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This is an op-ed piece that I submitted to the New York Times (but was not published.)

A lot of time has been expended on this idea that Republican Presidential frontrunner Mitt Romney, and by association, the wealthiest Americans, pay only 15% of their income in taxes.  As a former Accountant and a current Investment Manager, it’s quite vexing; not only because this idea is patently untrue, but also because it’s veering the national discussion away from the real problems with our tax system.   If we have an issue, it’s not one of “low rates”, but one of tax complexity that is more likely to favor the wealthy.

For some context on this, it’s useful to go back to 1980, when the top nominal tax rate was 70%.  Under Ronald Reagan, that rate was lowered to 28%.  Yet, contrary to conventional wisdom, Reagan’s “tax reduction” actually increased the tax burden on the wealthy.   In 1981, the top 1% paid 17.6% of the tax burden.  By 1988, that share had increased to 27.5%!  [SOURCE]

This seems counter-intuitive to many, but it’s not when you understand the nature of the US tax system.   It was the complexity of the pre-Reagan tax code that allowed the wealthy to pay so little; even if the advertised rate said “70%”, many wealthy individuals were paying effective tax rates near zero.  When Reagan radically lowered the nominal tax rates, he also eliminated a lot of the tax complexity that had allowed many ultra-wealthy Americans to pay virtually nothing.   And in this sense, he increased the fairness of the tax code.

Even if we’re going to focus on making the tax code “fairer”, the debate in Washington is based on myths and misunderstandings.  Back to our headline myth; the idea that Mitt Romney pays an effective 15% tax rate.  Romney has been used as a proxy to display the case of the “ultra-wealthy” and how they pay less taxes than middle income Americans.  This is largely smoke and mirrors.  Romney does pay a 15% income tax rate, but what politicians and the media fail to note is that Romney, and many other private equity firms, would have to indirectly pay corporate taxes.  In fact, the US has a system of “double taxation” on profits; the capital gains tax is only the second layer of that system.

In a simple example, let’s say I decide to form a new C-corporation (as a 100% owner) and put $1 million in equity into the company.  In the first year, the company makes a $100,000 pre-tax profit.   In a simple scenario, the corporation would have to pay 40% in taxes on that profit.  Why 40%?  35% Federal taxes and we’ll assume 5% in state corporate taxes (this varies from state to state).  My after-tax corporate profit is therefore $60,000.

Now, I decided to pay that entire profit to myself as a dividend.  On this dividend I’m taxed at 15%, which is another $9,000; leaving me with $51,000 of my original $100,000 pre-tax income.  I’ll likely have to pay a state income tax, as well.  Let’s assume my state has a 5% tax rate (about average).   That’s another $2,550 in taxes I need to pay.  Overall, my $100,000 pre-tax profit was whittled down to $48,450, for an effective “all-in” tax rate of around 51.5%.   This is much higher than 15% and it’s why the idea that Mitt Romney and Warren Buffett pay a 15% tax rate is misleading.

As I suggested earlier, this is not to say that our system works like this in practice.  Instead, the corporate tax code is riddled with loopholes, silly deductions, and bizarre incentives that large corporations often take advantage of, but that smaller companies often are unable to.   This is why you can find many major American companies with effective corporate tax rates under 10% or 15%, much lower than the 35% statutory rate.  One of the most egregious deductions is for interest, which promotes debt financing over equity financing, hardly a practice the government should be indirectly subsidizing.

By focusing on nominal tax rates, our politicians are focusing on the wrong problems and perpetrating tax myths.  The real problem is tax complexity, and a better solution would be to do exactly as Ronald Reagan did three decades ago — lower nominal tax rates, but make them much flatter.  In fact, the bi-partisan Simpson-Bowles debt reduction commission made a very similar recommendation, but our politicians have largely ignored it.

We should lower the corporate tax rate to 25%, but get rid of all the deductions.  We should lower income tax rates, but eliminate all these layers of complexity.   This is how we can make our tax system “fairer”, more straightforward, and more efficient.  Raising nominal tax rates is a formula that history and empirical evidence have frowned upon.

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