The other day I tweeted a paraphrase from one of my favorite bloggers Atrios regarding Mitt Romney's tax returns that went something like "the tax rate on any money the pile of cash earns is much lower than it is on the money earned by people who actually work." A couple people asked me to explain this a little more so I thought it would make a good bloggy topic.

Fairness
This is basically all about whether or not "the system", which for the purposes of this blog post means the IRS, is really all that fair. I would argue that it's not, that instead of favoring opportunity and growth for the general public, the system is sharply tilted to favor established interests and the already wealthy, whether self-made or born that way.

For background, GOP candidate Mitt Romney is the richest guy to run for president in a while. He's no Ross Perot, but he's up there. He'd be the richest US President since Herbert Hoover. In 2010, on an income of $21 million ($59k a day), he paid an effective tax rate of 13.9%.

This is quite favorable compared to income from wages, what most of us earn, which is subject to the normal income tax — ranging form 10% to 35% — plus around 7% payroll tax. In a system that is supposed to progressively tax higher earners, it's an failure to have the effective tax rate for the wealthiest individuals be about that of someone earning 300x less.

Self-employed people and small business owners (LLCs and S-Corps) face an even more daunting tax situation: double the payroll tax rate, as well as personal income taxes on all profits. Incorporated businesses (C-Corps) are theoretically taxed at a 35% rate, which is also high. However, in practice large corporations tend to avoid much of this taxation through loopholes, shelters and offshore holdings — e.g. GE earned $5B in 2010 and paid not a dime. Sadly, this kind of accounting ninjitsu is not readily available to even mid-size companies, much as the best tax-avoidance strategies for citizens are only really options for "high net worth individuals."

I've experienced this personally as an owner of all three kinds of major business incorporation forms. The structure of the tax code makes it hard for small businesses to grow beyond a modest break-even status. Any attempt to build up cash reserves is taxed heavily. The incentive is to spend down any profits and fund growth by taking on debt or financing. I think there's some value in encouraging businesses to spend — we don't want corporations to become hoarders of cash — but it should likely be focused on larger entities — who are, in fact, hoarding cash, by the way — rather than mom-and-pops, regional outfits, or bootstrapped ventures. Not to mention what happens in this model when bank lending dries up.

But I digress. The point is that "high net worth individuals" like Mitt Romney and Warren Buffett are treated differently than most of us by the tax code. It seems unfair.

Capital Gains
As Mitt is quick to point out, his tax return is all perfectly legal*. He's just paying what he owes, and it's true. This illustrates quite well how the system is slanted to favor "the 1%"**. For people of means such as him, income is derived largely through un-earned means. In tax terms, that's called "capital gains", meaning investments. Income from capital gains are taxed at 15%, and not subject to payroll tax. If you add in some charitable donations and a few other tax shelters, it's easy to see how Mitt gets that low effective rate.

There are many proponents of this status-quo, even those who want capital gains taxes eliminated entirely. The primary moral argument is that capital gains taxes are a tyrannical "double taxation" because at one point the were "already taxed as profits", or "already started as earned income". The primary practical argument is that investment should be incentivized, and thus taxed at a lower rate. The moral argument is by far the more flimsy, so I'll deal with that first.

Other than income from dividends — where corporations deliver some of their profits direct to shareholders, and which represents a small portion of most income in most portfolios — capital gains come from the classic buy low/sell high. Usually stocks. It doesn't take a mathematical wizard to understand the difference between a spread in stock price and corporate profit. For starters, the average price-to-earning ratio of the S&P 500 is currently 22x, creating a problem of proportion. Further, stock values do not closely track profits or profit margins. The connection between a capital gain made by buying stock in Google at IPO and selling it now is at best tangentially related to the amount of money Google made in the mean-time.

Dividends, though, are in fact a pass-through of corporate profit to shareholders. Here the argument of double-taxation has some potential merit. However, as the GE example shows, the notion that corporations "already paid taxes" on the profits may or may not be accurate.

Finally on the notion of the original stake for any investment "already being taxed", that's most likely true. Unless a portfolio was inherited under Bush-era estate laws — which allow wealth to pass to an heir without restriction; something that once set the US apart from aristocratic monarchies in Europe — people tend to start by investing their earnings. So they pay tax before buying their stocks, it's true. But note the "gain" part of capital gains tax: you're not being taxed on your investment or net worth; you're taxed on a realized gain in your cash position. When you buy low and sell high, you pay the tax-man only after selling high.

In terms of the practical argument, I don't find it especially compelling. It's the sort of thing that sounds nice on paper, but doesn't deliver in reality. Investment is great for those who can afford it, but the practical reality is that most people aren't going to be in a position to take advantage of these tax incentive outside of potentially buying a house and watching its value appreciate over a few decades. In practical terms, what this means is that people who subsist on un-earned income — people who don't need jobs — are treated preferentially by the tax code.

In short, the rich are assisted in getting richer, which fairness aside this leaves us with a more fragile and less innovative economy. That's why farther-sighted wealthy folks like Mr. Buffett are calling for a change: they can see that their future prosperity rests on improving the foundations of the economy. Others in finance seem to mistakenly think they themselves are the foundations (rather than the beneficiaries) of the current order, and regard any attempt to increase their share of the tax burden as an existential threat.

Clearly I'm in the Buffett camp. I think a strong practical argument can be made for re-balancing the tax rates, using that to provide relief to middle class families and also to subsidize some of the important work which the government is uniquely situated to do in order to help citizens broadly prosper. Renewing infrastructure, delivering on universal health care, driving basic research, these are all things which the private sector either can't or won't do. As a nation we have to spend money to make money, and our current strategy of "spending" (via preferential tax rates) to reward the already-wealthy and (by proxy) inflate the stock value of private corporations clearly isn't working.

What About People Who Pay No Taxes!?!!?!
It's true that a great many taxpayers actually pay no federal income tax. However, more than 80% of them earn less than $40k a year. Those making more typically support multiple children, have a mortgage, and are generally in non-enviable positions.

All these people are paying payroll taxes, likely state taxes, almost certainly sales and gasoline taxes. Consumption taxes on necessities are regressive — that is, they take a greater portion of income from those who earn less — so they hit these people proportionally harder.

Back to Romney
Getting back to Romney, his main virtue is he's an excellent catalyst for a broader discussion of how we deal with inequality. Not only does his personal fortune provoke this discussion, but the source of his fortune presents a few object lessons as well.

Most of his income come from the fortune he made at Bain Capital which was derived through the "carried interest" loophole. This allows managers of funds to take their fees — which can be staggering on a large fund — as capital gains rather than income, even though they aren't investors themselves, just managing other money. People have tried to close this loophole before, but it's obscure and the people who benefit from it are able to finance quite a lot of lobbying.

Secondly, there's his track record at Bain, which consisted of leveraged buyouts. This is the process by which Bain would identify a company that was down in the dumps but had assets (e.g. factories, inventories, natural resource rights, etc) which exceeded its market value. They would then raise a bunch of money, buy the company, sell the constituent parts off or otherwise "turn the company around", and pocket the difference.

That usually meant significant disruption and job losses, but it did require creating at least some value. You can argue they were agents of the infamous "creative disruption" of capitalism: what was ones less-than-the-sum-of-its-parts is broken up and the individual pieces freed to thrive anew.

However, there are a number of cases where it didn't quite go down like that, where finance gimmicks were the profit center: Bain would buy a company, load that company up with debt, pull back a healthy profit for themselves via a "special dividend", and leave the company to go bankrupt. That's much harder to spin.

Finally, there's Romney's family background. He likes to portray himself as self-made, and surely he's been very successful, bully for Mitt, but his dad was also CEO of American Motors Corporation, then governor of Michigan for two terms, then a cabinet secretary for Richard Nixon. Though he certainly seems more capable than George W Bush, Romney is another example of creeping aristocracy in the US: a second-generation elite, seeking the most power ever. It's an increasing and alarming trend in a country that prides itself on being a "land of opportunity".

Romney makes a fascinating GOP candidate because he naturally sees nothing wrong with his position. In his mind he's earned everything fair and square. He doesn't want to increase his own tax burden, or listen to anyone complain about fairness. There is no classic sense of nobilesse oblige; not even a moderately enlightened sense of self-interest. Instead he exudes smarm, condescension, entitlement. A classic lord. If anything, he wants to do something about all those freeloaders.

The Actual Road to Serfdom
I don't use the term "aristocracy" as an exaggeration. Over my lifetime, and especially in the past decade, we've seen a degree of entrenched inequality that's uncommon in our history. Basically, the gap between the haves and have-nots is widening, and fewer families and individuals are moving between the two, even intergenerationally.

That's worrying. Already it seems like humanity is developing into different strata, and that the dominant cohort isn't very bright or keen on much except enhancing/maintaining their position. That's now how I want the 21st Century to go down, as the beginning of a new Dark Age.

There's no forcing universal equality — different people will get different outcomes based on skill, will, starting place and (of course) lady luck — but there is something to be said for fairness, for fluidity, for the egalitarian ideal. Talk won't bring that about, but it's only possible if we start talking about it.

While I like Newt for sheer entertainment value, Romney will make a much more interesting opponent for Obama in this election. It will continue a conversation the Occupy movement finally got rolling this fall: what is the best way to promote prosperity? What is prosperity? How does this relate to individual wealth? How does it relate to public works, public goods, social welfare?

I have some flickering hope that in such a conversation we'll turn away from our implicit future as a nation of lords, middle-managers and serfs: start dismantling the systems which create and support latter-day landed gentry and put those resources to use creating real value, real opportunity.

The choice is ours, really.

• While Romney has a number of tax-haven-style accounts, they appear to be the kind a good accountant sets up for you. If he had shady offshore accounts they would be hiding income, so it wouldn't affect the equation here anyway. Though there's some shady-sounding stuff going on:

A review by the Los Angeles Times/Tribune Washington Bureau found that at least 23 funds and partnerships listed in the couple’s 2010 tax returns did not show up or were not listed in the same fashion on Romney’s most recent financial disclosure, including 11 based in low-tax foreign countries such as Bermuda, the Cayman Islands and Luxembourg.

** Really, it's more like the "0.1%" or even "0.01%" but you get the point