gains should be taxed at the same rate as ordinary income? No. I do believe that there’s is value in encouraging investors to put their money into equities. It clearly is a riskier proposition, and I’m OK with a lower capital gains rate being a reward for taking that risk.
My suggestion would be to make the capital gains rate 2/3 of the rate for ordinary income. Under this plan, the capital gains rate would be 7% for those in the 10% tax bracket and would top out at 23.45% for those in the 35% tax bracket. Mitt Romney would still pay a lower effective rate that Newt Gingrich or Alex Rodriguez, but would pay far more than he does today.
What’s an effective rate?
As a last bit of explanation, let’s look at the difference between a marginal rate and effective rate. You might be in the 25% tax bracket. This doesn’t mean that you pay a 25% tax rate on all your earnings. Tax rates on ordinary income are marginal. If you are single and make $50,000 (this would be in the 25% bracket), you would pay 10% on the first $8500 of taxable income , 15% for the amount between $8500 and $34500, and 25% on the amount that exceeds $33950. That would be a total tax of $8625 on $50,000 of taxable income – or 17.25%.
The second point is that there is a big difference between your gross earnings and taxable income. You’ll reduce gross income by the exemptions for yourself, spouse, and children, and well as a variety of deductions (mortgage interest, property taxes, charitable contributions, etc), and credits (earned income credit, child tax credit, etc).
effective rate is often calculated against gross income (AGI), his effective rate drops to $12.5%.
A married couple with two dependent children who have an AGI of $50,000 and take only the standard deduction and personal exemptions (no itemized deductions or credits) will pay $2690 in federal taxes … an effective rate of 5.4%. This is achieved by excluding a total of $26400 via the $11,600 standard deduction for married filing jointly and $14,800 in personal exemptions (four exemptions @ $3700 each), dropping the couple’s taxable income down to $23,600.
Other tax articles by Kosmo