Politics & Policy

The Tax Reformers’ Tax Increase

Hidden in the package is an AMT offset that hits taxpayers hard.

President Bush’s tax-reform commission came up with some good ideas, and some not-so-good ideas. But buried deep within the details is one particularly bad idea: a $1.2 trillion tax increase.

#ad#The problem stems from the alternative minimum tax. The AMT was adopted over 30 years ago because a few hundred rich individuals with very high incomes qualified for so many deductions that they ended up paying very little in income taxes.

Even though these individuals acted in compliance with the law, liberals found the situation scandalous. So the AMT was adopted to make sure that these millionaires did pay their supposed fair share of taxes. The AMT accomplishes this by denying certain deductions as income rises, particularly when deductions are a high percentage of income. The trouble, however, arises in that the income thresholds for AMT penalties are not indexed for inflation or wage growth. So instead of applying to just a few millionaires, it is starting to apply to many upper-middle-class families. Over time, as nominal wages rise with no inflation adjustments, the AMT penalties will apply to more and more of the middle class.

The problem is getting so bad that the AMT is now projected to raise taxes by $1.2 trillion over the next 10 years, and much more beyond that. A fascinating political twist is that the AMT is hurting most the liberal states in the Northeast and on the West Coast, since incomes tend be substantially higher in these areas on average. Even liberal Democrats from these states have been squawking that the AMT has to go.

Thankfully, the tax-reform commission has recommended abolishing the AMT. But it has also recommended $1.2 trillion in tax-increasing offsets over the next 10 years to make up for the lost revenue. This is where the point of the AMT gets lost. It was never intended to collect big buckets of tax payments from the middle class.

Policymakers have generally assumed that the AMT would be indexed or abolished altogether before it started affecting large proportions of upper-middle-income earners, or the middle class in general. That’s why Senate Finance Committee chairman Charles Grassley recently called for the tax and budget committees in Congress to exclude expected AMT revenues from their baselines.

Republicans and conservatives must not accept $1.2 trillion in middle-class tax increases as the price for abolishing the AMT. When Congress enacted the AMT over 30 years ago, it did not vote for a whopping middle-class tax increase. The tax commission’s revenue offsets would turn it into precisely that.

There is, however, a solution to this problem that could also save the now politically still-born reforms proposed by the commission: Remove AMT repeal from the tax-reform package altogether. Doing so would force liberal politicians from California, New York, Massachusetts, Connecticut, and elsewhere to support outright repeal of the AMT in a separate vote — with no revenue offsets.

With the $1.2 trillion “revenue loss” from the AMT abolition out of the tax-reform package, tax rates in the package could be cut substantially. In addition, tax rates could be cut much more if the revenue impacts of the reform were estimated on a dynamic rather than a static basis.

Static estimates assume that nothing changes in response to tax reforms; in other words, no one alters their behavior in regard to savings, investment, entrepreneurship, and work when taxes are raised or lowered. As a result, static estimates tend be wildly inaccurate. Dynamic estimates, on the other hand, would take these expected changes into account, and would be far more accurate. In the case of lowered tax rates, calculating incentive changes would put more tax revenue into budget estimates, thereby giving reformers the opening to reduce tax rates more.

Ideally, income-tax rates under reform could be reduced to 10, 15, and 25 percent, with that last rate applying to the corporate income tax as well. The precise final revenue estimates would have to be more carefully calculated in this scheme. But maybe the above two suggestions — removing the AMT from the package and the use of dynamic scoring — would be enough to bring the tax reform package close to these rates.

All this would make the tax-reform proposals enormously appealing politically, and stunningly pro-growth. Of course, legislators should still consider more fundamental reforms, such as replacing the income tax completely with a sales tax, or adopting a more pure, but optional, flat income tax. But if all we can get now is the tax commission’s proposals with the above low rates, it would be a huge step forward.

Peter Ferrara is a senior fellow with the Free Enterprise Fund and director of entitlement and budget policy reforms at the Institute for Policy Innovation.

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