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Minimal Effort

"We've all seen those commercials where the parents tell the kids that, this year, they'll finally get to go to Disneyland. Well, imagine the follow-up conversation where the parents deliver the bad news that the [Alternative Minimum Tax] took away their trip to see Mickey. This is real life. These are the real economic consequences for middle-class working families who are told they owe more in taxes than they previously thought."

--Representative Richard Neal (a Massachusetts Democrat), House Committee on Ways and Means

Let's try and deconstruct the Alternative Minimum Tax (AMT) soap opera. The AMT is a provision of the federal individual income tax, launched in its current form in 1986. Its aim was to preclude the possibility of persons with high gross incomes escaping tax liability altogether. Essentially it is a parallel tax system. It affects people who tend to have high incomes, a lot of deductions, and returns with complex financial or business transactions. Presently, it is paid by fewer than four million taxpayers. But, without changes in tax law, according to the Urban Institute, it could be paid by as many as 32 million in just three years.

Under the AMT, you lose many offsets to taxable income--including the personal and dependent exemptions, and the deductions for state and local income and property taxes, medical and dental expenses, and other things. In return, you get one large exemption. Instead of the usual tax brackets with rates of 10, 15, 25, 28, 33, and 35 percent, you have just two brackets with rates of 26 and 28 percent. If your AMT comes out higher than your regular income tax, you pay the AMT instead. (Even for an ordinary salaried worker, calculating the AMT can exceed the capacities of the usual tax software.)

Since the AMT exemptions--in 2006, they were $42,500 for a single person and $62,550 for a married couple--are not tied to inflation, inflationary growth in incomes will push more and more taxpayers into the AMT. Before long, it could regularly affect people with annual incomes between $75,000 and $100,000. That's a frightening prospect for Democrats, and many in Congress are wondering how to stop it. The most obvious solution--one necessitated by the new budget rules--involves repealing the Bush tax cuts to pay for AMT reform. That may solve the immediate AMT problem, but not without nixing Democratic social priorities down the road.

The AMT's complexities really require a whole article to even begin to explain--one that nobody would want to read. They are a mess. But its most egregious feature is how, because dependent exemptions are forbidden, the lack of indexation is starting to catch un-rich families with three or more children.

Indexation is a bigger deal than it sounds like. Those of us old enough might recall the uproar over lack of indexation in the late '70s. High inflation pushed people into higher tax brackets, even if their real incomes hadn't risen. It didn't help Jimmy Carter fight off Ronald Reagan's campaign in 1980.

In recent years, inflation adjustments to forestall expansions in AMT coverage have been provided on an ad hoc basis. With the new Democratic Congress, however, these adjustments--tax cuts by another name--are no longer so easy. Under the adoption of pay-go rules, anything that reduces federal revenue (including AMT "adjustments") must be offset by an equivalent tax increase or a reduction in entitlement spending. Otherwise, middle-class people who did not come close to falling under the AMT when it first came into existence would inch closer to it every year. And Bush's tax cuts haven't helped. Since your ultimate tax liability is the higher of the AMT and the regular income tax (and since the tax cuts lowered your regular income taxes), more people end up paying the higher AMT.

Still, even if there were no AMT and no tax cuts, real income growth every year would push people into higher tax brackets (and increase income tax revenue relative to GDP). So, too, would the increasingly unequal distribution of income, since higher-income persons who climb up the tax brackets face higher average tax rates. More than a few people who are newly burdened by the AMT would be paying higher taxes if there was no AMT--because their income growth would push them into higher brackets. In fact, the very richest taxpayers tend not to pay the AMT because--even with all their deductions--the top income tax rates still produce the higher tax bill.

The AMT scourge has been taken up by the new Democratic majorities in Congress. The Wall Street Journal editorialists call it "the ultimate blue-state tax." That's because the AMT denies deductions for state and local income and property taxes, which are higher in the pricey real estate markets of high-tax coastal states. But others have guessed that the AMT falls more on Republicans in those states. Daniel Gross, writing in Slate this week, suggested that expanded AMT liability would hit people who will hate Bush regardless, in states that will vote overwhelmingly Democratic in any case. For that same reason, Gross noted that Bush could afford to ignore the AMT's growing burden on his own well-off supporters.

Democrats who rail against both the AMT and the Bush tax cuts are not being entirely coherent. If they repeal the Bush tax cuts, they raise income taxes on some of the taxpayers who would otherwise pay the AMT. Yet Democratic budget resolutions say nothing about changing the AMT and assume revenues that result from the tax cuts expiring.

For the fiscal year 2008 budget, Democrats need about $50 billion to keep the AMT from catching more middle-class families. Since neither cuts in entitlements nor tax increases on the middle class seem likely, pay-go rules require the Democrats to start attacking the Bush tax cuts this year, rather than allow them to expire after 2010.

One political gambit is to pay for AMT reform for middle-class families by repealing part of the Bush tax cuts. In other words, make no change in expected revenue levels, but change their composition (less AMT, more regular income tax). This is consistent with the Democrats' posture, but it raises a strategic problem.

The current Democratic budget resolutions assume that higher revenue levels (resulting from the expiration of the Bush tax cuts) are mostly devoted to deficit reduction and to Bush's military spending. Virtually nothing is allocated to any new domestic initiatives. A decrease in expected AMT revenue and a matching increase in regular income tax--done in a revenue-neutral manner--will only perpetuate a policy ill-suited to fundamental Democratic interests, for two reasons: First, under this regime, there is no room for domestic spending growth or public investment in the short and medium term. Second, in the longer term (without serious health care reform), there is no room for any domestic spending outside of Social Security, Medicare, Medicaid, defense, and interest on the national debt.

The most urgent incremental reforms are to simplify the AMT and prevent any further incursion into income levels below the six figure level. Taxpayers should be able to keep the most sacred benefit--the family exemptions and personal credits--and at least part of their state and local tax deductions. Naturally, much of the Bush tax cuts will have to go, sooner or later.

The valiant but misguided Democratic assault on the AMT is an unfortunate echo of bankrupt supply-side doctrine and anti-tax posturing. Somebody, sometime soon, will have to make the case for revenue, lest the welfare state fall asleep and drown in the bathtub.

By Max B. Sawicky