Sunday, August 28, 2005

The Alternative Minimum Tax (AMT) is the New Tax Code

Tax reform is always under discussion in the US. Here are some of the key themes:

  1. Complexity - the code is very complex, with effectively 2 Federal schemes for individuals (regular and the Alternative Minimum Tax or AMT) plus state taxes, estate taxes, property taxes, and often local taxes (New York City or Philadelphia).
  2. Progressiveness - as people make more money, the % of income that gets taxed gets higher and higher. Remember "Taxman" by the Beatles - 1 for you 19 for me (that was the Taxman talking, because the marginal tax rate for England at the time was a whopping 95% once you hit certain income levels)
  3. Key Deductions - deductions are meant to reward certain types of behavior - for example the deductions / exemptions for dependents helps families with lots of kids, the mortgage interest deduction helps people who buy houses, the charitable gift deduction helps people who give to churches, and then there are myriad other deductions that are supposed to encourage / discourage other behaviors
  4. Types of Income Covered - whether or not to tax capital gains, such as stocks held for a certain period of time, or businesses owned in the family then sold, or interest income on savings accounts, or dividend income received from corporations that was already taxed at that level, this is actually a key element of the tax debate, but it is more subtle

What is happening now is that George Bush has been pushing reforms that have made the Federal tax on individuals less onerous. Key items:

  1. Reducing the capital gains tax - if you hold property a long time the capital gains tax is far lower than ordinary income, encouraging people to make investments and then to sell and re-invest the proceeds (rather than holding them forever to avoid the tax bite)
  2. Reducing the tax on dividends received - dividend income was already taxed by the company, so now it is taxed at a lower rate when it gets to you
  3. Phasing out the estate tax - the estate tax exemption is being raised, so that less and less estates should be impacted by it
  4. Other cuts here and there

In general, however, most of these items above are being offset by the rise of the AMT. The AMT doesn't give you a deduction for state and local taxes, and these taxes are huge, especially in older industrial states like New York. More and more people are finding that they do all of their work on the code and then they get swept into the AMT, where their deductions don't count, and they pay more (the way it works is that you EITHER pay the standard liability or the AMT liability, but if you owe more under AMT that is your new payment level).

Here is a decent article about the flat tax from the Chicago Tribune - you need to register to see it.

The AMT is kind of a pathetic form of a "flat tax". The flat tax has been gaining popularity in Europe. Here is a link to Steve Forbes' article in Forbes magazine where he defends the Flat Tax - he has been a consistent and smart backer of the flat tax.

A true flat tax dramatically simplifies the tax code, with the "postcard" being the goal of these plans. A friend of mine who is a tax expert said that we still would have to figure out what to include in revenue, however, and that makes things complex, especially for businesses. Here is an article from the Christian Science Monitor about how are tax policies are becoming less progressive and "flatter".

In reality, of course, the tax code just keeps getting more complex. We keep making the "base" code more difficult, while trapping more people in the AMT. This is very counter productive and a big waste of time.

The reality is that ultimately the AMT WILL become our tax code. Right now our legislators can't find enough offsetting cuts to kill off the AMT without raising taxes elsewhere. And every year the AMT picks up more people because 1) its brackets are not indexed for inflation 2) state and local taxes keep going up, and this deduction doesn't count for the AMT.

I don't know if this is good or bad. It reflects how weak our legislators are, because they don't have the muscle to fix our current code, and a change to a consumption based tax (i.e. a really big sales tax, like 20%) or a European style "Value Added Tax" seems totally unlikely to occur. It doesn't seem likely that we can keep making cuts in the base code that are effectively undone by being irrelevant to your AMT liability indefinitely.

From a political landscape perspective, the AMT hits the high tax (i.e. Democratic) states hard. Thus the Republicans aren't really all that up in arms about fixing it. Since the Democrats will compromise on nothing (look at how obstructionist that they are being on social security reform and the new, middle of the road supreme court justice selection), the Republicans aren't about to offer them a fig leaf with AMT reform. This will definitely push harder on the exodus of people out of the high tax states (i.e. East and West coasts) and into Republican friendly states like Texas, Nevada, Arizona, Florida, etc...

My personal 2 cents is that we should move towards a flat tax and dramatically reduce the complexity of our tax code, which is just a waste of time for everyone and endless work for lawyers and accountants without really accomplishing anything. The endless expansion of the AMT will make it the de-facto tax code of the future, and it is a bit flatter and a lot simpler (by itself) than the current code. I guess that is good enough given our legislative gridlock, we can't expect anything better.

If you REALLY want to change the world, eliminate tax withholding. This idea changed the world because it made businesses responsible for collecting taxes on their employees. Imagine if you had to write your own tax check every month - there would be riots as people realized how much was being taken away from them! Withholding was instituted during WW2 in 1943 - and this, more than anything else, led to the giant growth of our Federal government.

Eliminating tax withholding and making redistricting of house seats would be the 2 biggest items to shake up our political system (in a positive way).

Short of these positive changes, we are stuck with the gradual growth of the AMT instead of the traditional code and direct political referendums such as are being used in California to circumvent our gridlocked and gerrymandered districts.


Dan from Madison said...

Fortunately some people seem to be finally realizing that the tax system is such a mess. The Fair Tax Book has been no. 1 on the NYT bestseller for a few weeks now. It is basically a consumption tax and you can read more at Whether you are a flat tax guy or fair tax guy that is OK with me, so long as it gets fixed!

Carl from Chicago said...

I am not such a believer in a consumption tax, but I agree that pretty much anything would be a conceptual improvement.

I still stand by my prediction that the AMT will effectively represent reform because it involves the least political capital and effort to make it happen - in fact, doing NOTHING (always the most likely course in Washingon) effectively makes it so.

I personally am more in favor of the flat tax. Sad to see us being passed up by Eastern Europe in economics, of all things :<

Dan from Madison said...

Yep, I am a flat taxer too, preferably 17% or so. Most who don't understand the flat tax can't seem to grasp the fact that if my business has extra money, we will buy new buildings, trucks, hire more people, etc.