Time to rein in the alternative minimum tax

Congress has a must-do tax task ahead of them this summer: It needs to fix, permanently or temporarily, the alternative minimum tax (AMT). Otherwise, millions more upper middle-class American households will get a financial shock when they calculate their taxes this winter. They will be subject for the first time to this oddball tax and could owe Uncle Sam thousands of dollars more than they expect.

In an election year, such a tax hit on important voters is a definite political "no-no."

So far, though, the House and Senate are divided on how to fix the AMT.

The Senate appears to be drifting toward a two-year "patch" – a bill similar to those in the past few years aimed at preventing the number of taxpayers subject to the AMT from growing. An estimated 4.2 million taxpayers were caught by the AMT on their 2006 taxes. Absent a change in law regarding 2007 taxes, the AMT would strike an additional 19 million households, some earning as little as $50,000 a year. By 2010, more than 30 million taxpayers would pay the AMT, and 39 million or more in 2017.

In the House, Democratic leaders are considering altering the AMT permanently in a way that leaves 97 percent of taxpayers alone and adds a 3 to 5 percent surcharge on adjusted gross income on the prosperous remaining half million.

In effect, the measure would modestly increase the progressiveness of the tax system, making the truly well-to-do pay more, possibly cutting taxes slightly for those with lower incomes. It would be a mildly populist measure that might even include ways to help the working poor and expand the child credit for poor families.

If the Senate and House don't agree on a joint AMT measure, their representatives could do battle in a congressional conference committee to resolve differences, perhaps in September.

"They get in a room, lock the door, scream and fight," predicts Stan Collender, a budget expert with the National Journal Group, in a half-joking way. "Or maybe gentle negotiations."

The legislation that emerges would land on the desk of President Bush. If it involves a tax hike for the relatively few rich and trims taxes for millions of middle-class voters, a presidential veto could be politically embarrassing.

"It's more of a political decision than anything else," says Mr. Collender.

The AMT was originally enacted in 1969 to guarantee that 155 high-income individuals paid at least a minimal amount of tax. By investing in tax-exempt municipal bonds and employing other so-called tax dodges these rich people had become infamous for escaping entirely any income tax burden.

But because the AMT was not indexed against inflation, the revenues it generates for the Washington tax system have grown. In addition, the tax cuts of 2001 and 2003 accelerated the risks for taxpayers of being subject to the AMT.

The nonpartisan Congressional Research Service last month did a study showing the "take back" effect of the AMT on those Republican tax cuts.

Commenting on the study's findings, Richard Neal, the Democratic chairman of the House Ways and Means Select Revenue Measures Subcommittee stated, "Those families who thought they were doing pretty well, at $200,000 to $500,000 in earnings, really take it on the chin, losing 63 percent of the promised Bush tax breaks." The super-rich, (taxpayers earning more than $1 million annually), lose to the AMT only 3 percent of the $65 billion in tax cuts they got in tax breaks, he noted.

A legislative remedy for the AMT is widely seen as a necessity, and several think tanks in Washington have come up with suggestions for a change.

The Tax Foundation, for instance, urges closing tax breaks in the regular income-tax system to provide the revenues that would allow repeal of the AMT without expanding the budget deficit.

As it is, the new Democratic Congress has reestablished the pay-as-you-go rule, starting with the 2008 federal budget now under consideration. This means that full repeal of the AMT would require an offsetting revenue increase (or spending cut) of $800 billion over 10 years. To cover such a huge revenue loss, Patrick Fleenor, chief economist at the Tax Foundation, suggests abolishing the deduction for tax payments made to state or local governments on federal income-tax forms.

Like many tax experts, Mr. Fleenor maintains that removal of many loopholes in today's tax code would improve the system. As it is, more than 60 percent of personal income was untaxed in 2006, he notes.

Both the Center on Budget and Policy Priorities and the Tax Policy Center, a joint venture of the Urban Institute and Brookings Institution, have proposed formulas for fixing the AMT. The influential and liberal New York Times recently supported the Tax Policy proposal in an editorial. "Probably the kiss of death," joked Leonard Burman, an author of the Tax Policy plan.

Think tanks can propose; but Congress must dispose. An AMT bill could reach the floor of the House in July, a congressional source noted.