Tuesday, December 12, 2006

Tom's Modest Proposal for Alternative Minimum Tax Reform

by Tom Bozzo

While I was in D.C. last week, I discussed a not-uncommon financing problem (use a standard auto loan or home equity credit to buy a car, the HELOC rate being a bit higher) with a friend of mine from grad school who works for Big Consulting Firm. The decision hinged on the tax treatment of the interest income; the combination of high (but not so high) income, absurdly expensive house in a close-in suburb, and two very cute and sweet young dependents put him in what was described as "AMT hell." As it turns out, this makes the financing decision in favor of the auto loan, since the interest on home-equity credit is not deductible when used for purposes other than home improvement.

When I got back, I popped some provisional 2006 tax data into a trusty spreadsheet to determine if we were going to enter the first circle of AMT hell ourselves — we've just missed it in recent years, but the crosshairs of the hidden Republican policy of soaking the not-quite-rich are squarely on us. It turns out that we will miss the opportunity to pay AMT again (yay!), but only because the AMT exemption amount was increased as part of the current stopgap fix to keep elements of the upper-middle-class pocketbook-vote from offering Republicans the cigarettes as anti-war and anti-stupidity voters line them up against the metaphorical wall.

One of the problems future Congresses will face is that the successive stopgap fixes to the AMT will cost progressively more in lost revenue, as its bracket-creep flaw was used as a feature in the design of the Bush tax "cuts" to make it look like they were blowing a smaller hole in the federal budget. So, as has been widely reported, AMT will gradually overtake the ordinary income tax system for the upper-middle and even middle classes.

The government needs the money to keep late Boomers and early Busters from eating cat food in the middle of the century, among many other things, and assuming Republicans aren't eager to raise the money from a simpler and fairer ordinary income tax, outright repeal of the AMT is not in the cards.

The question is, how to fix the AMT's major pathologies? Here are my suggestions:
  1. The obvious one, index the AMT's "brackets" for inflation. This will, itself, go most of the way to arresting the problem of the AMT sneaking up on lower-upper-middle class and eventually middle-class taxpayers without stopgap interventions by Congress. This will eliminate a good bit of the AMT revenue stream, so:
  2. Lower the AMT's exemption back to the $50,000 or so (for a family) that would prevail without the temporary fixes (it's $62,550 for 2006). To mitigate the effects on families who are on the bubble now:
  3. Incorporate personal exemptions into the AMT. This would make the exemption change a wash for a family of four, and eliminate the AMT penalty for large families of modest means.
  4. Currently, mortgage interest is AMT-deductible, while state and local taxes are not. Now, many economists will tell you that the tax subsidy of mortgage interest is unnecessary, while a common political justification for tax breaks that happen to benefit the very rich is that claimed double taxation is manifestly unfair. And, unlike some forms of capital income taxation, the AMT treatment of local taxes is manifestly double taxation. So the Tom Solution would reverse matters and allow AMT deductions of local taxes but not of mortgage interest. This, sneakily, would effectively retain the mortgage interest deduction for non-AMT payers while eliminating the subsidy for upper-income earners who've used easy mortgage credit to finance their exurban McMansions. As an added bonus for the new Congress, it would eliminate the tax-on-public-services part of the Blue State tax.
  5. The AMT has two rates for income above the exclusion amount, 26 and 28 percent, which once represented relatively low rates on a broader income base. But now the lower rate is arguably too high, in the sense that it's now higher than the 25 percent ordinary income tax marginal rate paid by many upper-middle income taxpayers and so AMT dings you in part just for paying the ordinary amount of ordinary income tax without any advanced tax trickery. So that rate should be lowered, a point or two below 25 percent, and the top AMT rate should be raised to, for a round figure, 33 percent (applicable to incomes north of $200,000 or thereabouts)-- closer but not quite to the top ordinary income tax rate.
  6. Additional political hardball bonus: the AMT is currently used as a blunt instrument for tort reform, as legal fees aren't AMT-deductible. This, David Cay Johnston documents in Perfectly Legal, has had the effect of socking rather grievously wronged individuals with huge tax bills. Such fees should be deductible. That's another obvious double-taxation case, since the fees are taxable as the attorneys' incomes
Of these, numbers 1-3 shouldn't really bother anyone — inflation indexing and eliminating the family penalty would be obvious targets for a permanent fix.

With number 4, I'm admittedly brandishing a long aluminum pole in the vicinity of overhead wires, if not quite sticking my tongue to the Third Rail. In large part, this is sticking it to conservatarian economists who decry pseudo-double-taxation of capital income while professing that real multiple taxation of wages and salaries is fine because it helps us all resent our local public services as if we were Stephen Moore.

Number 5 is simple reality — someone's tax rates will have to go up if the government's fiscal balance is to be kept even in the ballpark of a populist's moderate on-budget deficit. Call me crazy, but the taxes might as well be paid by people who can afford it.
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