Here's How Mitt Romney Might Have Paid No Taxes

One clue on his 2010 return suggests his 2008 and 2009 tax bills may have been extremely low.

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Did he or didn't he? This is the oddly intriguing question swirling around Mitt Romney as critics contend that he may have paid no income tax for some portion of the last 10 years.

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Senate Majority Leader Harry Reid has become chief inquisitor in this weird populist trial, claiming that a "successful businessman" familiar with Romney's finances told him that the Republican presidential candidate paid no taxes for a decade. There's a McCarthyist air to Reid's charge--since there's no proof that it's true--yet it may also be politically effective, since Romney already struggles with an aristocratic, out-of-touch image.

If Romney has paid taxes, as he insists, he could clear up the whole controversy by simply releasing several years' worth of tax returns, beyond the 2010 return and the 2011 estimate he's already released. But he has refused, and there may be good reason for that. "I wouldn't be surprised if he paid nearly zero taxes in 2008 and 2009," says Brad Badertscher, an accounting professor at the University of Notre Dame. "It's going to look bad no matter what he does."

Theories about Romney's tax strategy tend to focus on offshore investment vehicles and secretive accounts, but basic investing and accounting scenarios could easily explain a low tax bill. The clue comes in Schedule D of his 2010 return, in which he claimed a $4.8 million loss carried over from prior years. That helped reduce his tax bill for 2010, in which he paid $3 million in taxes on $21.7 million of income, for an effective tax rate of 13.9 percent.

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The carryover means that Romney probably claimed a much bigger loss a year or two earlier, which could easily have pushed his tax rate for 2008 or 2009 down to the low single digits. Most investors lost money in 2008, the year that Lehman Brothers collapsed and the S&P 500 stock index fell by 37 percent. Romney was probably no different.

During bad years, wealthy investors often use a legal strategy called "tax harvesting" in which they sell weak investments at a loss, which they can use to offset the tax they'd need to pay on gains from better-performing investments. The loss can be carried forward, to help lower the tax bill in later years when investments might have done better. "It's very common for sophisticated investors," says Badertscher. "It's a good time to clean out your portfolio, sell the losers, and use the losses for tax purposes." Romney has said that his investments are in a blind trust, so if his advisors made such moves, they may have done so without his input.

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In 2010, all of Romney's income came from investments as capital gains, dividends and interest. He claimed no income from wages or salaries. So his maximum tax rate would have topped out at around 15 percent—the rate that applies to most investment income. The loss carryover, sizeable charitable donations and other deductions helped shave his effective rate to 13.9 percent.

About half of Romney's income in 2010 came from capital gains. If that were zeroed out in 2008, say, on account of the crumbling economy, it could have cut his income for that year to $10 million or less, with a huge deduction for a capital loss. Combined with the same sorts of charitable donations and other deductions he claimed in 2010, that could have pushed his tax burden close to zero. If Romney's losses were big enough in 2008, he could have carried a portion of the loss forward into 2009, helping lower his taxes then, too. The fact that the loss carryover appeared on his 2010 return suggests that may well have happened.

Romney, in response to Reid's claim, has insisted that he paid taxes every year, and paid "a lot of taxes" overall. If true, that means Romney never evaded taxes altogether. And it would be hard to fault Romney for abiding by a tax code that simply tends to favor wealthy investors like him. Still, a typical worker earning $50,000 faces a maximum tax rate of 25 percent, so Romney's tax rate could have been a fraction of what most middle-class earners pay. Nor do most workers employ complex strategies to whittle their tax rate down to single digits.

Reid may suspect that, and simply be baiting Romney because he knows the candidate has little to gain and plenty to lose by releasing further returns. Meanwhile, Romney the candidate wants to eliminate taxes on all types of investment income for middle-class families, which might be a pre-emptive way of saying that the tax advantages he enjoys should be extended to all taxpayers.

President Obama wants to do the opposite. He has proposed raising the tax on capital gains from 15 percent to 20 percent, and treating dividend and interest income the same as earned income, subject to whatever bracket the taxpayer happens to be in. If more of Romney's tax returns do become public, they might have the unintended effect of advancing his opponent's tax plan.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.