At Arm's Length - Financial Commentary about Money, Investing, and How It Affects the Average Investor

At Arm's Length: 09.27.05

The Unkindest Cut

If you are among the wealthy, your only reaction to the term tax cuts would be, for lack of a better word, hooray! If you are among the millions of tax payers who have a home, kids, and find yourself comfortably middle class, you will be far less enthusiastic about any promises of tax relief. According to the Congressional Joint Committee on Taxation, the burden of tax paying will be done by the majority of us because of a tax that was originally enacted to tax the wealthy, who had cleverly managed to avoid taxes altogether.

Designed in 1969 to levy a tax on the wealthy, the Alternative Minimum Tax (AMT) has since lost its bite for those select few. Instead, more and more Americans who consider themselves middle class have found that personal deductions for things such as home equity lines that are not used for home improvements, state and local taxes and medical expenses are no longer exempt under the rules of AMT.

Over the next nine years and as a direct result of the President's tax cuts, the number of people paying this tax will provide an excess of $1.1 trillion revenue for the federal government amounting.

According to the Brookings Institute, the AMT will:

Under current law, AMT coverage will skyrocket. By 2010, the AMT will affect 33 million taxpayers‹about one-third of all tax returns‹up from 1 million in 1999. This would make the AMT almost as common as the mortgage interest deduction is today. The AMT will be the de facto tax system for households with income between $100,000 and $500,000, 93 percent of whom will face the tax. It will encroach dramatically on the middle class, affecting 37 percent of households with income between $50,000 and $75,000 and 73 percent of households with income between $75,000 and $100,000 (compared to less than 3 percent for each group in 2002).

If the Bush tax cuts were made permanent and there is growing likelihood that they will, these numbers would increase. In 2014, a projected 44 million tax payers would lose deductions that allow them to remain middle class while taxing them as if they were wealthy. If the tax cuts were allowed to expire, a compromise added to the tax cuts to make the numbers compute, only 26 million would be affected by the growth of AMT payers.

Originally designed to chase down tax dollars hidden in shelters, the incredibly complex tax does not get applied evenly across. The difficulty in enforcing the law, often not completely understood by even the IRS lies in its inability to tax capital gains hidden in those shelters. In fact, the AMT offers special treatment for gains made in these types of tax shelters, protection that is beyond the reach of the average taxpayer.

The disincentives go far beyond the consideration that many will have by refusing to pay the tax and in most cases, working and saving less. The reach of the AMT will be felt in families with two or more children where the taxpayers are married. It is estimated that by 2010, deductions will be eliminated for 85% of the tax payers with dependents including nearly all taxpayers earning between $75,000 and $100,000.

But doing the math on reform options would put additional strain on an already troublesome deficit. If you will recall, the Bush administration's selling point for the tax cuts in 2001 was the incentives they would create. By giving back what has now become much needed money from the surplus, the President claimed that the incentives would have the net effect of raising tax revenues because the cuts would stimulate investment and growth. By targeting the wealthy, he and his tax advisors believed that this elite group of taxpayers would then funnel that savings back into the economy.

What he failed to mention was that the money received by the federal government would not be spent by this group to grow the economy, business, or entrepreneurship. They would, as we have found out after the fact, save the money.

If the tax cuts were allowed to retire on schedule, the cost in lost revenue would be staggering. Mr. Bush knows this.

Based on his administration's own numbers, the AMT is expected to add over $660 billion to the bottom line through 2014. According to the Brookings Institute, it would cost more to repeal the AMT in 2008 than it would to zero out regular income tax in terms of revenue lost.

The best tax cuts would come from reform to the AMT. Refocusing the tax on the wealthy as it was originally intended would be the easiest. Allowing deductions for taxpayers with dependents would cut the amount of unsuspecting taxpayers from dealing with AMT by 88%.

Without reform to the Alternative Minimum Tax, any discussion about making the 2001 tax cuts permanent would not only be misguided but sad to say, typically Bush. His disregard for this growing problem, something he choose to pay no lip service to in his 2004 inaugural address leaves us with little chance that reform will take place. As many as a 100 members of Congress have raised their voice against the effects of AMT on the growing pool of average taxpayers.

But the tax remains. Just remember this in 2006, as many Congressional members are stumping for re-election.

The previous week's articles.

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