Believe it or not, for a tax professor I actually have not been following the tax plans of the two candidates for president very closely ... mostly because they are both frustratingly vague. But as of late one particular item has caught my eye: Romney's proposal to cap itemized deductions at a fixed dollar amount (not a percentage) combined with a large cut in the marginal tax rate. The idea, I think, is that marginal tax rate reductions lower the substitution effect on labor while capping deductions offsets the revenue on a less elastic base, thus increasing growth with no revenue cost. There is some theoretical support for a proposal like this, and some theoretical critiques as well. But I would like to focus on a different issue.
Romney likes to say that this is a return to the Reagan tax policy. But it seems to me this more closely matches another aspect of tax law - the AMT. Under the AMT, taxpayers recalculate their tax liability by getting rid of a number of deductions and applying a lower marginal rate. Sounds familiar. Of course, Romney also proposes repealing the current AMT. But the combined effect of repealing the existing AMT with the other proposals seems quite similar (at least to me) to repealing the entire income tax and leaving the AMT.
Romney says that his proposal will only effect the wealthy. This was the same justification for the AMT in the first place. In fact, I have no reason to believe this was not sincere. Unfortunately, the experience with the AMT has not matched this expectation.
Take the Klaasen family. According to the case, the Klaasen's faith required large families, and the Klaasens had ten children. Under the regular income tax, the Klaasens owed very little tax due to the large number of exemptions and credits available for children, as well as other itemized deductions. Under the AMT, however, the itemized deductions and tax benefits for children were taken away and a much lower rate applied. Despite the lower rate, the Klaasens ended up owing significant AMT. They sued, claiming this violated their First Amendment rights and that the AMT was not intended to reach poor families with large numbers of children. The court disagreed, noting that the statute was clear in how it worked and was neutral as to religion on its face.
Similarly, the wealthiest rarely get hit by the AMT for one simple reason - the capital gains preference does not get taken away by the AMT. Similarly, under Romney's plan as I understand it, the preference would not be affected (in fact, Romney proposes dropping it even further for taxpayers under some threshold). Thus, taxpayers earning primarily capital gains (and presumably qualified dividends) won't be affected by the cap on itemized deductions.
The AMT also sneaks up on people with unexpectedly high, nonrecurring itemized deductions in any one given year, such as professors visiting at another school for less than one year. Presumably a cap would do the same.
Perhaps the biggest problem with the AMT, however, is that the "AMT Exemption Amount" - basically the amount of income exempt from tax - is a fixed dollar amount not adjusted for inflation. Thus, as salaries grew over time due to inflation, more and more people were thrown into the AMT. Similarly, Romney has proposed a fixed dollar amount cap on itemized deductions. Presumably, unless Romney proposes adjusting his itemized deduction amount for inflation, the same effect would occur under his plan. As inflation increases salaries, more and more people would be hit by the cap. This would increase revenue, but it would do so by taxing inflationary gains of middle class earners rather than real consumption or savings. This was not an unexpected accident under the regular income tax, in fact CBO counted increased AMT collections without the so-called "AMT Patch" - which would offset inflation - in calculating revenue under the so-called "Bush tax cuts" in marginal tax rates. It is also why the "AMT Patch" hits the budget every year, in increasing amounts. (See here for a summary).
I do not know if this analysis is correct, mostly because of a lack of detail, but it seems plausible. If true, both candidates propose raising revenue - one through higher marginal rates and one through taxing inflationary gains of earners on the margin of the deduction cap. This really presents a true choice between theoretical tax bases, and thus is how I wish the choice was presented. Perhaps the Wall Street Journal and New York Times editorial boards will read this?
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