Republican presidential nominee Mitt Romney last week promised ABC News he would “go back and check” whether he had ever paid a tax rate lower than 2010's 13.9 percent. He hasn't, and the questions keep piling up. This week Senate Majority Leader Harry Reid repeated a rumor, attributed to a former Bain partner, that Romney had paid no taxes for 10 years. And in the New York Times on Tuesday, Michael Graetz, a former official in the first President Bush's Treasury, speculated about what might be in the returns. It's possible we'll find something in Romney's taxes that's disqualifying or suggests that he broke the law, but I doubt it. We're unlikely to learn anything about Romney from his tax returns that we don't already know – that he's a very rich man with a taste for cutting-edge financial engineering. It's what we'll learn about taxes that might shock us. The Romney tax returns are a rare opportunity to see how the tax code really works for the very wealthy and whether we want to change it in the direction that Romney has proposed or take it in the direction of real fairness and efficiency.
Let's start with the possibility that Romney paid a tax rate much lower than 13.9 in some years, or something in the low single digits. Graetz says that's “plausible” but might be “perfectly legal.” If he did, he would probably have to show real losses on his investments, which would offset his gains. These might be “capital loss carryovers” from previous years. He had a $4.5 million carryover on his 2010 taxes, from which NYU professor Dan Shaviro inferred that he probably had more losses than gains on his 2009 return – that is, he had to “carryover” the extra losses to the next year. If so, it's possible that he paid very little in taxes in 2009 – a bad year on the stock market – because he lost money. It's hard to see that as a problem, though. If Romney really lost money, he had no gains to pay taxes on.
But this also reveals another way in which the tax code benefits those whose income comes from investments: they are able to move their gains and losses around and use the losses when they need them to offset their gains. Most of us can't do that. With a couple of exceptions, as our income goes up and down, we can't move deductions that we couldn't use in one year and carry them over to another. We can't use our bad years to offset the good ones.
And then there's that massive Individual Retirement Account, valued in his financial disclosure at between $20 million and $101 million. How does that happen? Contributions to that type of IRA are limited to $30,000 a year, so these are remarkable returns. (The average IRA has about $67,000 in it.) The answer is that he's not putting cash in the IRA; he's putting in stock. The trick is to put in stock that has a low value but a huge upside. Graetz says that “we have to presume that Mr. Romney valued the assets he put in his retirement account at far less than he would have sold them for.” Apparently this is not uncommon – if you had just founded Facebook, for example, you could load up your IRA with shares when they were valued at $1, and then as the company grew, the capital gains would be tax-deferred in the safety of the IRA. As Graetz says, “The IRA also allows Mr. Romney to diversify his large holdings tax-free” – by which he means that if you want to have a typically diversified portfolio of high-risk/high-return investments and low-risk ones, by putting the high-return stocks into the IRA, you keep all the capital gains in that tax-deferred space. (I say tax-deferred rather than tax-free because eventually the gains are supposed to be taxed, depending on whether the Romneys withdraw funds from it or pass it on to their heirs.)
More interesting than how Romney did it is the fact that it's even possible to wall off such a massive amount of money in an IRA. A policy that allows and encourages people to save enough for retirement makes a lot of sense, but this is way beyond what anyone needs for retirement. It's doubtful that anyone in Congress, when IRAs were created in 1974, imagined they were creating a system for large fortunes to be held untaxed, but that seems to have been the effect.
There are two important points about the tax system that Romney's taxes, even what we already know about them, reveal: The first is that the creation of tax-deferred accounts can take huge amounts of investment income out of the tax system entirely. A major thrust of Republican tax policy has been to expand the number of opportunities to put money – and the income it generates -- into accounts that fall outside the scope of taxation. These include various forms of IRAs, health savings accounts, education savings accounts, and others. Many of them benefit the middle class, although they provide little value for low-income workers. But as we see from the Romney example, they can provide huge benefits to the wealthy. Any serious tax reform should aim to reduce the number and scope of these accounts in order to bring as much income as possible under the purview of the tax system and keep rates as low as possible.
And second, Romney's taxes reveal how misleading just looking at the “rate” paid by Romney or any other wealthy person really is. When we eventually see the returns, we won't know what percentage of Romney's income he pays in taxes because we aren't seeing all of his income – some large amount of it is flowing through this IRA. Again, that's not a Romney problem; it's an example of how ordinary high-end tax practices make it difficult to even judge whether the system is fair or equitable.
When we eventually see Mitt Romney's tax returns, I hope that the debate about whether he's a tax cheat or a mere tax-avoider won't distract us from the fact that we've created a tax system that doesn't make any sense and absurdly benefits the very well-off. There's a choice between policies that would take the tax code even further in that direction and policies that would begin to restore sanity and fairness.
Mark Schmitt is a senior fellow at the Roosevelt Institute.