Tax trading trickery

Posted: Apr 20, 2006 12:05 AM

Those who have always opposed all reductions in tax rates on dividends or capital gains believe they have schemed-up a way to cut a one-sided deal. The latest effort appeared in a New York Times piece by David Cay Johnston, "With Tax Break Expired, Middle Class Faces a Greater Burden for 2006."

The tax break was that an extra $58,000 could be excluded from last year's joint return before the 26 percent Alternative Minimum Tax (AMT) might apply to those with a lot of deductions. That "patch" trimmed revenue by $15 billion last year -- less than seven-tenths of one percent.

The idea of trading another AMT patch for a much higher tax on dividends and capital gains has long been a dream of The Tax Policy Center (TPC) -- a collaboration of the Brookings Institution and Urban Institute, two nonpartisan think tanks that always happen to be short of Republicans.

The newest proposed tax deal goes something like this: If obstinate congressional Republicans would simply agree to tax dividends at the same 35 percent rate as salaries, and hike the capital gains tax to 20 percent, then the generous folks on the other side of the aisle might agree to do something (but not much) about the Alternative Minimum Tax (AMT).

To sell such a lousy deal requires a few lousy arguments. The tax traders' most pathetic argument has been to say that millions would be better off with an across-the-board increase in marginal tax rates because then they'd owe so much more in regular tax that they needn't be troubled by the AMT.

As the TPC put it, "If the tax cuts were made permanent, a projected 44 million taxpayers would face the AMT in 2014. In contrast, if the tax cuts are allowed to expire as scheduled, 'only' 26 million would face the AMT in 2014." That means 18 million taxpayers (44 minus 26) would owe so much more in ordinary income tax that the AMT would be comparatively low (and a much better deal than the one they'd be stuck with).

On the other hand, the tax traders' most clever marketing ploy has been to depict the AMT as anti-family. Johnston shamelessly quotes someone from "a politically influential Christian ministry" griping about the AMT punishing the nuclear family. It does, but only because its Democratic architects designed it that way. The anti-family aspect would be easy to fix by removing personal exemptions from "preference items" subject to the tax. That would trim AMT revenues by just 22 percent -- small change.

The tax traders' most devious marketing ploy is to depict the AMT as a huge tax burden about to fall on the "middle class" right away. Yet the only reason anyone in tax brackets of 25 percent to 28 percent became vulnerable to the AMT was because the Clinton administration raised the AMT from 20 percent to 26-28 percent in 1993. Repealing that tax hike would remove from the AMT's grasp anyone whose income is remotely "middle class."

Do you suppose Tax Policy Center economists advocate rolling back the nasty 1993 increase in the AMT? On the contrary, they hope to make it nastier. Their January 2004 "Key Points on the Alternative Minimum Tax" suggested "the AMT could be retargeted at high-income tax avoiders by ... treating the lower rates on capital gains and dividends as a preference item." They were not only opposing reduction of the AMT, but also urging its expansion into a vast new territory.

Since their goal is to retarget high-income families, these seemingly sincere AMT critics are adamantly opposed to repealing the AMT. To repeal the AMT would be "regressive," they argue, because "more than 75 percent of the benefits of repeal would go to households with income above $100,000 in 2010."

For two-earner couples to earn more than $100,000 four years from now may not sound like such a "high income" to you, but it does to them. Since a future income of $100,000 is upper class, then what do these folks mean when they claim the AMT is about to "clobber the middle class"? They certainly don't mean those earning less than $75,000. The TPC estimates in The New York Times show everyone with an income up to $75,000 paying significantly higher taxes from the proposed increase in dividend and capital gains taxes than they would if the AMT went unpatched.

The tables do show that failure to extend the patch might mean an annual tax increase of $212 for any taxpayers earning $75,000 to $100,000 and subject to the AMT, but a prudent man would wonder whether that's a serious number of taxpayers or a hypothetical handful. It is common knowledge that scarcely any taxpayers are seriously hit by the AMT unless they earn between $200,000 and $500,000, with by far the biggest bite being at the upper end of that range. Those earning over $1 million have had their exemptions and deductions phased out, making the AMT's limits irrelevant. Since most of their income is taxed at 35 percent, that also makes the AMT's highest 28 percent rate irrelevant in most cases, but a bargain for a few.

To propose allowing the tax on dividends to leap from 15 percent to 35 percent in exchange for some temporary AMT patch is a terrible idea -- one that would do swift and serious damage to the economy, the stock market and federal revenues. There was never any excuse for trying to tax dividends at a higher rate than capital gains, and it never worked. Anyone who endorses such an incompetent proposal is not speaking as a tax economist, but a political dealmaker.

If anyone seriously wants to make a serious deal, however, let them first propose yanking personal exemptions out of the AMT and rolling back the rate to 20 percent. That would be worth trading something for, but what?

It's heresy, I know, but I would not rule out raising the tax rate on dividends and capital gains to, say, 18 percent. That principal of applying the same flat tax to all capital income could also be applied to large estates, as California Republican Bill Thomas once suggested (we could not have a matching 18 percent tax on interest income, however, if investment interest expense remains tax-deductible).

Until the tax rate on dividends came down, smart investors kept most dividend-paying stocks inside tax-exempt foundations and tax-exempt Roth savings accounts. Nobody can be forced to invest in stocks that pay dividends, and companies can't be forced to pay them. I am not sure if an 18 percent tax on dividends would yield any more revenue than a 15 percent rate, but I am quite sure it would yield much more than a 35 percent rate.

That makes the proposed trade-off as fiscally foolish as it is economically uneducated. It would not be difficult to come up with a deal that is much better on both sides -- a more serious repair of the AMT together with a far less damaging tweak to a couple of tax rates. Any takers?