- The Washington Times - Saturday, April 16, 2005

It is traditional for columnists to preach about tax simplification in April, although many of us find tax filing so arduous we put it off until August. Still, the spring rite of calling for tax simplification carries added import this year because a presidential commission is to report on tax reform by July 31.

The task of tax simplification could be greatly simplified if we stop pretending serious improvement must begin by eliminating popular tax deductions. Unlike numerous tax credits, which are phased out if you earn or save too much, tax deductions are rarely a serious source of tax complexity. The amount each taxpayer pays in property tax, for example, is received in the mail and easily transferred to the tax return.

The main source of tax complexity is not reporting deductions but reporting income — particularly minute details about interest, dividends and capital gains. Countries with simple tax systems, such as Hong Kong, have a single tax rate on investment income, which allows the tax to be easily collected directly by financial intermediaries (who already send us the information), rather than from millions of individuals.

Those who attempt to redefine tax reform as a crusade against tax deductions do so to make tax reform seem impossible.

This anti-reform lobby relies heavily on a myth that reducing deductions was the essence of the 1986 tax reform. Even the judicious George Will has come to believe that, “In the great … 1986 turn toward simplification, the reduction of rates was paid for by reducing exemptions and other complexities.”

He presumably meant there was a reduction in deductions rather than exemptions, since personal exemptions were actually doubled by the 1986 reform. Yet deductions were not reduced. Itemized deductions for sales tax and credit card interest were indeed eliminated. But the standard deduction was increased 36 percent — leaving no net effect on the portion of income taxpayers deducted.

Deductions were 23.3 percent of gross income in 1984 and still 23.2 percent in 1990. The reduced maximum tax rates — from 50 percent in 1986 to 28 percent in 1988-90 — was definitely not “paid for” by reducing exemptions or deductions.

What “paid for” lower tax rates in 1986 was not smaller exemptions or deductions but lower tax rates, largely through reduced tax avoidance. Tax receipts from the individual income tax averaged 8.1 percent of GDP from 1988 to 1990 (when the top tax was 28 percent), which was just as high as in 1983-1986 (when the top tax was 50 percent), a bit better then the 7.9 percent average of 1993-1995 (when the top tax was 39.6 percent) and virtually the same as the 8.2 percent average the Congressional Budget Office projects for 2006 to 2010 (when the top tax rate will be 35 percent).

As Reynolds’ Law says, federal revenues from the individual income tax (aside from capital gains) are about the same share of national or personal income whether the highest tax rates are increased or reduced.

Unlike the 1986 tax reform, the alternative minimum tax (AMT) really reduces exemptions and deductions in exchange for a lower tax rate. Yet feigning indignation about the AMT has become a new favorite sport among Democratic economists who (1) had no objections when President Clinton increased the AMT tax rate in 1993, and (2) still claim they would support tax reform if it did what the AMT does — traded reduced tax deductions for a relatively low, flat tax rate.

What is happening, as I hinted in a column last month, is bait-and-switch politics. To play, one appears horrified that many “middle-class” taxpayers will somehow be treated unfairly by the AMT unless it is “reformed” in a way that requires raising the top four tax rates by 3 to 5 percentage points. That cure would raise average and marginal tax rates for most taxpayers. Yet by paying a few thousand more in regular income tax, some could save the few hundred dollars they might otherwise pay through the AMT. Thanks, but no thanks.

“A tax increase that Bush didn’t mention” is the New York Times’ take on the new party line on the AMT: The Urban Institute’s Leonard Burman was quoted saying of the AMT that “over time, we move to a tax that is much less progressive … and penalizes people with children who live in high-tax states.”

There were complaints about complexity, too, but anyone subject to the AMT uses tax software or a tax expert, and calculating the AMT with a computer takes an extra minute.

The AMT penalty for large families would be easy to fix: Just exclude personal exemptions from the AMT formula. The complaint about high-tax states has been echoed in numerous articles claiming any cap on deductions for state and local property and income taxes is unfair to “blue” states.

But until very recently taxpayers from six “red” states with no income tax were denied one cent of deduction for state sales taxes. We still don’t allow both income and sales taxes to be deducted — a limit on deductions far tighter than the AMT. Besides, it usually takes unusually large property tax deductions (as well as income taxes) to trigger the AMT, which means unusually valuable homes.

Mr. Burman’s complaint about moving to a “much less progressive” tax system is revealing. The AMT limits outsized deductions for income and property taxes, which means it affects people with high incomes and valuable property. Yet the marginal tax rate is just 26 percent on that portion of income affected by the AMT, or 28 percent at very high incomes.

Contrary to Mr. Burman, it is unlikely a 26 percent tax rate on a broader definition of income is “much less progressive” than pre-Bush tax rates applied to income after subtracting unlimited deductions for state and local taxes.

All such stories make a big deal of the number of taxpayers who might owe a few more bucks because of the AMT, without telling you nearly all of them still will pay less than they would have paid before the Bush tax cuts.

They also exaggerate how big a deal this is. In a 2003 paper for the National Bureau of Economic Research, Dan Feenberg and James Poterba projected that, when it peaks in 2010, the AMT will still account for less than 9 percent of total income tax revenue. Indexing the AMT for inflation would reduce AMT payers in 2010 from 37 million to 14 million, they estimated, but the resulting revenue loss would be only about 5 percent of the revenue collected from individual income taxes (and a tinier fraction of total revenues).

For former officials from the Clinton administration, such as Mr. Burman and Peter Orszag at the Brookings Institution, it seems restoring the Clinton era’s higher tax rates has symbolic priority and nothing to do with revenues, nor even actual tax burdens of wealthy people (providing they live in blue states). The AMT is merely the latest of several excuses.

The “tax increase Bush didn’t mention” was initiated by Presidents Johnson and Carter and greatly raised by President Clinton. Neither the New York Times nor its partisan sources have suggested rolling back AMT tax rates to the earlier level.

We might all enjoy an honest debate about tax policy. But on tax deductions and the AMT, there has been too little debate and much too little honesty.

Alan Reynolds is a senior fellow with the Cato Institute and a nationally syndicated columnist.



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