David Cay Johnston

If President Barack Obama can persuade Congress to reduce the corporate income tax rate to 28 percent from 35 percent, he will move tax rates closer to what other modern countries charge.

But his plan to treat “manufacturing” as a special category, with a 25 percent tax rate, brings us to what I call Obama’s hamburger problem.

The problem is how to define manufacturing. To paraphrase Justice Potter Stewart on obscenity, I know manufacturing when I see it; I just don’t know how to define it in tax law.

Assembling automobiles is considered manufacturing. So what about assembling two hot protein discs with special sauce, lettuce, cheese, pickles, onions — all on a sesame seed bun?

The notion of hamburger-making as manufacturing may seem silly, a bit like the 1981 U.S. Agriculture Departmentproposal to classify ketchup as a vegetable for school lunches. But classifying activities as manufacturing or not becomes crucial if manufacturers pay taxes at a reduced rate.

Imagine all the high-paying jobs Obama’s plan would create. Companies of all kinds will want to hire more tax accountants and lawyers making the case their client’s business activity is manufacturing. These are not the sort of additional jobs America needs.

There could also be more work for economists, engineers and historians whose expertise would be tapped for creative ways to expand the definition of manufacturing. We have the prototype for the reduced manufacturer’s tax rate in the Domestic Production Activities Deduction, a law implemented in 2005 which comes with a plethora of complex eligibility rules that already create more work for tax professionals.

DRAG ON ECONOMY

Scrutinizing tax returns to determine what is and is not manufacturing would further require a diversion of IRS auditors, lawyers and specialists from the more important job of hunting for calculated tax evaders. Inevitably there would be litigation aplenty, a boon to trial lawyers but a drag on the economy.

Building an automobile obviously involves manufacturing. Rocks must be refined to turn their useful elements into steel and aluminum. Much of the added value will be in the engine and transmission, where steels made with special alloys must be heat-treated and machined to endure enormous, and rapid, twisting forces. Increasingly cars are built with plastics, sophisticated chemical compounds that must be created from base materials and then molded or extruded.

But should mere assembly of an automobile qualify as manufacturing? Does fitting the already manufactured pieces together qualify as manufacturing? And what if the parts were all manufactured in, say, Japan while the only activity in the United States was assembling them into a whole?

Would tax law define manufacturing as the process of making a car as a whole? Or would companies lobby for laws that break it into parts with profits earned at different stages of production taxed at different rates? Would that, in turn, mean accounting practices that load costs onto one stage of production to take profits at the 25 percent rate and losses, such as an assembly line, at the 28 percent rate?

Imagine a car company that reports a $200 million profit to shareholders. Now imagine that it reports a $300 million manufacturing profit taxed at 25 percent and a $100 million assembly line loss at the 28 percent general corporate rate. The company’s profit would still be $200 million, but its blended tax rate would be just 23.5 percent.

Hamburgers may seem like pure assembly, but a case can be made that they are more like manufacturing than assembling a car from finished parts made overseas.

Your local hamburger joint starts with raw meat, fresh or frozen. If it comes in lumps then someone must make the meat into uniform discs or squares. Then the protein must be fried, grilled or broiled. Only then can the meat, lettuce and whatnot be assembled.

Eight years ago the Bush administration used this very example to warn about the unintended consequences of tax incentives for manufacturing.

The 2004 Economic Report of the President asked, “when a fast-food restaurant sells a hamburger, for example, is it providing a ‘service’ or is it combining inputs to ‘manufacture’ a product?”

The comment, put in a box on its own page to draw attention to the issue, also noted that “sometimes, seemingly subtle differences can determine whether an industry is classified as manufacturing. For example, mixing water and concentrate to produce soft drinks is classified as manufacturing. However, if that activity is performed at a snack bar, it is considered a service.”

Taxing different corporate activities at different rates is a bad idea unless you think we need more national income spent on gaming the tax system. Let’s not go there.

PHOTO: Russia’s President Dmitry Medvedev (2nd  L) and U.S. President Barack Obama (R) eat their hamburgers during lunch at Ray’s Hell Burger in Arlington, Virginia, June 24, 2010.     REUTERS/Kevin Lamarque

With so much attention placed on Mitt Romney’s verbal blunders, much less has been given to his written plans for the economy and taxes.

The Republican frontrunner’s 160-page “plan for jobs and economic growth,” which he released in September, contains some sound ideas. He would encourage more Americans to save and invest. And one of his proposals would strengthen America’s status as a technological powerhouse. See the plan here.

But there’s a side to the plan that would raise taxes on the poorest 125 million Americans while tilting tax cuts further toward the rich.

President George W. Bush cut taxes for almost everyone who paid income taxes. Romney would make the Bush tax cuts permanent. But that’s only a first step.

He would also raise taxes on poor families with children at home and those going to college. Romney does this by reducing benefits from the child tax credit and the earned income tax credit and by ending the American Opportunity tax credit for college education.

Without these tax breaks, the poorest fifth of taxpayers would pay $157 more in taxes in 2015 than under current policy, the Tax Policy Center says in its analysis of Romney’s plan. The second poorest group would pay $82 more, according to the center, whose past work has been praised by Republicans and Democrats alike.

TAX CUTS

While Romney would make these two groups — the poorest 125 million Americans — pay higher taxes, the top 60 percent all would get tax cuts. The top tenth of one percent would save, on average, $464,000 a year, the Tax Policy Center’s analysis says.

His plan gives one third of his tax cuts to the top tenth of one percent of taxpayers. By comparison, Bush gave this group only one eighth of his cuts.

Romney would also eliminate estate and gift taxes, a policy that I believe would damage the spirit of striving that has served us so well until now, replacing it with a new era of dynastic wealth.

Romney’s campaign did not answer specific questions about his tax proposals, referring me instead to the plan itself.

On the more positive side of the ledger, Romney’s plan would let households earning less than $200,000 a year collect capital gains, dividends and interest tax-free. That would encourage more Americans to build cash nest eggs and to own stocks and bonds above and beyond their retirement plans.

Unlike today, when a shrinking minority of Americans has savings accounts and bonds, in the 1970s a majority earned interest. Back then, a couple could collect $400 of interest and dividends tax-free.

Romney’s plan would give unlimited tax-free interest, dividends and capital gains to about 98 percent of households. (I have recommended the same tax break be given to everybody, but with a $1,000 cap, twice that for married couples, on tax-free capital income.)

NO TAX BREAK

Given the news coverage of the low tax rate Romney paid in 2010, and expects to pay for 2011, people could easily assume he would get a huge tax break under his own plan. That is not the case.

Under his plan, high-income taxpayers would continue to pay 15 percent on their capital income, about the same rate Romney paid in 2010 and expects to pay for 2011.

As a taxpayer, Romney would do much better under rival Newt Gingrich’s tax plan. Gingrich would let everyone collect capital gains, dividends and interest tax-free. Had that been the law in 2010, Romney’s tax bill would have been cut by at least 97 percent, my calculations show.

Another provision in Romney’s plan would be to raise the ceiling on the number of visas issued to holders of advanced degrees in math, science and engineering who have job offers in those fields from U.S. companies.

While this seems like a smart idea, it does have a downside. Software engineers and others already complain that foreign workers on visas are depressing their wages, and Romney’s plan would likely make it worse. But employers will love it.

Romney, whose father was born in Mexico, would also let foreign-born students stay in the United States, provided they earn advanced degrees in engineering, math or science. And he would open the doors to wealthy people because he believes they are “job creators.”

Those last two provisions seem very smart. It is also exactly what happens in Canada, where one in five Canadians is an immigrant.

These are serious issues with potentially far-reaching implications. This is what the media should be examining, instead of verbal trivia from the campaign trail.

PHOTO: Republican presidential candidate Mitt Romney speaks at a campaign event at an RV dealer in Loveland, Colorado February 7, 2012. The Colorado caucuses take place today. REUTERS/Rick Wilking

Newt Gingrich’s 2010 income tax return inspired a quick response from U.S. congressman Pete Stark.

Twelve days after Gingrich, a Republican presidential hopeful, made his return public, Stark proposed the Narrowing Exceptions for Withholding Taxes (NEWT) Act.

This proposal has an uncertain future in Congress, but it would be a good addition to our tax laws, closing a significant loophole that Gingrich took advantage of.

In their 2010 return, Newt and Callista Gingrich declared that most of the money they earned from their multimedia company, Gingrich Productions, was dividends, rather than compensation for their services.

Because the Medicare tax applies only to labor income, this move allowed them to avoid paying $71,152 in Medicare tax — the amount of the dividend times the 2.9 percent tax rate.

Michelle Selesky, Gingrich’s spokeswoman, did not respond to multiple requests over several days for an interview or comment.

This technique is used by many accountants, lawyers, lobbyists and performers who, like Gingrich, set up S corporations, a type of business organization that passes any tax obligations on to its owners.

The same loophole was used by John Edwards, the 2004 Democratic vice presidential nominee, to avoid about $600,000 of Medicare tax on his earnings as a trial lawyer over a period of four years, information he made public showed back then.

THEIR OWN LABOR

Some investors in S corporations have capital at stake but do little or no work. It is reasonable to classify their profits as dividends. But in the case of Gingrich, and Edwards, their income resulted from their own work and it should be taxed as such.

Stark, a California Democrat, told me he introduced the NEWT Act after learning that Newt and Callista Gingrich reported 80 percent of their nearly $3.2 million in income in 2010 as dividends, mostly from Gingrich Productions, which is set up as an S corporation.

Under Stark’s bill, the income from an S corporation with three or fewer principals would be taxed as compensation, thus incurring Medicare taxes.

Passing Stark’s bill and closing this loophole is a matter of fundamental fairness. The principle that government should tax makers of microchips and potato chips alike should also apply to earnings from work, whether it comes from work on the factory floor, or, as in Gingrich’s case, making videos.

Just as you cannot claim a depletion allowance for your aging body, you should not be able to declare that money you earned by working is a dividend.

The official scorekeepers on tax matters, Congress’s Joint Committee on Taxation, estimated in 2009 that closing the loophole would raise $11.2 billion over 10 years.

IRS ATTACKS LOOPHOLE

The IRS has been attacking this loophole in audits, challenging many tax filings that have used the same strategy that Gingrich used. One of those challenges is now before the 8th U.S. Circuit Court of Appeals in St. Louis in a case watched closely by tax professionals.

It involves David Watson, a certified public accountant in West Des Moines since 1982, who paid himself a salary of $24,000 in 2002. He then reported nine times that much in dividends, which reduced his Social Security and Medicare taxes. He followed a similar pattern in 2003. The IRS said the dividends were really labor income and demanded Medicare taxes.

Watson sued. Robert W. Pratt, the chief federal judge in Iowa’s southern judicial district, wrote in a 23-page decision in 2010 that such a small salary was “unreasonable.” A salary of $91,044 would be reasonable for someone with Watson’s skill and experience, he wrote.

The judge then ruled that Watson owed payroll taxes on $67,044 of the money he had labeled dividends, saying this finding “is amply supported by the evidence.” Watson’s case has been argued on appeal and he now awaits a ruling.

Watson told me that he does not think the IRS has the authority to decide what is salary and what is a dividend. Other court cases show that it does. But Congress should remove any ambiguity by passing Stark’s bill now.

Stark’s proposed NEWT Act contrasts with Gingrich’s own tax plan, which he released in December. Under Gingrich’s plan, dividends would not only be free of Medicare tax, they would also be entirely tax-free.

Had Gingrich’s tax proposal been the law when he filed his 2010 return, my calculations show that his income taxes would have fallen more than 90 percent. His is one of the most outrageously self-serving tax proposals I have seen in years of studying our tax system.

When the Romney campaign disclosed in December that the couple’s five sons had a $100 million trust fund, I suspected that, in setting up the fund, the Romneys used a tax strategy that allows some very rich people to avoid paying gift taxes. But it was impossible to know if this was the case without seeing their tax returns going back years.

So when Mitt Romney released the family’s 2010 tax return last week, I went looking. I found a hint on pages 132 and 134 of the return. It showed that the value of property placed that year into another family trust, the Ann D. Romney Blind Trust, was, for tax purposes, zero. The Ann Romney trust is not the same trust as the one that holds the Romney sons’ $100 million, but I wondered if the Romneys used the same approach in prior years when it came to valuing property placed into the sons’ trust.

Reuters emailed the Romney campaign spokeswoman to ask how much the Romneys paid in gift taxes on assets put into the sons’ trust over the last 17 years. The spokeswoman, citing Brad Malt, the Romney family tax lawyer, answered: none.

The idea that someone could pay zero gift taxes on contributions to a $100 million trust fund may surprise people who have heard arguments that the wealthy are overburdened by gift and estate taxes. But the Romneys’ gift-tax avoidance strategy is perfectly legal.

Under tax rules, wealthy people must pay a gift tax of 35 percent on gifts above a lifetime limit known as the “unified estate tax credit.” That limit was $1.2 million for a married couple in 1995 when the sons’ trust was created and $2 million in 2009, but is now $10 million.

So, if the limit is, at most, $10 million, how did the Romneys create this $100 million fund without paying gift taxes?

The explanation may stem from how the Romneys were able to value the assets put into the trust. If I’m right, it involves a special tax deal that Congress gives to people who manage investment partnerships, as Romney did at Bain Capital from 1984 to 1999.

This deal allows these managers to receive a kind of compensation known as “carried interest.” As the tax law sees it, carried interest does not represent ownership of stock or other securities, only the right to receive future profits. Because there is no ownership, the IRS lets people value their carried interest at zero for gift tax purposes if they meet certain technical rules. We asked the Romney campaign if carried interest was involved several times in emails. The campaign declined to comment about this and other specifics.

VALUING A GIFT AT ZERO

To understand how this works conceptually, imagine your employer gave you a bonus in company stock.

You would owe income taxes immediately on the stock as compensation, and it would be taxed at the same rate as a cash bonus. And if you gave the stock to your children, you would owe, on stock above $10 million, a gift tax of 35 percent of the market price on the day you gave it away.

Now imagine that instead of giving you stock outright, your employer gave you only the right to future increases in the value of company shares – which, like carried interest, is just a right to some potential future income. You could give that right to your children and legally tell the IRS that its value was zero provided they hold onto it for several years.

This would be legally true, even if the company’s stock had been steadily rising for years and was virtually a sure bet to continue going up in value. Of course as a matter of economics it would be a very valuable gift to your children.

The scenario of transferring a right to something of value in the future and valuing it at nothing shows up on the Romneys’ 2010 tax return, which reveals two contributions to the Ann D. Romney Blind Trust. Both contributions were valued at zero.

NO COMMENT

The Romney campaign declined to confirm that this is what happened with the sons’ trust. Malt, the family tax lawyer, and spokeswoman Andrea Saul have declined to go further than Malt’s statement that the contributions fell below the unified credit.

The campaign, which set up an email address for journalists with questions about the tax returns, did not offer any comment nor did it respond to specific questions, including whether any of the personal or trust returns had been audited, whether any adjustments had resulted and whether the gifts to the sons had been completed more than three years ago, which would put them beyond any review by the IRS.

There are other perfectly legal techniques that would also allow many millions of dollars to be passed on while avoiding gift taxes.

The Romneys could attain the same result by putting into the trust any asset whose value was expected to rapidly increase. They could also use a trust that creates an annuity for themselves for a few years provided the trust assets grew much faster than the minimum interest rate payout set by the IRS each month. In each of these cases the parents would pay any income taxes and that is just what the Romneys’ 2010 and preliminary 2011 tax returns show. They report the trust income as their own and pay the taxes on the income the trust earned from its rapidly appreciating assets — but no gift taxes.

How much income will flow from these gifts is known only to the Romney family and to Malt, who works at the Ropes & Gray law firm in Boston.

Mitt and Ann Romney appear to have complied with the law. What’s at fault is the law. Congress treats ordinary taxpayers one way and managers of private equity and hedge funds like Mitt Romney another. It’s also a fiction that there is a lifetime limit on tax-free gifts of $10 million when Congress lets unlimited sums pass untaxed this way.

Will this change? It’s hard to say, given the gridlock in Washington. But President Barack Obama’s State of the Union message could signal a new direction. In a speech that mentioned taxes 34 times, he proposed sweeping changes in the tax code, a message that could resonate in the 2012 campaign and in Congress in 2013. Watch this space.

PHOTO: Republican presidential candidate and former Massachusetts Governor Mitt Romney (L) introduces his sons Tagg (2nd L), Craig (3rd L), Josh (2nd R) and Matt, as his wife Ann (C) looks on, at a campaign rally in Des Moines, Iowa January 3, 2012, the day of the Iowa caucus.   REUTERS/Brian Snyder

A tax return says a lot about a man, especially one aspiring to be president.

If Mitt Romney makes good on his promise during Thursday night’s Republican candidates’ debate to release “multiple years” of his returns, it will likely stir up rather than calm the political storm unless he makes public all of his returns from 1984 through 1999. Those are the years when he built a fortune of more than $200 million while running Bain Capital Management.

There’s no suspicion that Romney has done anything illegal. But what should be secret about the taxpaying relationship between a presidential hopeful and his government?

Romney himself said late on Thursday: “I’m not going to apologize for being successful.”

The former Massachusetts governor disclosed this week that he pays about 15 percent of his income in federal income taxes. That’s the same effective tax rate as a single wage earner making $60,000. Most of Romney’s income consists of dividends and capital gains, which Congress taxes at 15 percent. Were his income in wages, he would have paid a much higher rate.

Congress requires that most workers have income taxes withheld from their pay, but not so investment partnership managers like Romney, who cofounded Bain Capital Management and ran it for 15 years. They can earn compensation now and pay taxes later, decades later if they want. It’s called “carried interest.”

At the debate Romney wouldn’t say just how many years of returns he would make public. He has yet to share any of them. Before Thursday night, he had spoken only of releasing returns come April, the 2011 tax deadline. He came under public pressure to deliver more.

Unless he releases the tax returns from his Bain Capital years he will surely be pressed about how much, if any, of his fortune has yet to be taxed and how long he deferred paying on the portion that has been taxed. He will be asked about Bain accounts in the Cayman Islands, Bermuda and other tax havens. While perfectly legal, these offshore accounts convey an unsavory political whiff to many people, including some of his rivals for the Republican presidential nomination.

And what about taxes on the $100 million that Romney put into a trust for his five sons. How much Massachusetts and federal income tax, as well as gift tax, was paid on that money?

None of these questions can be answered without the returns from his Bain years.

MANY HAPPY RETURNS

Romney’s political problems could multiply once families around kitchen tables grasp the fact that while they pay taxes before getting paid, Romney arranged to delay paying his for years. The disclosures could also lead to popular support for ending such deferrals, which President Barack Obama, a Democrat, proposed in 2008 and again in September. Hedge fund and private equity firms have spent a lot of money on lobbying and campaign donations to avert any such change.

Newt Gingrich, a rival for the Republican nomination, released his own tax returns on Thursday to try to embarrass Romney. Gingrich has warned Republicans that Obama’s campaign in the run-up to November’s elections will hammer these tax issues if Romney is nominated. For sure, the Obama campaign would also hammer Romney over any refusal to disclose the full story of his income and taxes going back to 1984. A no-win situation for Romney? Maybe not.

There are presidential precedents that strongly favor disclosure. In March 2008 Obama released his returns from 2000 forward. In 1999 George W. Bush released his 1998 tax return showing how he made $17 million in carried interest from the Texas Rangers baseball deal he managed.

The practice of releasing returns even predates the revelation during Watergate that President Richard Nixon filed four fraudulent tax returns, resulting in felony indictments of two of his tax advisers.

Back in 1968, another Republican businessman seeking his party’s presidential nomination disclosed 12 years of tax returns. That man was George Romney, Mitt’s father, who said it was the right thing to do.

PHOTO: U.S. Republican presidential candidate and former Massachusetts Governor Mitt Romney and his wife Ann relax while on the campaign bus as they leave a campaign stop in Gilbert, South Carolina, January 20, 2012. REUTERS/Jim Young