Recent News about Tax Fairness and Tax Reform

This one page fact sheet includes the information you need to understand the debates taking place around Tax Day.

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Tax Tips with Mitt

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Tax Planning for the Super Wealthy

Millions of Americans will spend part of this upcoming weekend trying to navigate tax preparation software or filling out the actual paper forms to file their income tax returns before the Tuesday deadline. For those wishing they could pay less tax, outlined below are some tax planning ideas taken from a review of presidential candidate Mitt Romney’s tax returns.

Don't Work for a Living

The single best way to reduce your income tax bill is to make sure that your income is subject to the lower preferential rates for dividends and capital gains. The federal tax system taxes “ordinary” income, like salaries and wages, at much higher rates (up to 35%) than investment income (maximum 15%). Many states have capital gains tax breaks, too. The low capital gains tax rate explains Romney’s 14 percent effective federal income tax rate. Almost all of his income is taxed at the low rate — the ordinary income he does have, from interest and speaking fees, is mostly offset by his itemized deductions.

At any level of income, a taxpayer with income from capital gains and dividends will pay less than half of the federal income tax paid by a taxpayer with the same amount of wages. Here are some examples:

Federal Income Tax

If Wages

If Capital Gains

Single, doesn’t itemize, $60,000 income

$8,750

$2,400

Married, itemizes, $250,000 income

$43,400

$19,300

Married, itemizes, $20 million income

$6,276,000

$2,695,200


The wage earner pays payroll taxes on top of the income tax. So it’s best, like Romney, to be unemployed.

Federal Income and Payroll Taxes

If Wages

If Capital Gains

Single, doesn’t itemize, $60,000 income

$17,930

$2,400

Married, itemizes, $250,000 income

$63,900

$19,300

Married, itemizes, $20 million income

$6,867,100

$2,695,20


If You Do Work, Disguise Your Compensation as Capital Gains

Romney’s return does report quite a bit of compensation (in addition to that “not very much” in speaking fees of $529,000), but it’s disguised as capital gains, to make it subject to that special low rate. About half of the $15 million in capital gain and dividend income reported on his 2010 tax return is compensation from Romney’s partnership interests in Bain Capital funds.

These “carried interests” were earned by Romney in exchange for the services he performed while at Bain Capital. Private equity, hedge fund, and other investment fund managers structure their compensation so that most of it is received in the form of a partnership interest — a piece of the deal — and the income from those carried interests is taxed at the capital gain rate. In addition to paying a much lower income tax rate, Romney also avoids paying the Medicare payroll tax on the income.

Give to Charity — But Not Cash

If you give a gift of appreciated property, like stock, to a charity, your deduction is the value of the stock, even though you may have paid far less for it. In Romney’s return, there’s a deduction for just under $1.5 million worth of Domino’s Pizza stock (which he likely received in a Bain Capital deal) to the Tyler Foundation (more about that below). The price he paid for the stock was zero or something so close to zero that the accountant didn’t bother reporting it. Giving the stock to the foundation saved Romney an estimated $220,000 in taxes that he would have owed if he had sold the stock and given cash instead.

Give to Charity — But Not Now

In Romney’s tax return, there’s income from the W. Mitt Romney 1996 CRUT (that’s a Charitable Remainder UniTrust). That means Romney set up a charitable trust in 1996 (with a half million dollars or more) and he kept the right to receive income from the trust for a certain number of years or, quite likely, for the rest of his life.

In 1996 Romney got an income tax deduction for what will go to charity when the trust ends. The charity won’t get a dime until that trust ends (and it’s already been 15 years since the contribution), but Romney got a big deduction on his 1996 return (it’s hard to know how big without seeing the return). In addition, he or one of his close advisors can be the trustee of the trust and control the money until the trust ends.

In addition, the trust is a tax-exempt entity, so it can sell whatever assets are in the trust and pay no capital gains taxes, diversify Romney’s portfolio, and increase his investment return. Of course, at the end of the trust’s term, whatever remains in the trust must be distributed to a charity. In the meantime, Romney has enjoyed some generous tax benefits.

Give to Charity — Your Own

Of the almost $3 million in charitable contributions on Romney’s 2010 tax return, about half went to The Tyler Charitable Foundation which Mitt and Ann Romney set up in 1999. When Romney makes a contribution to the foundation, it is fully deductible on his personal income tax return that year.

The foundation itself doesn’t provide direct services like a soup kitchen does. The “private” foundation (whose donations come from only one or a few supporters) gives money to charities like the Boys and Girls Club (known as “public” charities because their support is from the public more broadly) that generally do provide direct services.

The foundation only has to distribute 5 percent of its assets each year. So while Romney got a $1.5 deduction for the amounts transferred to the foundation in 2010, the foundation can take its sweet time getting the money in the hands of a public charity. At the end of 2010, the foundation had over $10 million in assets.

Use Offshore Investment Vehicles

An American citizen is taxable on all of his income, no matter where he lives or where the income is earned. If the income is subject to any foreign tax, the taxpayer gets a credit against his U.S. tax, to avoid double taxation. Romney reduced his U.S. tax bill by almost $130,000 in foreign tax credits on his 2010 return.

The earnings on any foreign investments would be fully taxable in the year earned, so it seems there would be no tax advantage to investing offshore. But using certain foreign investment vehicles allows a U.S. taxpayer to avoid some rules and thereby save some tax.

(For tax nerds: Investing in a Bain Capital fund formed in the Cayman Islands through a PFIC (Passive Foreign Investment Corporation), for example, can save an individual investor tax by avoiding the limitations on miscellaneous itemized deductions. A tax-exempt investor, like Romney’s Individual Retirement Account, can avoid the Unrelated Business Income Tax (UBIT) by investing through a foreign corporation as well, instead of investing in the fund directly.)

There are reports that Romney may have taken advantage of the tax savings offered by investing through these offshore vehicles, although it’s not apparent from the tax return. The return does have 55 pages of forms for reporting Romney’s transactions with foreign corporations, foreign partnerships, and PFICs. At least eleven of the entities from which Romney earns income are located in countries considered to be offshore tax havens, such as Bermuda, the Cayman Islands, and Luxembourg.

Invest in Sexier Financial Instruments

If you’re investing in plain vanilla stock and bonds, you’re missing some tax planning opportunities. For example, Romney’s return includes a $415,000 gain from certain investments that get special treatment under the tax rules (for tax nerds: section 1256 contracts).

The gain on these investments is treated as 60 percent long-term capital gain and 40 percent short-term gain, no matter how long you’ve actually held the investment — even if it’s for only one day! The amount treated as long-term gain gets taxed at that special low capital gains rate. Romney’s return also discloses income from foreign currency transactions, swaps and other derivatives, and investments which are written up to market value each year.

Borrow Money Only to Invest

If you borrow money to buy a car, the interest is not deductible even if you need your car to get to work. If you use a credit card to buy personal items, that interest is not deductible. If you borrow money to buy a house, the interest is deductible but only on a loan of $1 million or less. (Romney’s three homes are valued in the neighborhood of $25 million.) If you borrow money against the equity in your home, interest on only $100,000 of principal is deductible.

But if, like Romney, your interest expense is “investment interest expense,” it is deductible, limited only by the amount of your investment income. When your investment income is in the millions of dollars, you can deduct a lot of interest.

Be Aggressive in Your Tax Planning

When a taxpayer engages in a type of transaction that the Internal Revenue Service has identified as potentially abusive, he must disclose that in his tax return. It’s called a “reportable transaction” and the taxpayer has to file a Form 8886 to tell the IRS about it. Romney’s 2010 return included six Forms 8886 (16 pages) related to investments in hedge funds and private equity funds.

But Don’t Do Anything Illegal

There’s nothing in Romney’s tax return that indicates anything necessarily illegal or improper. On the contrary, it appears that he has been conscientious in filing the necessary forms and disclosures.

In addition to the disclosures noted above, on Schedule B, Interest and Dividends, the “yes” box is marked on that pesky question about foreign financial accounts and “Switzerland” is shown as where the account is located. If Romney was going to use offshore accounts to illegally evade taxes (as opposed to merely avoid them), he might decide not to complete that part of the return or he might omit some of those disclosure forms.

For Your Return

While in theory any taxpayer could use the tax planning techniques outlined above, in reality only the wealthy can take advantage of them. It takes a substantial amount of money to set up a charitable trust, for example. In addition to the money you put in the trust, you have to pay the attorney who draws up the trust documents and the accountant who files the trust’s annual tax returns. So unless you’re making a pretty substantial contribution, the costs would outweigh the tax benefits.

You have to have significant resources to be able to structure your debt for the best tax result. Or to set up a private foundation. Or make offshore investments. Or structure your compensation as capital gains.

The fact that there doesn’t appear to be anything improper in Romney’s tax return — and yet the return is full of ways only a wealthy person can reduce his tax bill — is the problem.

Read the PDF of this report.

Congress should approve Senator Sheldon Whitehouse’s proposal to implement the “Buffett Rule” to raise badly needed revenue and make our tax system fairer, but should also recognize that this must be followed by far more substantial reforms. In particular, Congress can’t stop at limiting breaks for millionaire investors but should completely repeal the personal income tax preference for investment income, as President Ronald Reagan did in 1986.[1]

A previous CTJ report concluded that Senator Whitehouse’s bill would raise $171 billion from 2013 through 2022.[2] The non-partisan Joint Committee on Taxation (JCT) has estimated that it would raise much less revenue, probably because JCT overestimates behavioral responses to changes in tax rates on investment income.[3] But even if Senator Whitehouse’s bill would raise $171 billion over a decade, that’s only a fraction of the $533 billion that CTJ estimates could be raised by completely ending the tax preference for investment income.

Why We Need the Buffett Rule

The “Buffett Rule” is the principle, proposed by President Barack Obama, that the tax system should be reformed to reduce or eliminate situations in which millionaires pay lower effective tax rates than many middle-income people.

An earlier report from Citizens for Tax Justice explains how multi-millionaires like Warren Buffett who live on investment income can pay a lower effective tax rate than working class people.[4] As the report explains, there are two reasons for this. First, the personal income tax has lower rates for two key types of investment income, long-term capital gains and stock dividends. Second, investment income is exempt from payroll taxes (which will change to a small degree when the health care reform law takes effect).[5]

The report compares two groups of taxpayers, those with income in the $60,000 to $65,000 range (around what Buffett’s secretary is said to make), and those with income exceeding $10 million.

For the first group, about 90 percent have very little investment income (less than a tenth of their income is from investments) and consequently have an average effective tax rate of 21.3 percent. For the second group (those with incomes exceeding $10 million), about a third get a majority of their income from investments and consequently have an average effective tax rate of 15.3 percent. This is the fairness problem that the “Buffett Rule” would address.

 

The Best Way to Implement the Buffett Rule: End the Tax Preference for Investment Income

The most straightforward way to implement the Buffett Rule would be to eliminate the personal income tax preferences for investment income. This would mean, first, allowing the parts of the Bush tax cuts that expanded those preferences to expire. Second, Congress would repeal the remaining preference for capital gains income, which would raise $533 billion over a decade.

When President George W. Bush took office, the top tax rate on long-term capital gains was 20 percent, and the tax changes he signed into law in 2003 reduced that top rate to 15 percent. The same law also applied the lower capital gains rates to stock dividends, which previously were taxed as ordinary income. If the Bush tax cuts, which were extended through 2012, are allowed to expire, then capital gains will again be taxed at a top income tax rate of 20 percent (meaning there will still be a tax preference for capital gains) and stock dividends will once again be taxed like any other type of income.

The Bush tax cuts for capital gains and dividends should be allowed to expire at the end of this year. In addition, Congress should repeal the capital gains break that will still exist (the special rates not exceeding 20 percent). Under this proposal, capital gains would simply be taxed at ordinary income tax rates. This would raise at least $533 billion over a decade. [6] The table above shows that 80 percent of the tax increase resulting from eliminating the capital gains preference would be paid by the richest one percent of taxpayers in 2014.

Senator Sheldon Whitehouse’s Buffett Rule Bill

Senator Sheldon Whitehouse of Rhode Island has introduced a bill that would take a more roundabout approach to implementing the Buffett Rule by imposing a minimum tax equal to 30 percent of income on millionaires. This would raise much less revenue than simply ending the break for capital gains, for several reasons.

First, taxing capital gains as ordinary income would subject capital gains to a top rate of 39.6 percent in years after 2012, while Senator Whitehouse’s minimum tax would have a top rate of just 30 percent. Second, the minimum tax for capital gains income would effectively be even less than 30 percent because it would take into account the 3.8 percent Medicare tax on investment income that was enacted as part of health care reform. Third, while most capital gains income goes to the richest one percent of taxpayers, there is a great deal of capital gains that goes to taxpayers who are among the richest five percent or even one percent but who are not millionaires and therefore not subject to the Whitehouse proposal.

Other reasons for the lower revenue impact of the Whitehouse proposal (compared to repealing the preference for capital gains) have to do with how it is designed. For example, Senator Whitehouse’s minimum tax would be phased in for people with incomes between $1 million and $2 million. Otherwise, a person with adjusted gross income of $999,999 who has effective tax rate of 15 percent could make $2 more and see his effective tax rate shoot up to 30 percent. Tax rules are generally designed to avoid this kind of unreasonable result.

The legislation also accommodates those millionaires who give to charity by applying the minimum tax of 30 percent to adjusted gross income less charitable deductions.

These provisions would not be necessary if Congress took the more straightforward approach of simply ending the tax preferences for investment income, which would simply require that all income be taxed at the same rates.

 

Photo of Warren Buffett and Sheldon Whitehouse via The White House and Transportation for America Creative Commons Attribution License 2.0

 


[1] The Tax Reform Act of 1986, signed into law by President Ronald Reagan, ended the tax preference for capital gains and resulted in a personal income tax that imposed the same rates on all types of income.

[2] Citizens for Tax Justice, “Policy Options to Raise Revenue,” March 8, 2012. http://ctj.org/pdf/revenueraisers2012.pdf

[3] The Joint Committee on Taxation (JCT) estimated that Senator Whitehouse’s bill would raise $47 billion over a decade. James O’Toole, “Buffett Rule would Raise Less than $5 Billion in Taxes a Year,” March 20, 2012. http://money.cnn.com/2012/03/20/news/economy/buffett-rule-analysis/index.htm CTJ’s report, “Policy Options to Raise Revenue,” includes an appendix that describes the literature concluding that JCT overestimates behavioral responses to taxes on capital gains.

[4] Citizens for Tax Justice, “How to Implement the Buffett Rule,” October 19, 2011. http://www.ctj.org/pdf/buffettruleremedies.pdf; Citizens for Tax Justice, “The Need for the ‘Buffett Rule’: How Millionaire Investors Pay a Lower Rate for Middle-Class Workers,” September 27, 2011. http://www.ctj.org/pdf/buffettrulereport.pdf 

[5] The health care reform law effectively expanded the Medicare tax to include a top rate of 3.8 percent and to apply to investment income for taxpayers with adjusted gross income in excess of $250,000 for married couples and $200,000 for single taxpayers.

[6] Figures used here incorporate the assumptions of the Congressional Budget Office that capital gains income will decline in 2013, presumably in response to the end of the Bush tax cuts, and then quickly recover in years after that.

Who Pays Taxes in America?

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It’s often claimed that the richest Americans pay a disproportionate share of taxes while those in the bottom half pay nothing. These claims ignore the many taxes that most Americans are subject to — federal payroll taxes, federal excise taxes, state and local taxes — and focus instead on just one tax, the federal personal income tax. The other taxes are mostly regressive, meaning they take a larger share of income from a poor or middle-income family than they take from a rich family.[1]

Many Americans do not have enough income to owe federal personal income taxes, but do pay these other taxes. The federal personal income tax is a progressive tax, and the combination of this tax with the other (mostly regressive) taxes results in a tax system that is, overall, just barely progressive. Total tax obligations are, on average, fairly proportional to income.

This table illustrates the share of total taxes (all federal, state and local taxes) paid by Americans in different income groups in 2011.

 

• The share of total taxes paid by each income group is similar to that group’s share of total income.

• The share of total taxes paid by the richest one percent (21.6 percent) is almost identical to that group’s share of total income (21.0 percent).

• The total effective tax rate for the richest one percent (29.0 percent) is only about four percentage points higher than the total effective tax rate for the middle fifth of taxpayers (25.2 percent).[2]

• The share of total taxes paid by the poorest fifth of Americans (2.1 percent) is only slightly less than this group’s share of total income (3.4 percent).

Virtually every person in America pays some type of tax. Everyone who works pays federal payroll taxes. Everyone who buys gasoline pays federal and state gas taxes. People who shop in stores pay the sales taxes that most state and local governments impose. State and local property taxes affect everyone who owns or rents a home. (Even renters pay property taxes because landlords pass some of the tax on to them in the form of higher rents). Most states also have income taxes, most of which are not particularly progressive.

 

 

Why the Federal Personal Income Tax Is Progressive

We need the federal personal income tax to be progressive to offset the regressive impacts of these other taxes. 

For example, the federal personal income tax provides refundable tax credits like the Earned Income Tax Credit and the Child Tax Credit, which can reduce or eliminate personal income tax liability and even result in negative personal income tax liability, meaning families receive a check from the IRS. These tax credits are only available to taxpayers who work, and who therefore pay federal payroll taxes, not to mention the other taxes that disproportionately affect low- and middle-income Americans.

In other words, the parts of the federal personal income tax that seem like a boon to the poor are justified because they offset some of the other taxes that poor and middle-income families must pay.

As these figures illustrate, America’s tax system as a whole is just barely progressive.

 


[1] For a state-by-state break down of the distribution of state and local taxes, see Institute on Taxation and Economic Policy, Who Pays: A Distributional Analysis of the Tax System in All 50 States, November 2009. http://www.itepnet.org/whopays.htm   

[2] There are some high-income individuals who have effective federal tax rates that are much lower than average for their income group. See Citizens for Tax Justice, “How to Implement the Buffett Rule,” October 19, 2011. http://www.ctj.org/pdf/buffettruleremedies.pdf

 

This presentation was given to participants of the Ecumenical Advocacy Days, an event that brings the perspectives of faith-based organizations to Capitol Hill. The presentation explains federal tax issues that are being debated today.

Read the presentation.

Recent polls show a large majority of Americans, including small business owners, are convinced that profitable corporations are not paying enough in taxes. Citizens for Tax Justice and U.S. PIRG’s Loopholes for Sale pursues the intersection of corporate campaign contributions to members of Congress and the absence of Congressional action to close corporate tax loopholes and raise additional revenue from corporate taxes.

The report includes the following findings:

  • 280 profitable Fortune 500 companies collectively received $223 billion in tax breaks between 2008 and 2010 while contributing $216 million to Congressional candidates over the last four election cycles.

  • The thirty most aggressive tax dodging corporations—dubbed the “Dirty Thirty”— collectively paid a negative tax rate between 2008 and 2010 while spending $41 million on Congressional campaign contributions.

  • Of the 534 current members of Congress, 524(98 percent) have taken a campaign contribution from one or more of these thirty corporations since the 2006 election cycle.


Full Report Here

Read Our Press Release With Key Findings

Check Out the Special Report Landing Page


Policy Options to Raise Revenue

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This report describes eleven options for Congress to raise revenue by reforming our tax system, including taxing capital gains the same as other income, ending corporations' ability to "defer" paying taxes on offshore profits, enacting the "Buffett Rule," ending tax subsidies for oil and gas companies, and several other sensible reforms.

Read the report.


The revenue impact of the Buffett Rule, as proposed by President Obama, depends on how it is implemented and whether or not the Bush tax cuts are extended again. Ending the breaks for investment income in the personal income tax would be a more straightforward approach that raises more revenue.

Read the report.


Three Republican candidates for president have released tax proposals with enough detail for CTJ to estimate their effects, and all three would give greater tax cuts to Iowa's highest earners, whether measured in dollar terms or as a percentage of taxpayers’ income.  Under any of these three plans - Romney's, Gingrich's or Perry's - the richest one percent of Iowa’s taxpayers would receive the largest share of the tax cuts.

CTJ's new analysis is here.

How to Implement the Buffett Rule

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A change in the Medicare tax that was enacted last year as part of health care reform will take an important but limited first step towards implementing President Obama’s “Buffett Rule,” the principle that tax laws should not allow millionaires to pay a smaller percentage of their income in federal taxes than do middle-class taxpayers. To further implement the Buffett Rule, Congress could end the existing income tax preference for capital gains and dividends or enact the type of surcharge for income exceeding $1 million that Senate Democrats recently proposed.

Read the report.

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