Exchange Rate

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POLITICS JANUARY 24, 2012

Exchange Rate

When it comes to taxes, the Republican primary electorate this year has a split personality. As ever, it demands that presidential candidates pledge to lower tax rates on the rich. But show it a living, breathing rich person whose effective federal tax rate is demonstrably low—say, Mitt Romney, who in 2010 paid 13.9 percent on his $21.7 million income, compared with about 25 percent for the typical middle-income family—and the GOP base is suddenly appalled. Republicans like the idea of being rich and not paying much in taxes, but give them too close a look at a candidate who’s living the dream and they’re enraged by the inequity.

Newt Gingrich has managed to caricature Romney as a top-hatted plutocrat while simultaneously proposing to lower Romney’s federal taxes from 13.9 percent to nearly zero. Gingrich would do this by eliminating the capital gains tax. Romney’s effective tax rate is so low because most of his income is from capital gains, which are taxed at a top rate of 15 percent. Romney, too, wants to eliminate the capital gains rate, but only at incomes below $200,000 a year. Under Romney’s plan, his own taxes would go down a little. Under Gingrich’s plan, they would go down a lot.

The problem here, obviously, is much broader than the income of one presidential candidate. Romney pays only slightly less in taxes than other rich people typically do. (His effective federal tax rate is not even the lowest of any recent presidential candidate: When John Kerry ran in 2004, his tax returns from the previous year showed that he and his wife paid a combined effective tax of about 13 percent, according to a calculation by The Washington Post’s Bradford Plumer.) A 2010 survey by the Center on Budget and Policy Priorities of the 400 richest taxpayers in America found that their average effective tax rate was 16.6 percent in 2007. As recently as 1995, this group’s average effective tax rate was 30 percent—nearly twice as high. The main reason is that the top capital gains rate fell during this period by about half. Part of this drop occurred in 1997, when President Clinton cut a deal with congressional Republicans to lower capital gains rates in exchange for creating the Children’s Health Insurance Program. President Bush lowered the rates further still in 2003. As a result, we are today ever closer to the situation described by Leona Helmsley when she infamously said, “Only the little people pay taxes.”

The standard argument for low capital gains rates is that they stimulate investment. But there is no plausible evidence to support this cherished hypothesis. In 2005, the Tax Policy Center, a nonpartisan joint venture of the Brookings Institution and the Urban Institute, compared capital gains rates to GDP growth over the previous 50 years. It found that there was no correlation. A follow-up study in 2010 by the Congressional Research Service pointed out that the drop in capital gains rates did nothing to halt the 30-year drop in national savings rates. Venture capital, the lifeblood of innovation, is almost entirely unaffected by capital gains rates, the study noted, because the main sources are college endowments, foundations, pension funds, and insurance companies—all “not associated with the capital gains tax.” The only stimulus that capital gains cuts reliably provide is to the incomes of rich people.

Under current law, the top capital gains rate is scheduled to rise next year from 15 to 20 percent. You’ll hear a lot in the coming months about how this tax increase will destroy jobs. That’s demonstrably untrue. Indeed, we’d like to see capital gains rates rise to the level of income taxes. For one thing, it would prevent the sort of tax-code gaming that occurs when wealthy investors disguise what’s actually income as capital gains, just so they can pay the lower rate. For another, a capital gains tax lower than the regular income tax causes the U.S. Treasury to forego a vast amount of revenue—and, given the budget deficit, that’s something we can ill afford.

But, perhaps most importantly, there’s a basic matter of justice at stake: Why should we tax labor at a higher rate than capital? Why should the wealthy be able to contribute at lower rates than other Americans? These were some of the principles behind a 1986 tax reform bill that taxed capital gains at the same rate as wages. It was signed by a notorious left-winger named Ronald Reagan. It did not cause the sky to fall. And it made America, however temporarily, a fairer place.

This article appeared in the February 26, 2012 issue of the magazine.

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