Romney, The Election and Double Taxation – An Allegory

Normally I try to stay clear of partisan politics – especially during campaign season. But this week the news from the Presidential campaign has brought up some concepts which are useful case studies in the kind of tax planning and thinking we routinely help our customers work through.

At issue: Media reports are surfacing that Mitt Romney, himself a wealthy investor and stockholder with a net worth somewhere between $190 million and $250 million, pays a lower effective percentage tax rate than his secretary. And campaign politics being what it is, I’ve seen Facebook and other social media efforts playing this up.

Is it true? Well, it depends on how you slice it. As with so much in economic and tax policy, the devil is in the details. Let’s set aside the issue of whether capital gains should be taxed at a lower percentage rate than income from wages for now, and look just at income.

Suppose you owned a faithful dog, and trained him to hunt pheasants. Over time, the dog became a capable hunter, and was able to bring you a pheasant every day for dinner.

Suppose further that the government appointed a tax collector to come to your estate every day, and collect a tax – say, one leg of the pheasant.

And suppose further that the tax collector had trained the dog to come to him with the pheasant each day, so that the tax collector could cut off the pheasant’s leg. Then the tax collector handed the pheasant carcass back to the dog, and the dog brought the pheasant back to you.

The tax collector then comes to your house, and demands that you present the pheasant with a wing. Every day, before you get to keep the legless pheasant, the tax collector comes to you and you give him a wing. Yes, you have already paid

What am I getting at?

  • The dog is your corporation. You own it, or you and a whole bunch of other people own the dog together.
  • The live pheasant is your corporation’s profits.
  • The dead pheasant – after your dog has killed it – is your dividend.
  • The drumstick the tax collector takes from your dog is the government’s 35 percent tax on corporate income for C corporations.
  • The wing the tax collector takes from you before you can eat anything is your individual dividend income tax.

C corporation dividends – the kind that come from publicly traded stocks and some privately held companies – are subject to double taxation: Once at the corporate level, and then again, when the corporation distributes profits to its owners.

Now, imagine you have a good and faithful servant – and as part of his wages, you give him a pheasant each week, as well. The tax collector, however, does not take anything off of this pheasant until after your servant receives it. Your servant receives the whole pheasant, complete and entire.

However, after your servant takes possession of the pheasant, the tax collector comes and says “not so fast, you owe me half the meat off of that drumstick!”

The drumstick, in this case, is your servant’s income taxes. The wing the tax collector didn’t collect is the deduction against corporate earnings for the payment of wages as a business expense.

The servant complies. And happily sets about cooking and consuming the rest of his pheasant… about But when he looks around, he sees the tax collector dealing with you in the kitchen over your pheasant – and all he notices is that you have only given a wing.

He pays no heed to the drumstick the taxman already took from your dog before you ever received the dividend.

This is double taxation at work. And it’s also politics – the servant will continue to work for you, and he’s grateful for the job. But he also wants to reduce his taxes from a drumstick to a wing – and will argue for it and work hard to convince his friends to vote for it as well.

 

So what’s fair?

Well, it depends. Do you believe that the tax on the dog is effectively a tax on the owner? Or do you consider the dog a totally separate entity from the owner? If you believe the tax on the dog is effectively the same as taxing the owner, anyway, then you would probably object to characterizing the additional second wing taxed off the pheasant as unfair, since your dog has already paid a drumstick before the pheasant even got to you. In fact, the more you understand the tax code, the more you would probably object to disregarding the tax on the dog when calculating an investor’s true tax burden.

On the other hand, if you believe the dog’s owner should get full credit for having paid the dog’s drumstick, then be very careful about claiming credit for paying the workers’ half of Social Security tax as well! Ultimately, both halfs of payroll taxes come out of money that would otherwise be available to pay workers – and when you factor this into account, the workers’ tax burden is higher than a pure income tax model of analysis would indicate.

On the other hand, the worker eventually gets payroll taxes back in the form of Medicare and Social Security Benefits – which are, by design, somewhat redistributive. And there things get pretty murky.

The bottom line.

Be careful of news reports or analysis trying to score points on politicians during electoral campaigns. Often, gullible reporters are spoon-fed partial information on topics they don’t quite understand, in the hope of getting them towrite a story a certain way. Both sides do this routinely, and even major network reporters and big newspapers get caught in the trap all the time. Very few general assignment or politics reporters have any kind of detailed knowledge of tax policy or financial matters.

Take tax stories and economic stories with a big grain of salt.

 

 

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7 Comments

  • By Jason Cabler (@DrCabler), January 23, 2012 @ 11:25 am

    Great article, I’ve never seen it explained in that way. Maybe now more people can understand how the taxation of business owners works instead of just claiming that they get more tax benefits than everyone else.

  • By thomas, January 23, 2012 @ 11:29 am

    Thanks Jason – It took me a while to figure out a way to explain it. Double taxation can be a tricky thing to explain if you’ve never been subject to it.

  • By John | Married (with Debt), January 23, 2012 @ 12:04 pm

    Great analogy! Do you plan to follow up when he releases his returns this week?

    I’m middle class and I want to say that my federal tax effective rate was under 10%, but I’m not sure if I’m recalling correctly.

    I’ve heard some can be clever with how they pass profits through to avoid corporate tax.

    Lots of problems with America’s tax code, complexity being number one.

  • By thomas, January 23, 2012 @ 1:30 pm

    Yes, once Romney releases his tax return I’ll follow up – granted, I don’t think we’ll see too many surprises.
    There are a number of ways that you can pass profits through the corporation and avoid double taxation. A common way is to file as an S-corp. Still, dividends are typically taxed first at the corporate level and again as a dividend. The Internal Revenue Code is a right mess! The problem is that Congress doesn’t have the guts to overhaul the system – instead, they just keep adding code and patching loop holes.

  • By Hank, January 23, 2012 @ 1:39 pm

    Great analogy! There is still another layer of potential taxation as well. At some point, Romney earned some type of income in order to purchase the shares of stock in the first place that produced the dividend. And, he was taxed on that income as well.

  • By thomas, January 23, 2012 @ 1:51 pm

    Hi Hank – yes that’s possible. Either he earned it as income and then purchased the shares, or he received stock options as part of his compensation. Either way, he’s paid some kind of tax (either income or capital gains) of the money used to acquire the stocks. It’s no different than if you or I bought shares in Bain Capital (if we could) but I think the press and general public forget that. All they see is a rich guy who “gets away” with 15% tax.

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