Sunday, April 16, 2006

AMT: Catalyst for Tax Reform?

There has been a rash of recent news stories about the alternative minimum tax, including one in Slate and one on the PBS Newshour. Over time, this tax is hitting more and more Americans, which is why the media are paying attention.

The AMT is an income tax system that runs parallel to the regular income tax, but with its own rules and tax rates. A taxpayer has to pay the maximum of the two computed tax liabilities. So if your regular income tax liability is too low, the AMT kicks in to make sure you don't get away with it.

If it sounds crazy to you for the government to have two parallel tax systems with the taxpayer paying the maximum of the two, you are not alone. I don't know any economist who thinks it makes sense to conduct policy in this way. (Challenge to budding economic theorists: Can you think of any set of assumptions under which two parallel tax systems like this is optimal? I know if you try hard, you can do it!)

There may be one small advantage to this situation: As more taxpayers hit up against the AMT, they may complain enough to force Congress to pay serious attention to fundamental tax reform. Last November, the President's Advisory Panel on Federal Tax Reform put forward a very sensible report describing two prototypes for reform. Either plan if enacted would be a large step forward toward a more rational tax policy.

The panel included two top-notch economists, Eddie Lazear from Stanford and Jim Poterba at MIT. Eddie is now chairman of the Council of Economic Advisers, the job I had for the two years I was away from Harvard working in Washington. Jim is a renowned specialist in public finance (who began his economics career about thirty years ago as a student in ec 10).

The Panel recommended repealing the AMT. By itself, repeal is very expensive. To make the reform revenue-neutral, the Panel also recommended broadening the base of the income tax by eliminating the deductibility of state and local taxes (as well as many other changes, such as cutting back on the mortgage interest deduction). There is a certain rough justice in this recommendation: The taxpayers in high-tax states would lose more from eliminating deductibility of state and local taxes, but they would gain more from repealing the AMT.

Will we see fundamental tax reform over the next few years? It is far from certain, but every news story about the AMT reminds me that there is reason for hope.

Question for ec 10 students: Should people living in high-tax states pay less in federal income taxes than other people with the same income living in low-tax states? Current law answers YES to this question, while the Panel answered NO. What do you think?