The media focus on Mitt Romney’s wealth and the amount of tax he pays brings attention to the difference in capital gains and ordinary income. The two are quite different, starting with their tax rates. Capital gains are taxed at a rate of 15%; ordinary income carries a top rate of 35%. Deciding which category income falls under is the trick. Carried interest received as a private equity partner and on real estate investments is an example. Romney’s tax experts classified his as capital gains rather than ordinary income.

 

This treatment differs from that received by doctors, lawyers, and other wealth owners. These wealth owners interest income falls into the ordinary income category. For example, someone who buys a house for $450,000 and sells it later for $1 million or more will be able to classify that profit as a capital gain. If the house was the person’s primary residence, half of the gain would not even be subject to tax.

 

A professional who earns $1 million over the same holding period, however, would pay the top ordinary income rate on anything above $388,350 per year. The argument for different tax treatment is to foster the creation of new capital. Some politicians seem to take advantage of this treatment and become reluctant to disclose this fact. The challenge is to create a system that is fair and makes politicians have to account for their indirect spending.