First Restrain Spending, Then Ax The AMT
President George W. Bush's tax reform panel, scheduled to complete its work by Nov. 1, seems to be zeroing in on ways to repeal the alternative minimum tax. This frustratingly complex parallel tax system, instituted in 1969, was intended to reduce the value of tax preferences claimed by the affluent. But because the AMT is not indexed for inflation, it is quickly morphing into the bane of the American middle class -- expected to afflict almost 30 million taxpayers by the end of the decade, up from 3.6 million today.
Yet when it comes to trying to kill this wildly unpopular levy, the spirit is willing but the purse is weak. The AMT is expected to fatten government coffers by a remarkable $1.3 trillion over the next decade. In 2010 alone it will bring in an estimated $112 billion, says the nonpartisan Urban-Brookings Tax Policy Center. Even in a tax system that generates nearly $2 trillion a year, that kind of cash is hard to replace. And since President Bush has made talk of a tax increase off-limits, his reform panel is forced to explore funding any AMT repeal by curbing much-loved tax breaks for mortgage interest, state and local taxes, and fringe benefits.
If that sounds like a zero-sum game, you're right. Relief for any one group of aggrieved taxpayers (say, homeowners) likely would be offset by increasing tax bills for another group (say, residents of high-tax states in the Northeast or California). Add in the inevitable class warfare and the political horse trading required to make those choices, and it's easy to see how this tax-restructuring effort risks creating a cure that's worse than the ailment it's trying to treat.
For example, nearly 40 million Americans take the mortgage-interest deduction, and the huge financial benefit it gives owners -- $76 billion this year alone -- is built into U.S. housing prices, especially for high-end homes. So tinkering with the mortgage-interest deduction, either by giving a fixed mortgage credit or lowering the cap on deductible interest, risks spooking a housing market just now cooling from near-bubble conditions. Moreover, any hit to the prices of homes -- most Americans' biggest investment -- would shrink consumer wealth and borrowing power. And let's not forget that home-related borrowing has been a prime engine of consumer spending and domestic growth in recent years.
A similar danger of unintended consequences lurks in a proposal to partially tax the value of employer-paid health insurance. The plan won't raise much money right away because the $11,000 tax-free cap the panel is considering is still above the $10,000 a year cost of today's typical company-sponsored family policy. But because U.S. health costs are rising so fast, over time it could cost taxpayers a bundle. To be fair, we must note that it also would surely spur many workers to buy medical care more prudently. But, depending on whether these taxes were levied on individual taxpayers or employers (who currently deduct health insurance premiums as a business expense), taxation could either discourage companies from giving generous health benefits or reduce workers' ability to pay their share of premiums -- just when Washington is struggling to deal with the growing ranks of the uninsured.
Even proposals to fund AMT repeal by eliminating the current federal tax deduction for state and local taxes paid pose problems. True, many upper-middle-class taxpayers already lose much of the deductibility of state and local taxes because of the AMT's preference-trimming methodology. But many taxpayers in high-tax states such as New York or California probably still would suffer more by losing the state and local deductions, setting up a regional fight that could degenerate into a red state-blue state battle royal.
To be sure, we're certainly not opposed to calls for making the tax system more equitable or efficient. But both the Bush Administration and Congress seem to be missing the more pressing point here: Runaway government spending (epitomized by expensive porkfests such as the recent transportation bill) is a bigger problem that continues to be ignored.
Even a dramatic restructuring of the tax system is no substitute for smarter government-spending decisions. Indeed, Congress and the President's growing "spend now, pay later" mentality -- at the same time the U.S. must fund mounting near-term costs for its wars in Afghanistan and Iraq -- is what got us into this fiscal mess. And as more than $100 billion of unexpected Hurricane Katrina reconstruction spending ramps up, the focus on revamping the tax structure to abolish the AMT seems a bit ill-placed. Unless Washington starts making more rational, realistic spending decisions, tax reform may be the least of our worries.