Why the 'tax the rich' debate doesn't matter

  • Article by: PAUL G. GUTTERMAN
  • Updated: December 5, 2012 - 9:19 PM

The alternative minimum tax means higher rates would change very little.

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Although the majority in Congress appears to believe that some combination of additional taxes and spending cuts are necessary to get America's budget deficit under control, few if any believe that the package of taxes and cuts scheduled to occur Jan. 1 is the right mix.

Indeed, the "fiscal cliff" legislation was enacted last year on the assumption that it was so repugnant that both parties would be forced to compromise so it wouldn't take effect. And yet with each passing day it seems more likely that no compromise will be accepted.

The key sticking point is the Democrats' insistence that the top tax rate on individuals must be increased and the Republican obstinance against any increase. Yet the truth is that a rate increase is irrelevant to most taxpayers earning $250,000 to $1 million a year.

The reason is the alternative minimum tax. The reason you don't hear much about the AMT is that it is complicated and it gets in the way of each party's talking points. But understanding it also offers a way out of the box Democrats and Republicans have created.

To simplify matters: A taxpayer computes his or her "regular" tax liability and his or her AMT liability, and then pays the larger of the two. So, if a taxpayer's regular tax is $200,000, but her AMT is $210,000, she would pay $210,000 in tax. If the top rate for regular tax goes up, so that she owes $208,000 in regular tax, she still pays $210,000. The rate increase is irrelevant to this taxpayer.

The AMT was originally enacted in 1969 because some wealthy taxpayers were paying little or no tax, due to large deductions and other tax benefits. It initially snared 155 taxpayers. But because it was not indexed for inflation more taxpayers come under its provisions each year. Today it affects millions.

If the Bush tax cuts expire and no action is taken on the AMT it is estimated that another 33 million taxpayers could pay AMT in 2013. The AMT may be one of the few things that Congress would agree should be eliminated. However, since it brings in over $100 billion in additional revenue each year it cannot be repealed in the current environment.

In most cases, the reason a taxpayer is in the AMT is that deductions for state income taxes, property taxes and dependents are eliminated. So taxpayers with families in high tax states who own expensive homes tend to be in the AMT. Approximately 85 percent of California taxpayers earning $250,000 to $1 million are in the AMT.

Ironically, the super rich are less likely to be in the AMT, for a couple of reasons. First, capital gains are currently taxed at 15 percent (set to increase to 20 percent in 2013) and are not subject to the AMT. Most of the super rich (think Warren Buffett, Mitt Romney) get most of their income from capital gains. Second, property taxes and family size max out at some point, limiting the deductions for regular tax purposes.

At all events, once we consider the AMT we see the utter folly of this standoff. Democrats are greatly inflating the revenue to be gained from increasing the top tax rate. Republicans are simply wrong in assuming any significant impact on job creation. Politicians in both parties are ready to drive over the fiscal cliff for no apparent reason -- except their utter lack of understanding of the very laws that they created.

One solution is to increase the rate on only those higher-income taxpayers who are less likely to be affected by the AMT. That income threshold should not be less than $1 million. Another solution is to cap the amount of itemized deductions as proposed by the Republicans. This will actually decrease the number of taxpayers in the AMT, which makes sense from a policy standpoint.

Individuals and businesses not only have no idea what the tax laws will be in 2013, but also no idea what the law is in 2012. That's because it's assumed that some expired provisions will be extended retroactively. As I tell students, this is no way to run a tax system.

But what becomes clear in the fiscal cliff argument is that it has nothing to do with the reasons each side gives for its position, and everything to do with politics. And that is no way to run a country.

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Paul G. Gutterman is director of the Masters of Business Tax Program at the University of Minnesota's Carlson School of Management.

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