Romney's Tax Disclosures Provide Perfect Foil for President's Proposals for Tax Fairness

Last edited Thu Jan 19, 2012, 01:34 PM - Edit history (5)

Now that we've been promised by Mitt Romney that he'll release at least one year of tax returns of the normal twelve that candidates for office produce for public scrutiny (the George Romney standard), a glimpse at the private equity manager's income and tax treatment should play right into President Obama's term-long fight against the abuses and privileges of the private equity industry; most notably, recently, with the President's proposal in his jobs bill to raise $18 billion by taxing the 'carried interest', or profits-based compensation of private equity managers (like Romney), real estate investors and venture capitalists as ordinary income, instead of regarding them as capital gains; effectively subjecting their income to the cap of 35% that other higher wage earners pay right now.

“My income comes overwhelmingly from investments made in the past rather than ordinary income or rather than earned annual income,” Romney said at a news conference in South Carolina.

“What’s the effective rate I’ve been paying? It’s probably closer to the 15 percent rate than anything,” Romney said. “My last 10 years, I’ve -- my income comes overwhelmingly from investments made in the past rather than ordinary income or rather than earned annual income . . . . “I got a little bit of income from my book, but I gave that all away. And then I get speaker’s fees from time to time, but not very much,” he said.

The 'investment' income Romney's referring to isn't what folks might imagine when they think of 'investing'; as in putting up your own money for a venture and assuming most of the risk, taking responsibility for the infrastructure and overhead. What Romney is profiting from is the service his private equity company, Bain Capital, provided the actual investors; the folks whose profits are correctly treated as capital gains and taxed at the 15% rate. Romney derives his income from an arrangement where fund managers receive 20% of the profits from the investment and a typical 2% management fee. If Romney isn't investing his own money -- just managing someone elses' -- how is the fee for his service regarded as 'capital gains' from that original investment?

Dan Primack at CNNMoney describes the terms in detail: http://finance.fortune.cnn.com/2011/07/08/the-case-for-raising-taxes-on-private-equity/

In many cases, people invest their own money directly and pay capital gains rates on any subsequent profits. In others, they pay an investment adviser or mutual fund manager to invest on their behalf, in exchange for a fee. The actual investor still receives capital gains treatment in these arrangements, while their adviser pays ordinary income on their fees.

Alternative investment funds, however, operate differently. They structure themselves as partnerships, so that both the investor (limited partner) and fund manager (general partner) are effectively treated as a single entity for tax purposes. Investment profits flow into the partnership as capital gains, and then are divvied up between the two sides at a pre-negotiated rate -- typically with fund managers receiving 20%.

The fundamental problem with this arrangement, of course, is that fund managers don't actually invest. Don't actually put anything at risk.

The problem with Romney's tax treatment isn't that he's committed some crime or ethical lapse in accepting the benefits of what presidents from Clinton to Bush helped legislate into the tax code. The problem is in the way he boasts of his role in 'job creation' at the private equity firm he founded. The dubiousness of that claim lies in the fact that there is no actual risk inherent on Mr. Romney's part in the investments that his firm manages.

from the Fiscal Times: http://www.thefiscaltimes.com/Articles/2012/01/09/Private-Equitys-Edge-Buy-Now-Deduct-Taxes-Later.aspx#page2

Private equity is actually a misnomer, since the modus operandi of those investors is no different than the leveraged buyout firms that pioneered junk-bond financing in the 1980s. Private equity firms generally finance anywhere from 60 to 90 percent of their purchases with borrowed cash. Interest payments on those debts are treated just like any other expense, and are therefore deductible from earnings.

President Obama has focused his efforts on repealing the so-called carried interest loophole, which allows private equity investors pay taxes on earnings at a lower capital gains rate.

The business interest deduction distorts economic activity, according to a report issued last year by the Joint Committee on Taxation. It encourages companies to raise capital through debt rather than equity, since returns to stockholders – dividends – come out of after-tax profits (and then are taxed again as part of recipients’ individual tax returns). Payments to bondholders, on the other hand, is a deduction from earnings.

The one thing that experts agree on is that the hefty returns to private equity investors were beefed up by the income deduction on the interest they paid while owning the firm. “While the performance (of the purchased firms) is pretty much on a par with their industry peers, we know the returns to the private equity investors are quite stellar,” said Edith Hotchkiss, a professor of finance at Boston College. “A part of that increased return is from the tax yield.” (Estimates are that some 10 percent to 20 percent of the returns from private equity transactions come from reduced taxes.)

There's no recognition in the tax code of whether the money manager does a good job at his money managing, or not. A company can be hemmoraging jobs and investment managers like Mr. Romney are still entitled to the reduced tax rate on the money paid them, by investors, for their services. Since the former governor hasn't managed to produce any evidence at all of jobs created while he was actually working at Bain, we're left to doubt that his venture was anything more than a standard, profit-taking enterprise, with little ultimate responsibility for the plights of employees of the companies he dealt with. That responsibility; that risk, is what the lower capital gains tax rate is meant to buttress against; not the income of its vendors and accountants.

President Obama has highlighted the role of private equity funds, or proprietary trading companies operating for their own profit, unrelated to serving their customers, at the beginning of his presidency for their involvement in the bank collapse. In proposing the 'Volker Rule' the president called for reponsible practices from these entities that benefited from our federal largess.

"Banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers, he said in Jan. '10. " If financial firms want to trade for profit, that's something they're free to do. Indeed, doing so –- responsibly –- is a good thing for the markets and the economy. But these firms should not be allowed to run these hedge funds and private equities funds while running a bank backed by the American people."

The President took that sentiment further as he advocated for student loan relief.“How can we ask a student to pay more for college before we ask hedge fund managers to stop paying taxes at a lower rate than their secretaries?" he asked recently.

More to the point, in September, President Obama proposed eliminating the tax advantage that Romney and others in both parties have so zealously guarded by proposing in his jobs bill to treat private equity income like Mr. Romney's the same as every other working Americans'. No more pretending that the fee he collects for managing these firms' money is what the tax code was meant to enhance.

In the upcoming debates over whether Romney was a jobs creator, or a jobs destroyer, it will be interesting hearing the republican candidate defend the 'services' he provided the investors -- who actually put up the money and assumed the responsibility and risk for their company and employees -- as the job creation that the capital gains tax break he takes advantage of intends.

It will be even more interesting to see just how that tax break-advantaged income is enhanced under his economic plan -- whatever part of his fortune he finally reveals a tiny sliver of -- and just how much Mitt Romney stands to gain under his tax proposal he intends to enact if elected president. He's certainly ambled recklessly into the path of President Obama's plan to have folks like him pay their fair share at tax time.

As one economist complained this week, Romney may well be the very one who draws enough attention to, and ultimately brings about, the end to the tax loophole which assumes he's something more significant in the job creation process than just a facilitator. I mean, it's not as if Romney and all the rest of his private equity firm friends are going to quit their lucrative enterprise and refuse to engage prospective companies just because they're paying their fair share of taxes like the rest of us.

-Ron