A Bad Tax With Good Timing

The unsung virtues of the Alternative Minimum Tax

In 1969, Treasury Secretary Joseph W. Barr announced that 155 taxpayers with incomes over $200,000 had paid no income tax. "The news created a political firestorm," write Leonard E. Burman, William G. Gale, and Jeffrey Rohaly of the Tax Policy Center, a joint project of the Brookings Institution and the Urban Institute. "In 1969, members of Congress received more constituent letters about the 155 taxpayers than about the Vietnam War." Thus was born the alternative minimum tax, more widely known as the AMT—the single most reviled initialism in the tax lexicon, which is saying something.

Michael J. Graetz, a tax expert at Yale Law School, writes that the AMT is "the train wreck coming down the tracks." Other commentators make him sound gentle. Announcing the introduction of a repeal bill last May, Sen. Max Baucus (D-Mont.) called the AMT "Darth Vader lurking in our tax code." Senate Finance Committee Chairman Charles Grassley (R-Iowa) another sponsor of repeal, said it was "a mess, and we need to clean it up for good."

Well, any policy so uniformly reviled in Washington can't be all bad. The AMT is a dog, no doubt about that.

But every dog has its day.

The AMT is a separate tax code that operates parallel to the regular income tax. It allows fewer deductions than does the income tax, and it has only two rates, 26 percent and 28 percent. If they earn enough money to be subject to the AMT, taxpayers figure their tax liability both ways and then pay whichever is greater. This weird doppelganger has reduced the number of tax escapees, but that is the only respect in which it has worked as planned.

Because of its 28 percent top rate, it goes easier on the super-rich than does the regular income tax, which tops out at 35 percent. The wealthiest generally pay the income tax, not the AMT. The group that the AMT hits hardest is in the $200,000 to $500,000 range. Moreover, most of the tax breaks that the AMT disallows aren't plutocratic tax shelters at all; they are ordinary deductions that benefit the middle class. The AMT also arbitrarily cancels out many provisions of the regular tax code, which are themselves often pretty arbitrary; if the regular income tax is nonsense, piling the AMT on top of it is nonsense on stilts.

Most important, Congress never got around to indexing the AMT for inflation, as it did the income tax in the early 1980s. The result is that as nominal (not real) incomes increase with inflation, more and more taxpayers fall into the AMT's clutches. Already, in 2006, about 20 million taxpayers qualify to pay the AMT, and the number will rise to 30 million or so by 2010. The number of AMT payers will approach 60 million in 10 years, according to the Treasury Department. For the upper-middle class, the AMT will gradually become the de facto tax system. "It's like kudzu," says Gale, a Brookings Institution economist. "Eventually it just takes over."

As it sweeps in more taxpayers each year, the AMT becomes a revenue machine. In 2007, according to Treasury, it will increase individual taxes by $48 billion; in 2016, by $261 billion. Without reform, the result is an inexorable middle-class tax increase. This is not nice. It is especially not nice for married couples and families with children, because the AMT raises their taxes.

Granted, this is no one's first choice. But is it a train wreck? Darth Vader?

In the real world, the alternative to the AMT is not some clean, rational, fair tax code. The alternative is the income tax, which Graetz is not alone in describing as "a horrible mess." The code contains more than 1.4 million words, he writes, "four times larger than War and Peace and considerably harder to parse." Tax regulations run to an additional 8 million words. Treasury figures compliance costs at roughly $125 billion per year. In his 2005 State of the Union speech, President Bush called the tax code archaic and incoherent. No one was heard to disagree.

The AMT is no less complex than the income tax, and running both systems in tandem is complexity squared. On the other hand, it is not clear that the AMT is a worse tax code than the income tax, and the AMT does have one considerable advantage: It collects more money.

What tax codes are supposed to do, after all, is pay the bills. The current income tax is not doing that. It could pay the bills, of course, if Congress raised taxes, but Congress is more interested in cutting taxes. The bills would be lower if Congress cut spending, but dream on.

Controlling spending is about to grow even harder, with the imminent retirement of the Baby Boom Generation, which will drive pension and health costs rapidly upward. Any politically imaginable spending reductions will be inadequate to pay for the coming increase in entitlement costs. To pay the bills in the next decade, tax increases will need to be part of the picture.

Seen in a fiscal light, the AMT looks less like a train wreck than a safety net. It produces automatic tax increases as inflation extends its reach, and does so at precisely the time when tax increases will be most needed. If one believed in providence, one might say it had pre-positioned the AMT to kick in at America's hour of maximum fiscal need and minimum political will.

For several years, Congress has held off AMT increases by passing short-term patches. It will do so again this year, and no doubt will keep patching for as long as possible. But each year, the cost of the patch grows as the AMT's revenue take rises. "It gets harder and harder to patch," says G. William Hoagland, the director of budget and appropriations for Senate Majority Leader Bill Frist (R-Tenn.) And then what?

"I think the AMT is the key to forcing some form of fundamental tax reform," Hoagland says.

Filling the revenue gap left by an AMT fix will be difficult without looking at the rate structure and other tax code fundamentals. Indirectly, the AMT may impel Congress toward a value-added tax or a consumption tax, reforms that many economists have long favored. Already, the Bush administration is saying that AMT changes should be part of a broader tax reform, implicitly holding one hostage to the other. Where tax reform is concerned, then, the AMT seems less a train wreck than a locomotive.

Or the AMT might itself become the tax reform. "The AMT is in some respects a cleaner blueprint to start from," says Barry Bosworth, a Brookings economist. A number of tax experts, such as Graetz, have spoken of tweaking the AMT to ameliorate its excesses and inequities, and supplementing it with a value-added tax or other reforms. "Everybody seems to want to repeal the AMT," Graetz writes. "Let's repeal the regular income tax instead." Indeed, by 2012 the income tax will be the cheaper tax to repeal, according to the Treasury Department.

Or perhaps, in the end, Congress will just stick with the AMT. Many tax experts and politicians assume that the AMT, in its present form, will prove intolerable. They may be wrong. Given that higher revenues will be necessary to prevent a fiscal meltdown, from a politician's standpoint the AMT has a singular advantage: It increases taxes without requiring anyone to vote for a tax increase.

There is nothing new about automatic tax hikes. Until indexation came along in the 1980s, the income tax, like today's AMT, rose stealthily with inflation; far from being politically intolerable, "bracket creep" was an accepted fact of life until inflation reached the double digits in the 1970s. As the fiscal vise closes during the next decade or so, and as the cost of curtailing the AMT rises, incumbents of both parties may find they can live with the AMT. Stealth taxes are sneaky, but they beat political suicide.

Moreover, the AMT has its partisan attractions. Democrats loathe the Bush tax cuts but lack the nerve to repeal them. As it happens, the AMT will gradually do the job for them. According to Burman, Gale, and Rohaly, by 2010 the AMT will have taken back 29 percent of Bush's tax cuts, and that is just for a start. Taking note of this fact, Democrats may decide that the AMT doesn't need fixing after all.

For their part, Republicans have noticed that the AMT gets much of its revenue-raising horsepower by disallowing the deduction for state and local taxes. It thus disproportionately hits high-tax states: Democratic states, in other words. Left in place, the AMT would force blue states to choose between paying a higher share of the federal bill or cutting their own taxes. Either way, Republicans win.

The upshot is that the AMT may spur a broad tax reform; it may lay the groundwork for a broad reform; or it may simply turn out to be a politically tolerable tax increase at a time when the country needs all the fiscal help it can get. In a first-choice world, the AMT is a horror. But in Tax Land, which is a third-choice world at best, the AMT looks heaven-sent.

© Copyright 2006 National Journal

Jonathan Rauch is a senior writer and columnist for National Journal and a frequent contributor to Reason. The article was originally published by National Journal.