Carried Interest Canard: Romney’s Inane Bain Pain

by Kurt Schulzke

Time to blow the whistle on a bit of journalistic ignis fatuus.  Multitudes of marginally-informed pundits — none of whom has seen Republican presidential candidate Mitt Romney’s tax returns and most of whom know nothing about income taxes — have had plenty to say about Romney’s reported tax rate of around 15 percent.  Beltway commentators eager to create an uproar want to know what kind of tax trickery could give a high-earner like Romney such an “outrageously” low tax rate when the top individual marginal rate is 35 percent.  Sorry to spoil the fun, but no tricks are necessary.  This is a made-up issue.  Which is not to say that it can’t be spun into campaign gold by Romney’s opponents.  In politics, reality counts for nearly nothing.

Romney’s tax returns themselves — reportedly set for release tomorrow — may tell a more complicated story.  However, pre-publication, the most obvious (and entirely ethical) ways that Romney could achieve a 15 percent effective tax rate are (a) he earns the vast majority of his income in the form of capital gains,* (b) he probably has well-above-average charitable contribution deductions, and (c) like Bill and Hillary Clinton before him, Romney’s U.S. tax bill is likely reduced through the foreign tax credits resulting from income taxes paid to other countries on income earned in those countries.  There’s nothing occult about any of this.  Yet…

On Romney’s capital gains, the internet has been hopping with faux indignation (none of it credible, so no links) over so-called “carried interest” income from Romney’s private equity work at Bain.  This feature of the tax law — the capital asset classification of a general partner’s profits interest in a partnership — is well-settled.  It has been thoroughly regulated by the IRS and litigated by the courts.  Any attempt at reclassifying these private-equity “carried interest” capital gains (taxed at 15% under current law) as ordinary income (taxable at up to 35%) would make no sense within our current income tax framework.  It would up-end the entirely legitimate, economically sound and fair tax treatment of a wide variety of other partnerships and would further distort business decision-making with yet more nonsensical income tax system complexity.

For an in-depth yet highly readable exposition of the carried interest question, I recommend “The Taxation of Carried Interests In Private Equity Partnerships,” a 2007 paper by David A. Weisbach.  Weisbach is Walter J. Blum Professor of Law at University of Chicago Law School.  His paper was funded by the Private Equity Council which has since changed its name to the Private Equity Growth Capital Council.  Weisbach effectively debunks will-o’-the-wisp arguments by a few other writers that private equity carried interest income should be treated as service income.

Republicans worried over the bona fides of their rapidly shrinking pool of presidential applicants may want to spend less time dwelling on Mitt’s taxes and more on Newt Gingrich’s Freddie Mac lobbying contracts and congressional ethics-violation files.  So far, Mr. Gingrich appears to have finagled to keep both under wraps.   Which candidate’s history harbors more lurking whistleblowers with stories worth hearing?

UPDATE:  The article originally referred to Mr. Gingrich’s Fannie Mae contracts and has since been corrected to refer instead to Freddie Mac.  Since this article was originally posted, Mr. Gingrich published his 2006 “consulting” contract with Freddie Mac which, as explained by Timothy Carney, indicates — contrary to Mr. Gingrich’s prior assertions — that Gingrich was indeed paid to lobby on behalf of Freddie Mac.

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 * For lay readers, the sale or other disposition of a capital asset — as defined in Internal Revenue Code Section 1221 — generates a “capital gain” or “capital loss” equal to the difference between the “amount realized” and the “basis” of the asset.  The amount realized is the fair market value received in exchange for the asset while the “basis” is the original cost of the asset adjusted downward for “cost recoveries” like depreciation and upward for capital improvements (which add value to or extend the useful life of the asset) such as “additional paid-in capital” contributed by a corporation’s shareholders.  For example, if an investor pays $100 for a share of stock and later sells it for $125, the taxpayer’s amount realized = $125, the basis is $100 and the capital gain is $25.

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