The tax report

Posted: Oct 25, 2005 12:05 AM

Next week, the President's Advisory Panel on Federal Tax Reform will issue its report. According to press leaks, its principal recommendation will be to eliminate the Alternative Minimum Tax and pay for it by scaling back deductions for mortgage interest, state and local taxes, and health insurance. This is necessary because President Bush mandated that the commission's proposals be revenue-neutral -- neither raising nor lowering aggregate federal revenues.

 Almost all economists on both the left and the right decry the AMT and welcome its abolition. It is complicated and time-consuming to calculate, and increasingly affects those in the lower and middle classes who were never meant to bear its burden. This results from the fact that the income threshold that triggers the AMT has not been increased permanently since the tax was imposed in its current form in 1986. Over the years, inflation, real growth and various tax cuts have exposed more and more taxpayers to it.

 The AMT is truly an alternative tax system that operates in parallel with the regular income tax. It is a kind of flat-rate tax system with just two brackets, 26 percent up to $175,000 of income and 28 percent on the balance. The base of the AMT is broader than that of the income tax. For example, one loses deductions normally allowed for state and local taxes and interest on home-equity loans. There is an exclusion of $58,000 for married couples filing jointly and $40,250 for single persons. Unless Congress acts, however, these thresholds will fall next year to $45,000 and $33,750, respectively.

 According to Congress' Joint Committee on Taxation, in the absence of legislative action, the percentage of taxpayers affected by the AMT will rise from 2.7 percent this year to 13.9 percent next year and continue rising to 20.4 percent in 2010. Net federal revenue from the AMT will rise from $20.7 billion this year to $109.6 billion by 2010.

 According to a Treasury Department fact sheet prepared for the tax commission, revenues from the AMT are rising so rapidly that by the year 2013, it will raise more gross federal revenue than the regular income tax. However, this assumes that AMT income thresholds fall as scheduled and that existing tax credits can be applied against the AMT. Elimination of the tax credits would cause AMT revenues to exceed the income tax several years sooner.

 Clearly, the easy thing to do is support elimination of the AMT. It is stupid to have two separate tax systems operating simultaneously. However, I think the tax commission missed an opportunity to use the AMT creatively to implement radical tax reform. Instead of keeping the regular income tax and getting rid of the AMT, the commission should have considered getting rid of the income tax and keeping the AMT.

 This is not a new suggestion. As long ago as 1983, Yale University tax professor Michael Graetz suggested that the AMT might form the basis for a kind of flat rate tax system that could eventually replace the income tax. In 1986, flat-tax pioneers Robert Hall and Alvin Rabushka of Stanford's Hoover Institution wrote an article for The Wall Street Journal suggesting something similar.

 More recently, Graetz updated his proposal. In a 2002 article in the Yale Law Journal, he proposed a plan that basically involved getting rid of the income tax, keeping a version of the AMT and replacing the lost revenue with a value-added tax, a kind of sales tax. The result, he said, is that the vast majority of Americans would not have to file tax returns or pay any income tax at all.

 In August, Urban Institute scholars Len Burman and David Weiner published a discussion of the idea of keeping the AMT and abolishing the income tax in a paper titled, "Suppose They Took the AM Out of the AMT?" They point out that the main drawback is elimination of the Earned Income Tax Credit, which gives many low-income workers a negative tax rate -- that is, they pay no income taxes but get a "refund" from the government anyway. This is also the main problem with the flat tax -- even imposing a zero tax rate would constitute a tax increase for many people.

 Burman and Weiner report that abolishing the income tax and keeping the AMT would reduce average and marginal tax rates for most tax filers. The average marginal rate would fall from 24.7 percent to 23.4 percent, and from 34.4 percent to 27.9 percent on those at the top.

 Clearly, a simply substitution of the AMT for the income tax is not viable. It could still form the basis upon which a viable proposal can be developed, however. When Congress gets around to looking at tax reform, it should at least consider the idea.