An Accidental Tax Boon

By Robert H. Nelson
Thursday, June 1, 2006

Sometimes in Washington, good things are more likely to happen by accident than by congressional or executive design. Treasury secretary nominee Henry M. Paulson Jr. is no doubt aware of this fact, but it's one worth keeping in mind in the continuing debate over tax reform, which is sure to command a good deal of the new secretary's attention. I'm thinking of one program in particular: the alternative minimum tax, or AMT.

The AMT is viewed by many as a bad thing. Yet, consider this: There is wide agreement among economists on the benefits of a federal "flat tax" on income that would apply a uniform rate to every taxpayer and eliminate most current deductions and tax credits. A flat tax would get rid of a large number of economic distortions resulting from the many tax "subsidies" that often benefit narrow interest groups. This is tax "pork," and Congress is as addicted to it as to the ordinary spending kind.

In places around the world, including Eastern Europe, governments creating new tax systems have been turning to a flat tax to avoid this sort of thing. What does this have to do with the AMT? Just this: As Post business reporter Albert B. Crenshaw has noted, the AMT "approaches a modern-day flat tax." It imposes a uniform rate of 26 percent up to $175,000 in income, and above that 28 percent.

Tax revolutions are few and far between. Taxes are so important to the economy that major changes in tax law are best achieved incrementally, giving notice well in advance and avoiding potentially large disruptions from big surprises. That's part of the genius of the AMT. If it is left alone, it will move us gradually but steadily toward a flat tax on income as inflation brings more people within its ambit.

Some leading Republican conservatives have long advocated a flat tax. Yet few of them are speaking out vigorously for retention of the AMT. In fact, many are joining the clamor in Congress for its repeal or limitation. It would seem that they were either hypocritical in advocating a flat tax or have somehow failed to recognize that the AMT is in essence a new, evolving form of flat tax.

Many Democrats are joining the calls for drastic cutbacks in the AMT. This shows a certain disregard for the fact that the existing system of tax subsidies is most generous to higher-income groups and does less for the bottom half of the income distribution -- their supposed constituency.

The alternative minimum tax dates to the 1960s -- and in its present form, to the 1980s. It was never intended as a major tax reform but rather was simply a political expedient to provide some cover when a few very rich people were revealed to be paying little in income taxes. But as Americans' incomes have risen, more and more people have been finding that their tax payments are now determined by the AMT.

Congress has already taken steps to reduce the AMT's impact. The recently enacted tax bill raises the special AMT "standard exemption" to $62,550 for a couple filing jointly and to $42,500 for a single filer. At these levels, some 5 million taxpayers will be subject to the AMT for their 2006 taxes. But these changes are for one year, and absent new congressional action, the exemption will fall back to $45,000 for couples and $33,750 for individuals in the 2007 tax year. If that happens, as many as 25 million taxpayers might be affected by the AMT. We would be moving toward a nationwide flat tax.

If we wait long enough, and with some continuing degree of inflation, the AMT flat tax eventually will apply to most taxpayers. The AMT will, in effect, have become the federal income tax system. And unlike most other important policy changes, this is one in which Congress need do nothing, although at some point it would probably be desirable to modify details of the current AMT that limit its effectiveness as a flat tax.

If the present AMT rates were applied as a universal flat tax -- and especially if the AMT exemption were reduced and certain remaining AMT exclusions eliminated -- the resulting federal revenue might even come to exceed current expenditure levels. The solution would then be to reduce the flat tax rate (the AMT rate) so that revenue and expenditures were brought back into balance.

In the longer run, the AMT could open the way to more radical reforms that might even change the basic nature of Washington spending habits. One option would be as follows: Each year the president would submit his budget proposal, and Congress, in response, would enact final appropriations. A neutral expert commission would then estimate the resulting federal revenue requirements, and a new flat tax rate, calculated to balance the budget, would be set for the forthcoming tax year. If Congress wanted to go on a spending spree, taxpayers would see the consequences directly and immediately in their pocketbooks.

The Social Security system is another area in which the AMT might facilitate radical change. Social Security taxes could be abolished and the flat tax adjusted upward to compensate for the lost revenue. The Social Security trust fund is largely an accounting fiction, and it is time to integrate the Social Security tax with the income tax system. Alternatively, Social Security tax payments could become a deductible credit from the required AMT payment.

Such major changes in tax law, and some needed refinements to the existing AMT, can be debated and discussed. Right now, the most important step is to keep Congress from ruining a good thing. If it can be persuaded to leave the AMT alone next year and in future years, Congress will continue progress toward a flat tax revolution that has been in the works for many years. Such a gradual process is probably the only way the United States will ever adopt such a major change. The AMT is a tax policy windfall that ought to be protected and preserved.

The writer is an economist and professor in the School of Public Policy of the University of Maryland.

© 2006 The Washington Post Company