Tax commission's recommendations include hidden tax increase

Friday, November 18, 2005

President Bush's Tax Reform Commission came up with some good ideas and some not-so-good ideas. But buried deep within its details is one particularly bad idea: a $1.2 trillion tax increase.

The problem stems from the Alternative Minimum Tax. The AMT was adopted over 30 years ago because a few hundred rich individuals with high incomes qualified for so many deductions that they ended up paying little in income taxes.

Even though these individuals were in compliance with the law, liberals found this scandalous. So the AMT was adopted to make sure that these millionaires did pay their supposed fair share of taxes. The AMT accomplished this by denying certain deductions as income rose, particularly when deductions are a high percentage of income.

The biggest problem is that the income thresholds for the AMT penalties were never indexed for inflation or wage growth. So instead of applying to just a few millionaires, it is starting to apply to millions of upper-middle-class families. Over time, as nominal wages rise with no inflation adjustment, the AMT penalties will apply to more and more of the middle class.

The problem is getting so bad that the AMT is projected to raise taxes by $1.2 trillion over the next 10 years, and much more beyond that. A fascinating political twist is that the AMT is hurting most the liberal states in the Northeast and on the West Coast, because incomes tend be substantially higher there on average. So even liberal Democrats from those states have been squawking that the AMT has to go.

Thankfully, the tax reform commission recommended abolishing the AMT. But it also recommended $1.2 trillion in tax-increasing offsets over the next 10 years alone to make up for the lost revenue.

The AMT, however, was never intended to raise big buckets of taxes from the middle class. Policymakers have generally assumed that the AMT would be indexed or abolished altogether before it started affecting large proportions of upper-middle -income earners or the middle class generally. That is why Senate Finance Committee chairman Charles Grassley recently called for the tax and budget committees in Congress to exclude expected AMT revenue from their baselines.

Republicans and conservatives must not accept $1.2 trillion in middle-class tax increases as the price for abolishing the AMT. When Congress enacted the AMT over 30 years ago, it did not vote for a whopping middle-class tax increase. The tax commission's revenue offsets, however, would turn it into precisely that.

But this problem suggests a solution that could save the politically stillborn commission reforms. Remove AMT repeal from the tax-reform package altogether. Force the liberals from California, New York, Massachusetts and Connecticut to support outright repeal of the AMT in a separate vote, with no revenue offsets.

With the $1.2 trillion revenue decrease from the AMT abolition out of the tax-reform package, tax rates in the package could be cut substantially. Moreover, tax rates could be cut much more if the revenue impact of the reform were estimated on a dynamic rather than static basis.

Static estimates assume nothing changes in response to the tax reforms -- no changes in savings, investment, entrepreneurship, work.

As a result, such static estimates tend be inaccurate, because the incentive effects from proper tax reform would produce dramatic changes in overall economic growth.

Dynamic estimates would take these expected changes into account, and so would be far more accurate. Counting these changes would produce more revenue from the reform, which could be used to reduce tax rates more.

Ideally, income tax rates under reform would be reduced to 10 percent, 15 percent and 25 percent, with that last rate applying to the corporate income tax as well. The precise final revenue estimates would have to be more carefully calculated. But maybe the above two changes alone -- removing AMT abolition from the package and using dynamic scoring -- would be enough to bring the tax reform package close to these rates.

That would make the tax reform proposals enormously politically appealing and stunningly pro-growth. President Bush, call your office.

Of course, we can still consider more fundamental reforms, such as replacing the income tax with a sales tax, or adopting a more pure, but optional, flat income tax. But if all we could get now is the tax commission's proposals with the above low rates, that in itself would be a huge step forward.

Peter Ferrara is a senior fellow with the Free Enterprise Fund and director of entitlement and budget policy reforms at the Institute for Policy Innovation based in Lewisville, Texas.

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