08/09/2012 11:58 am ET Updated Oct 09, 2012

Loophole Land: How the Wealthy Dodge Taxes

Harry Reid's unsubstantiated charge that Mitt Romney paid no taxes for a decade is a reminder of why so many Americans are turned off by politics. The Majority Leader of the U.S. Senate should not be trafficking in hearsay; if he has an evidence-based attack to make on Romney, he should start with the evidence -- if there is any. On its face, Reid's claim seems absurd: No politician as ambitious and calculating as Romney would pay zero taxes. Even if that were possible under law, Romney surely would have found a way to pay something.

That said, Reid is putting an important issue on the table: the fairness of a tax system in which many wealthy Americans often pay low or even no taxes. This problem is big and may be getting bigger, thanks to various loopholes and more sophisticated use of those loopholes.

Earlier this year, the IRS released a report analyzing the 2009 tax returns of Americans making over $200,000 a year. The report found that over 20,000 filers with an adjusted gross income above $200,000 didn't owe any taxes in 2009. The percentage of affluent filers who owed no taxes was five times greater than in 2001.

So how does a high earner owe no taxes? The IRS report explained that it was usually due to a combination of factors -- particularly income or deductions that do not trigger adjustments under the Alternative Minimum Tax. Investment losses can also be a major factor.

Romney paid a federal tax rate of 13.9 percent in 2010. It's hard to say what factors may have allowed him to pay an even lower rate in earlier years. Romney is known to have made huge contributions to the Mormon church, and one could imagine a combination of charitable contributions and investment losses, along with other deductions, leading to a very low tax rate.

But less flattering explanations are also possible, as tax expert Michael Graetz pointed out last week in a New York Times op-ed. Graetz noted that Romney had huge assets in an IRA -- between $20 million and $100 million. (That in itself is weird, given the strict annual caps on IRA contributions.) If much of his income was earned in the form of returns to these IRA funds, that would dramatically lower Romney's tax liability -- especially, Graetz said, if Romney put "business assets into an individual retirement account invested in a Cayman Islands corporation," thus sidestepping taxes on some of this IRA earnings.

More facts are needed, obviously, to comment authoritatively on whether Romney has engaged in aggressive tax avoidance. Harry Reid should stop making charges until those facts are public.

But the larger, more important point is that U.S. tax laws seem designed to facilitate tax avoidance by the super wealthy. And for every public figure like Romney whose taxes are closely scrutinized, there are thousands of wealthy Americans who needn't worry that their avoidance efforts will ever result in public criticism or shame of any kind. Taxes are private, between you and the IRS. As long as you're within the law, you can do whatever you want. But the law, it turns out, is extremely elastic.

All this points to an important agenda item for the next president: To just not raise taxes on the wealthy, but to significantly tighten the tax code to close loopholes. Interestingly, Romney has pledged to go after such loopholes, although he has been vague about which ones he would close. Perhaps, though, as a man intimately familiar with tax loopholes, Romney has a secret hit list that he'll share with us as the debate over tax policy heats up this fall.

Or so we can hope.