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Paulson's Special Tax Deal

By Bruce Bartlett

On Monday, Wall Street financier Henry Paulson was sworn in as the new secretary of the treasury, replacing railroad executive John Snow, who stepped down. Paulson and Snow have very little in common except for one thing: Both were very, very rich when they became treasury secretary. This raises a question in the minds of some people: Why do such people take government jobs, even if it is being secretary of the second-highest-ranking department in government? (State is first, by the way.)

One reason, obviously, is a desire to perform public service -- a belief that they can make a difference in terms of policy that will make America a better place. Another reason is prestige. The first treasury secretary was Alexander Hamilton, and I am sure it is a bit of a thrill to sit in his chair, figuratively speaking.

Also, every treasury secretary gets his portrait in the Treasury building. These portraits line the walls starting to the right of the secretary's office, winding around chronologically from Hamilton to the most recent secretary, who fills the space immediately to the left of the office.

This may not seem like all that much, especially in an administration known to treat its treasury secretaries like errand boys. But at least people sometimes remember treasury secretaries, and sometimes they can be extraordinarily important, such as when we are in a financial crisis of some sort. Who knows any of the former chairmen of Goldman Sachs, the New York investment bank where Paulson has worked for 30 years? I do only because another former chairman of Goldman Sachs was Bob Rubin, who was Bill's Clinton's second treasury secretary.

Last, but not least, among the reasons why an ultra-rich banker might want to be treasury secretary is a sweet little tax deal available only to high-level government executives: a one-time, tax-free capital gains exemption. Given Paulson's reported wealth, this tax deal could save him $100 million in taxes -- nice compensation for a job that will last two years at most. Nice even by Wall Street standards.

This provision, Section 1043 of the Internal Revenue Code, was enacted during the George H.W. Bush administration. It was needed, he said, because too many wealthy people were turning down high-level appointments because they didn't want to pay the steep capital gains taxes when they sold their assets to comply with government ethics rules.

Generally speaking, very wealthy people have the vast bulk of their wealth tied up in one thing -- a single stock or ownership of a business -- that consists mostly of unrealized capital gains. In the case of Paulson, for example, some $500 million of his estimated $700 million wealth is in Goldman Sachs stock. That is because most of his pay over the years has been in the form of stock, rather than cash.

Obviously, it would be inappropriate for a treasury secretary to own such a huge amount of stock in a company that routinely does business with the Treasury on a variety of matters. So he is required to sell his Goldman stock, as well as any other stock in individual companies. Interestingly, he must also sell any Treasury securities he owns. This is a rule that applies only to him.

Assuming that almost all his wealth consists of unrealized capital gains, he would pay 15 percent in federal taxes, plus state and local taxes that are pretty high in New York. That would probably come to about $100 million in taxes without Section 1043.

To prevent someone like Paulson from having to pay a $100 million tax just to become treasury secretary, the law allows him to roll these assets over into a blind trust or a broad-based mutual fund without paying tax at this time. After he leaves government service and sells these assets, the original tax basis would be retained, so in effect he would pay the tax then. But in the meantime, he has $100 million more working for him, earning a return, which would otherwise have gone into the Treasury's general fund.

This illustrates an important point about the capital gains tax. It is really not a tax on income in any meaningful sense, but a transactions tax that is paid when people sell one asset in order to buy another. As long as the money is not being taken out for the purpose of consumption, why shouldn't all investments be treated the way Paulson is allowed to treat his divestment?

It would be a simple matter to establish rollover accounts in which all gains within the account are tax-free and only withdrawals are taxed. It would be like a Roth IRA, except with no age or income restriction. Then everyone would have the same tax benefit Paulson and other government executives have.

Copyright 2006 Creators Syndicate

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