January 8, 2007

Cleaning Up The AMT Mess Requires More Than A Quick Fix

With the new efforts at bi-partisanship that the Congress and the Administration are making, one might think that reforming a universally despised tax — the alternative minimum tax (AMT) — would be an easy task.

But like the tax code itself, it’s not that simple.

When Congress enacted the AMT in 1969, it was responding to a media tempest about a few high-income people who had legally paid no income tax. Hardly a scandal, tax law had been explicitly written to encourage earning income from a variety of tax-free sources. Once taxpayers qualified for enough of those deductions and credits, they could actually wipe out their income tax liabilities. The AMT “fixed” this problem with a large, awkwardly shaped band-aid.

It consisted of two alternative tax rates – 26% and 28% – for any taxpayer whose regular deductions and tax credits allowed him to pay less than a certain amount.

Strangely, this second tax system was superior to the ordinary tax system in some ways even though it only hit a small percentage of taxpayers. The AMT system expanded the income base, taking away some deductions that had no economic justification in the first place. The most important is the itemized deduction for state and local taxes, a bad tax policy that encourages high government spending in states and localities where many taxpayers itemize their tax returns.

In effect, the state-local tax deduction funnels money from low-income, low-tax states to high-income, high-tax states. And there’s an even more perverse side effect. Because property taxes are also deductible, the tax code is actually widening the funding gap for education between high-income counties and low-income counties.

So instead of a band-aid solution, like raising the exemption level again, we need fundamental tax reform along with AMT repeal. That’s the only course that will avoid causing further damage that Congress will just have to fix later.

But why now? What has changed after almost 40 years? The AMT’s exemption level used to be high compared to the average income, so almost everyone was exempted. But as has happened many times, a tax originally designed to hit the rich ends up hitting everyone.

Now many taxpayers are wondering, “Will I be hit next by the AMT?” And since the Bush tax cuts in 2003, many more people have been moved into the AMT range. That’s because the Bush tax cuts have dramatically lowered ordinary tax liabilities on all income groups. In many cases, the extra liability is small, a couple hundred dollars from someone who’s already paying many thousands. But in some cases, people are shocked to find out how much more they owe.

Congress will no doubt attempt to relieve many of this new burden, but unfortunately, short-term political solutions are likely to exacerbate the problem. By themselves, proposals such as increasing the exemption amount only kick the can down the road and will have to be dealt with by future congresses. Instead, eliminating the AMT through comprehensive tax reform that combines the good portions of both systems would make a parallel tax system unnecessary in the first place.

First, the federal income tax system should tax all income equally. Preferences, carve-outs, and tax-exempt sources of income are what feed the perception of an unfair tax system.

Second, Congress should eliminate all specialized deductions that encourage people to make decisions based on tax purposes rather than personal preference. These provisions are nothing more than “pork-by-tax-code” spending that slow down the economy and enable lawmakers to quietly shift the tax burden onto less politically favored groups.

The new Democratically-controlled Congress has every reason to address the AMT because it is mostly a blue-state problem. Blue states tend to have the highest concentration of households that earn between $75,000 and $500,000 in Adjusted Gross Income, which is the prime AMT range. And these states tend to have very high state and local income taxes and high property taxes, which are not permitted as deductions in calculating AMT liability.

The AMT mess is a symptom of more fundamental problems in the tax code. Short-term political solutions from either side will not mend a broken, complex system that frustrates most Americans. The urgency over fixing the AMT could be just the catalyst we need for real bi-partisan tax reform.

Gerald Prante is an economist at the Tax Foundation in Washington, D.C.