A Bloomberg article from yesterday highlighted the fact that a trust set up by Mitt Romney to benefit his children and grandchildren relied heavily on tax loopholes for maximum returns. Romney was able to avoid gift and estate taxes by relying on a vehicle known as an “intentionally defective grantor trust,” or IDGT, which tax planners sometimes refer to as “I Dig It.” This type of trusts allow donors to gift unlimited amounts to their children and grandchildren free of gift or estate taxes (the top gift tax rate is scheduled to return to 55 percent in 2013, after being cut significantly by President George W. Bush). The value of the Romney family trust is not counted, according to the article, as part of the $250 million that Romney’s campaign cites as his net worth.
Tax avoidance such as this relies heavily on the preferential treatment of capital gains in the tax code. As the article highlights, when a trust such as the one set up by Romney sells assets at a profit, the donors are able to pay relatively low capital gains rates on behalf of the trust. A Tax Policy Center report earlier this year that looked at the distributional effects of tax expenditures found that “relative to the population as whole, high-income taxpayers would lose the most from eliminating special rates for capital gains and dividends.” Romney and his running mate Paul Ryan have ruled out closing this costly and lopsided loophole in the tax code, and would also do away with the estate tax.
As the figure below illustrates, the share of households paying taxes on qualified capital gains and dividends gets larger as filers fall into higher cash income distribution groups. Almost 90 percent of households with income over $1 million annually benefit from these preferential rates, as compared to just 32 percent of households with incomes below $100,000. This can lead to substantially lower effective tax rates for the very rich.
While taking advantage of these loopholes (and promising voters he will double down on their existence if elected), Romney has simultaneously criticized other Americans—the 47 percent he singled out who don’t pay federal income taxes (in reality it’s 46 percent, and they nearly-universally do pay other taxes)—as benefiting from favorable government policy. Yet, by avoiding the gift tax and taking enormous advantage of preferential tax rates on unearned income to keep his effective rate low, Romney is able to build, as one tax law professor quoted by Bloomberg noted, “dynastic wealth.”
It is policies such as these which constrain mobility—literally the likelihood of a person to move up or down the distribution scale of income, earnings, or wealth. As the figure below from The State of Working America, 12th Edition‘s mobility chapter shows, the wealth of one’s parents greatly impacts the wealth of their children. The first two lightly shaded bars show that 65 percent of children born to parents in the bottom wealth fifth ended up in the bottom two wealth quintiles (7 percent moved to the top quintile) while more than one-third of children born to parents in the top wealth fifth ended up in the top quintile. If there were perfect mobility, all the bars in the graph would equal 20 percent.
In short, people at the very top are able to take advantage of a number of different tax loopholes that can save huge sums of money—which they can then pass tax-free to their heirs. It is these loopholes that have allowed Romney to sidestep gift taxes on $100 million put into a trust, and these loopholes that have allowed Warren Buffet to pay a lower effective tax rate than his secretary. As the debate continues about tax fairness, it is key to keep in mind that loopholes and preferential tax rates afford massive benefits at the very top of the spectrum.