Wealth of Nations September 2004

The Message in the Budget

The alternative minimum tax is a nuisance, but the Bush administration is relying on it to balance the budget.
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Needless to say, President's Bush's budget proposal for fiscal 2008 was dead on arrival on Capitol Hill. This is not a criticism, because instant pointlessness is almost a procedural requirement. But it does have implications. Don't ask whether the budget makes sense on its own terms. All one can intelligently ask about these Washington set pieces is whether they advance the discussion of what needs to be done and move the likely outcome in the right direction.

The budget did both, though that was probably not Bush's intention. With a tight grip on spending, the president tells us, the country can have his tax cuts, and then some, and still balance the books by 2012. This is so misleading that, for anybody paying attention, it isn't really misleading: It has the virtue of being fully incredible. Is there anybody in Washington who does not understand by now what keeps the deficit falling in the administration's projections? The answer, not counting the usual fixes, is the alternative minimum tax.

You will have heard of this, because the chances are you are either paying it or soon will be. Because of inflation and rising incomes, the number of households caught by the AMT is growing. If the president gets his way, it will grow much faster. Suppose the budget were passed as it stands and that the tax cuts of 2001 to '04 were made permanent. Then, according to the Tax Policy Center, a joint venture of the Urban Institute and the Brookings Institution, the number of taxpayers caught by the AMT would rise from 3.5 million (4 percent of taxpayers) in 2006 to nearly 40 million (38 percent of taxpayers) in 2012. This massive expansion of the AMT's base is what brings the budget into balance, using the administration's own arithmetic.

True, the White House wants to halt the AMT's reach down the income scale. But the budget includes no long-term proposal to accomplish that. (The administration blandly calls for a "revenue-neutral" solution. But any revenue-neutral alternative to a widening AMT would, by definition, be just another tax increase.) In effect, the administration's outlying fiscal forecast assumes that AMT-creep will continue—and it takes full fiscal credit for this, even as Bush continues to proclaim his tax-cutting zeal. If your taxes go up because the AMT bites—which the White House is implicitly relying on—then that is a still a tax increase, isn't it? What am I missing here?

In short, even the White House is recognizing, albeit not very frankly, that higher taxes are going to be needed to balance the books. And that is the useful purpose that this budget serves. So far as the need for additional revenue is concerned, we are now, apparently, all on the same page.

Where ought we to find this revenue? One possibility might be to let the AMT crawl down the income scale until it has entirely taken over the tax code and the ordinary income tax can be repealed. You can make a case for this, in fact, since the AMT has some nice features, especially when you compare it with the ordinary tax code. But unless it is your intention to drive millions of taxpayers to the point of nervous breakdown, the prolonged transition would leave much to be desired.

When I lived in the United Kingdom, I imagined that American taxpayers had an easier time of things. They pay lower rates at the margin, or so I supposed, and they keep the Internal Revenue Service on a tighter leash than the Brits do with Her Majesty's Revenue and Customs—so calculating one's taxes was bound to be simpler in the United States. Ho. Living in the District of Columbia, I face a higher consolidated marginal rate than I did in the U.K. and higher property taxes as well. (In return, of course, the government here supplies first-rate schools and world-class health care; but I digress.) That is nothing—nothing—compared with the distress induced by calculating my American taxes. The code is insanely complex, of course, as I now appreciate.

But the final capping absurdity, the insult that really lets you know where you stand, is to be told, after hours of grinding through the endless forms, to start over. No, you have not misunderstood, says the IRS: Please calculate your taxes a second time, on an entirely different basis, for AMT purposes. We are concerned that the figure we first thought of is not high enough. Simply compare the two and pay us the bigger sum. Oh, and if you have any suggestions about how we might streamline this process, pursuant to the Paperwork Reduction Act, which we take very seriously, be sure to drop us a line. America, I ask you, is this why you fought the Revolution?

TurboTax notwithstanding (think about this: is it right that calculating your taxes should require a computer, or a professional adviser with a computer?) the docility of the American taxpayer surprises me. The compliance costs of the tax code have been estimated at 20 cents per dollar collected, and to me that feels like an understatement. Simplification surely ought to be a priority if the opportunity for meaningful tax reform should arise. Allowing the AMT to take over by degrees, rather than all at once, scores very low on that scale. Come on. Isn't one tax code enough?

An appealing step toward an outright AMT takeover—remembering that the need to collect more revenue is motivating this discussion—would be to abolish virtually all exemptions and deductions in the existing code, except for one standard deduction. The AMT would no longer be needed. Together with some spending restraint, this would raise more revenue than is required, in fact, to balance the budget. The surplus could be shared among lower rates, a bigger standard deduction, an expanded Earned Income Tax Credit (a necessary exception), and a means-tested health insurance subsidy.

A reform like this would so simplify the system that it would spare tens of millions of households the bother of filing a tax return in the first place. Too radical? Another milder possibility, a midpoint between a zero-exemption regime and where we are now, would be to convert all deductions into fixed-rate credits (so that tax breaks would be worth the same to middle-income earners as to people with very high earnings).

All kinds of blue-sky tax-reform blueprints are perpetually in circulation. Such has been the accretion of distortions and anomalies since the last big tax reform (in 1986) that almost any of these would constitute a huge improvement over what we have. But radical reform is a mighty political challenge—and even when it works (as in 1986) it can veer unpredictably out of control. Where you end up can be a matter of luck.

Radical systemic reform would be great if we could get it. The appetite for change seems to be growing, but a root-and-branch redesign may be beyond the country's political capacity. Short of that, one must hope for piecemeal improvements that push in the direction of fairness and efficiency. Abolishing or limiting some deductions is one such avenue. Another, again remembering that more revenue is needed, is a carbon tax. As I have previously argued, this would attack two significant forms of pollution—greenhouse-gas emissions and traffic congestion. It would make sense to levy such a tax even if additional revenue weren't needed (you could instead use the money to cut other taxes).

If Washington does gird itself to take on tax reform, one avenue is especially worth avoiding. This is the line of thinking, popular with some Democrats, that says, let businesses pay. Raise corporate taxes; shift public spending onto companies, with mandates of one kind or another; tax capitalists more so that hard-pressed workers can pay less. The first two ideas are based on a straightforward misconception—that corporations, as opposed to people, can be made to carry part of the fiscal burden. They cannot. The burden always gets divided between owners, workers, and customers. The third idea is based on the unrealistic hope that you can tax owners of capital more heavily than workers without discouraging investment. Discouraging investment really does, in the end, make everybody worse off.

Fairness and efficiency require that capital and labor be taxed at the same rates. What does that principle say about the Bush tax cuts on dividends and capital gains? It says they should be tweaked, but not abandoned altogether. If, but only if, profits have already been taxed at the corporate level, the distribution of those profits in the form of dividends and capital gains should not be taxed in full as ordinary income. The basic idea is simple: Tax people with high incomes at higher rates than you do people with low incomes. That is good policy. But it is bad policy to discriminate—in either direction—between income from capital and income from labor.

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