Most people know that tax rates on capital gains (selling an item for a price higher than its purchase price) and on dividends (distributions of profits to owners) can be lower than tax rates on income. There is a group of our fellow Americans who take full advantage of this feature of our tax code and presumptive GOP presidential nominee Governor Willard “Mitt” Romney is the walking embodiment of that advantage enjoyed by those who make millions of dollars through secondary market transactions. Such transactions involve the transfer of ownership in an existing asset (a stock, a bond, a house, a company, a collectible, etc.) from one owner to another in exchange for some form of value (cash, other securities, etc.). If I, for instance, purchase $100,000 worth of any security on the public securities markets, hold it for a requisite period of time and sell it at a profit, that profit is taxed at a capital gains tax rate (either 15% or 24%) which can be lower than tax rates on regular income, particularly for high earners. Good for me. But no one got hired as a result of that transaction. No equipment was procured, no facilities were leased and no inventory was purchased. Outside of the parties to the transaction and the brokers who made commissions, the transaction created no general economic benefit. The question that should run through the minds of everyone stapling a W-2 to their income tax return next week is whether or not capital even needs the reward of a lower tax rate than labor in order for secondary market transactions to occur.
The same principal applies to larger transactions – private equity for instance. A private equity firm like Bain Capital can – on behalf of its investors – purchase an entire company from existing owners, hold it for a requisite period of time and pay the low capital gains tax rate on any profits from the resale of that company. Hopefully, they created value while owning the company, but growing the business is not a prerequisite for enjoying favorable tax rate treatment. The private equity firm can create value for its investors by firing workers, or by eliminating a competitor that must then fire its workers, or by curtailing capital spending or by closing facilities, with the increased profits and market position resulting in a higher sale price later on. Further, the private equity firm can purchase the company with massive amounts of debt or pay themselves dividends (those are taxed at lower rates as well) by loading the company with debt later on. In short, a private equity firm can actually generate lower taxed investment income by actually shrinking overall economic activity. This is the “Opportunity Economy” that Governor Romney is talking about.
But wait, there’s more.
If, by chance, one of these sale transactions occurs at a capital loss, did you know the capital loss on a particular transaction can be used to offset any capital gains made on other transactions? In fact, any capital losses incurred in the current tax year can be held and used to offset capital gains generated in future years. So not only does the investor class enjoy lower tax rates, they are also able to minimize the pain of a bad investment call.
How is that opportunity economy working for you? Not so good? Well, that’s too bad, because we’re not done yet.
The people who run private equity firms are compensated with something called “Carried Interest” which is essentially a percentage of the gains made on an investment. The partners, associates and other professionals in a private equity firm apply their labor to the execution of these transactions for the benefit of their investors and they make a lot of money only when their investors make even more money. Usually the split on the profits is 80% to the investors and 20% to the private equity firm. Would you like to take a wild guess at the tax rate on that 20% Carried Interest earned by the private equity firm through the labor of its partners? You guessed it. Unlike the rest of our labor, the financial rewards generated from private equity labor are taxed at that low capital gains tax rate. That is part of the reason why someone who makes tens of millions of dollars a year winds up paying a lower tax rate than that which is withheld from your paycheck every two weeks.
This is why President Obama is proposing the Buffett Rule, so that those who make huge amounts of money from moving capital wind up paying a fair tax rate. The business community complains that the Buffett Rule is a backdoor way of taxing capital – as if that is some big sin. This is why everyone on Wall Street – from investment bankers, to private equity professionals, to hedge fund managers – are filling Mitt Romney’s coffers with hundreds of millions of dollars of cash. They’ve got a great deal going and they want to keep it going. They are indifferent to national debt reduction, national defense, infrastructure, Social Security, Medicare and Medicaid as long as they don’t have to pay for any of it. They would far rather have someone else step up with such spending (they won’t need Medicaid) or simply not provide the program. In the meantime, they will continue to pocket a larger percentage of their gains than you get to keep of your income by buying and selling securities and companies. If you happen to lose your job as a result of that buying and selling……well……that’s just the Opportunity Economy at work.
Ain’t it cool?