Article

No Alternative: Time to Fix the Tax Code

Surging sweep of Alternative Minimum Tax requires Congress to embrace comprehensive tax reform, says John Irons.

The 110th Congress has rightly re-embraced “pay-as-you-go” budget rules after six years of fiscal mismanagement by previous congressional leaders and the Bush administration. Getting our country’s fiscal house in order, however, is going to require more than “pay-go” discipline in Congress. Comprehensive tax reform also needs to be on the agenda, which means finding a fair and fiscally responsible alternative to the current Alternative Minimum Tax.

The AMT, initially designed decades ago to ensure wealthy individuals paid at least some tax, makes no automatic adjustment for inflation. By the turn of the century, the AMT began snaring upper middle-income and some middle-income taxpayers—a trend only exacerbated by the Bush administration’s tax cuts in 2001. The tax bill passed that year cut the maximum tax rates on the highest-income Americans and eliminated the estate tax while lowering regular income taxes, but without properly adjusting the AMT.

The result is an AMT that increasingly hits middle-income Americans. That’s why the Center for American Progress very much welcomes efforts by Congress to overhaul the AMT in a way that does not raise taxes on the middle class. Solving the AMT challenge in a fair and fiscally responsible manner is both smart policy as well as smart politics.

The reason? While there will likely be some credit for fixing it, there is significantly more danger in not fixing the AMT. Because the number of people who will be hit by the AMT will grow over time, a fix to the AMT will spare people from a tax that they currently do not see. The harm from allowing the AMT to exist in its current form would be felt more acutely than any benefit from a fix. 

Because the AMT will eventually affect so many people—around 30 million by 2010, many of whom live in “high-tax” states—Congress needs to enact a permanent fix to the AMT. But in the absence of a comprehensive reform, what would an intermediate fix look like? One appealing approach would be to exempt those making less than a certain threshold—say $200,000 or $250,000 a year—from the AMT; while at the same time implementing revenue increases on high-income earners above this bar so as to limit damages to the federal budget deficit.

Ideally, that effort should be accompanied by a 1986-style cleaning of the code, in which AMT reform, loophole closures, and rate adjustments on the top end would form a revenue-neutral reform package. In the meantime, though, concerns about the federal government’s massive fiscal deficit will make it hard for Congress to maintain current level of government services and even harder for them to follow a progressive agenda.  

Members of the House and Senate will have to turn quickly to the revenue side of the ledger to bring the budget closer to balance and to restore priority funding, but don’t expect a wholesale rejection and reversal of the Bush tax cuts. Progressives support plenty of the changes that happened over the last several years, such as the increase in amount of the child tax credit and the reduction in the income tax rates for low- and moderate-income taxpayers.

In fact, the child tax credit is one item that the Democrats will likely wish to expand by making the credit available to more low-income workers.

To the extent that recent tax changes are reversed, look first at the easy targets—loophole closures on corporations and further boosting tax compliance efforts by the Internal Revenue Service to close the approximately $350 billion annual tax gap. That last step alone could potentially yield tens of billions of dollars.

New pay-go rules will provide lawmakers with additional incentive to scrub the code as new initiatives are proposed. Over the long-term, however, we are looking at a fiscal gap that is beyond quick fixes. Ten-year deficit projections begin to show the strain on the system by Medicare and Social Security. Clamping down on annual discretionary spending is neither sufficient nor necessarily desirable to solve the entirety of the problem.

Instead, Congress will have to begin looking at significant new revenue streams. The most common new source of revenue mentioned in tax policy circles is a value-added tax. VATs are a major revenue source abroad, especially in Europe. In the United States, a VAT has been seriously mentioned as a replacement for a significant portion of current revenue or as an add-on to the current system.

Implementing a VAT, however, would create significant and well-known challenges, including adverse distributional consequences. Unless it was paired with a significant and popular national initiative, such as a revamping of our nation’s health care system, a VAT is unlikely to be added to our nation’s tax code in the foreseeable future.

So what does that leave? Over the next two years (and likely beyond) we should expect—and perhaps demand—a renewed interest in generating revenue from taxes or regulations that protect the environment. A carbon tax or a cap-and-trade program with auctioned permits could generate significant revenue, while at the same time reducing greenhouse gases and cleaning the environment.

To get the greatest gains overall, the green revenue would have to be used to offset other taxes (or to prevent rates from increasing in the future) that create efficiency losses. While the amount of revenue that could be raised from a carbon cap-and-trade program is potentially enormous—estimates range from tens of billions of dollars to $100 billion or more—we must also recognize that some of the money will be used to partially compensate businesses that might be disproportionately affected alongside low-income consumers, who spend a higher share of their income on energy-sensitive products.

The green revenue could be part of a larger tax reform, or it could be used to pursue an aggressive, innovation-driven energy strategy through investment in research on renewable, low-carbon technologies. And there ought to be enough revenue to put a dent in the deficit.

Enacting any one of the changes above would be a major achievement for the 110th Congress. Yet piecemeal reform is not the answer. The enactment of tax policy over the last several years has been a mess. The tax code is now riddled with temporary or phase out rules for everything from the AMT “fix,” to the estate tax, to the research credit.

Not every tax provision has to be fixed now. But responsible tax stewardship will require Congress and the Bush administration to work together on all of these reform proposals.

John S. Irons is Direct of Tax and Budget Policy at the Center for American Progress.

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