How Did We Leave Behind A Whopping Middle-class Tax Hike?

Throughout the frustrating 2008 Presidential campaign, many conservatives wondered:  How did our party allow Barack Obama to outflank us on middle class tax relief?

Here’s an even more painful question: How could the GOP, after 8 years in the White House, leave a whopping tax increase for millions of middle-class taxpayers?

America needed a tax cut in 2001–and the Bush administration delivered one.  It delivered again in 2003.  But our tax cuts left the possibility of sharp future tax increases for the middle class.  And it’s no surprise that the middle class did not rally to defend them.

What if we had done things differently? What if rather than waiting for “fundamental” tax reform–which never came–we had made the choice after 2003 to make it a priority to reform or repeal the Alternative Minimum Tax, the tax that falls hardest on the middle class?

The AMT was originally designed in 1969 as a legislative response to a famous list of 155 people who, despite having incomes over $1 million in today’s dollars, nevertheless managed to avoid Federal income tax liability.  But time and inflation has eroded this vision.  It has snared, or threatens to snare, millions of taxpayers in the middle class and above. With its complex and arcane rules about what qualifies as exempt for AMT purposes, no wonder Sandra Block of USA Today called it “the AMT zone, a parallel tax universe that’s much scarier than anything you used to watch on black-and-white TV.”

Had there been no 2006 AMT “patch,” over 75 percent of filers with incomes of between $100,000 and $200,000 (for instance, a married couple each earning $60,000) would have been subject to the AMT.  The Treasury Department estimated that for 2006, the AMT would have kicked in at $67,890. And because the AMT eliminates personal exemptions, it hurts families with children in particular.

Because of this direct threat to the middle class, every year Congress has enacted a “patch” essentially keeping the AMT rules the same as the previous year.  Otherwise, as many as 26 million more taxpayers would be caught in the AMT trap this year.  (The cost in lost revenue of this year’s fix will be about $70 billion.)  Even worse, when Congress delays passage of the fix, the IRS must delay the start of the filing season.  This happened last year, and the returns of 13.5 million taxpayers were affected.  (Because state and local tax payments are not deductible under the AMT, the over 10,000,000 returns that include Schedule A could not be processed until the IRS knew what the rules would be.)

So the political back and forth each year over a law that everyone knows will eventually be passed means inconvenience and delays for all.

The 2003 tax cuts lowered marginal rates for many filers, reduced the marriage penalty, lowered capital gains tax rates, capped taxation of dividend income, and helped small business-owners.  On the whole, it was a good package.  But with up to 35 million Americans subject to the AMT by 2011 and up to 45 million by 2014 if we keep the current income tax rates, would we have been better off simply repealing the AMT?

First, a clarification.  It’s true that the 2001 and 2003 tax cuts themselves are principally responsible for the vast increase in the number of filers subject to the AMT.  Lowering tax rates for everyone makes more people subject to the AMT, because it is not indexed for inflation.  And one may make a clever – perhaps too clever – argument that the AMT sword of Damocles hanging over Congress forces a “tax cut” every year.  Opponents of AMT reform such as the Center for Budget and Policy Priorities claim that the idea of a one-year repeal “masks” the true cost of AMT reform, because the “costs” of AMT repeal continue over time (in other words, the taxpayers who pay regular income tax at a lower rate will continue to do so).

But beware, then, of politicians saying that you won’t need to worry about the AMT when the Bush tax cuts expire – precisely so, because your income tax rates will have gone up, automatically, without a vote in Congress.

Treasury has estimated that by 2013 it would be more expensive to repeal the AMT than to eliminate the income tax.  But this analysis assumes that the Bush tax cuts will be made permanent rather than expiring – which no one now expects.

If we assume that the Bush tax cuts will expire in 2010 – as President Obama has repeatedly promised – some might argue this weakens the case for AMT repeal.   Quite the contrary.  Because the number of taxpayers potentially affected by the AMT would dramatically decline (as a result of people being pushed back into higher income tax brackets), the political pressure for AMT fixes will correspondingly decline.  But that doesn’t reduce the injustice inherent in the AMT capturing middle-class taxpayers who were never intended to be snared in its provisions.

During the Bush Administration, voices were raised in support of full AMT repeal.  Nina Olson, the Taxpayer Advocate at the IRS, endorsed repeal in 2003, stating “The AMT is extremely and unnecessarily complex and results in inconsistent and unintended impact on taxpayers… [T]he AMT is bad policy, and its repeal would simplify the Internal Revenue Code, provide more uniform treatment for all taxpayers, and eliminate the oddity of dual tax systems.”  Nancy Killefer, whom President Obama has named the Federal government’s first Chief Performance Officer, endorsed Olson’s views in 2004 in her capacity as Chair of the IRS Oversight Board.

And a bipartisan group of Senators (Grassley, Baucus, Wyden, and Kyl) endorsed repeal in their “Individual Alternative Minimum Tax Repeal Act of 2005.”  They freely admitted that their bill would cost the Treasury $611 billion in lost revenue by 2015 or $900 billion if the 2001 and 2003 tax cuts were made permanent.  Yet they addressed the issue squarely and fairly, not wanting to leave middle-class families at the mercy of Congress every year.

But the Bush Administration’s consistent position was that AMT repeal could only be addressed in the context of broader, “fundamental” tax reform.  After the Republicans lost Congress, that day would never come.   So the Administration’s position was tantamount to pushing AMT repeal off the agenda, leaving the country with what the Treasury Department described as “two parallel tax systems – even for the many millions who do the calculations but ultimately have no AMT liability.”

It’s no answer to respond that by limiting deductions, the AMT acts as a pressure valve to encourage high-tax states to lower their tax rates.  There’s simply no evidence that this has happened.  New York, New Jersey, California, and other high-tax states will make their own decisions regardless of what happens with the Federal AMT.

The Republican Congress was right to pass full AMT repeal in 1999, and Bill Clinton was wrong to veto it.  For many taxpayers, the AMT is a nightmare that threatens their family budgets.  Tax evasion is illegal; tax avoidance is legal but distorts economic incentives.  Tax planning, on the other hand, is what everyone should do.  But that’s exactly what the AMT prevents; with the AMT, for millions of families, it’s virtually impossible to know in advance what one’s tax liability will be.

It’s hard to escape the conclusion, therefore, that the Bush Administration missed a trick by not advocating full AMT repeal in 2003 or later.  Sadly, we cannot always assume that we will win elections.  Without the AMT, we would have had a fairer, cleaner, and more equitable tax system that does not discriminate against families with children or those who happen to live in high tax states.

Honest liberals oppose repeal because the AMT is “an important source of revenue for the Federal government.”  Fine – let’s have that debate, which will become an honest debate on the proper size of government.

So long as the AMT exists in its current form, simple inflation and every tax cut will force more and more people into the AMT, absent a never-ending series of “fixes.”  So these tax cuts won’t really be tax cuts at all.  The middle class faces the prospect of higher tax rates in 2010 when the Bush tax cuts expire or getting hit by the AMT.

Instead, Congress needs to face reality: If it wants to raise income taxes, then it should do so squarely and not rely on the unfair and inequitable AMT.