November 2006
Sun Mon Tue Wed Thu Fri Sat
      1 2 3 4
5 6 7 8 9 10 11
12 13 14 15 16 17 18
19 20 21 22 23 24 25
26 27 28 29 30    
Oct   Dec


Blog-Parents

RaptorMagic

Orcinus

Blog-Brothers

Callimachus
(Done with Mirrors)

Gelmo
(Statistical blah blah blah)

Other Blogs I Read
Regularly Often

Athletics Nation

Andrew Sullivan
(Daily Dish)

Kevin Drum
(Political Animal)

Hilzoy
(Obsidian Wings)

 Wednesday, November 22, 2006
In Defense of AMT

I'm feeling contrarian tonight. Maybe it has something to do with impending holiday. Rather than speak out against something universally beloved, I'll speak in defense of something universally condemned. Since I'm not quite ready to explain why the modern longing for the Caliphate is a worthy political ideal (hint: Aristotle), that leaves the AMT.

AMT stands for "alternative minimum tax". In the wildly divisive debate about tax reform, the one thing pretty much everyone agrees on is that the AMT is a bad bad thing that needs to be reformed and scaled back, or better yet abolished altogether. Democrats are very excited about AMT reform, as a middle-class tax cut they can get behind. Soon-to-be Speaker of the House Nancy Pelosi lists it on high on her legislative agenda.

There are three complaints I hear all the time about AMT, and all of them are misguided. First and foremost, in virtually every AMT discussion you'll find anywhere, the first description you'll encounter is "complicated". Everyone wants to tell you that AMT is some arcane and convoluted rule that no one can possibly make sense of, and that's part of the reason we should get rid of it.

Now it's true that determining one's AMT liability can be a difficult calculation, but that's not because AMT is complicated; it's because the regular tax system is complicated. Ultimately, the AMT calculation is a laborious exercise in undoing most of the stuff you just got finished doing in your regular tax return.

Let's back up a bit. Alternative Minimum Tax, as the name suggests, is an alternative way of calculating total tax liability. Per the AMT law, your tax liability as calculated the AMT way is the minimum tax you must pay. Thus, if the AMT amount is lower than your regular tax amount -- as it is for most taxpayers -- you just ignore the AMT altogether; if the AMT is higher, you pay the AMT amount instead.

That's the net effect anyway, but the way the forms are designed, they don't just say throw out the regular tax amount and pay the AMT amount instead. Rather, you calculate the difference between your regular tax liability and your AMT liability, then that difference is added to the regular tax liability and called "AMT". It makes it look like an extra bonus tax is tacked on top, when in fact what has really happened is that total tax has been calculated by two different methods and the higher result is the one you have to pay.

OK, I know. All my non-economist readers are now thinking: Gee, that sounds pretty complicated to me. Look at it another way. Forget all about AMT. Suppose AMT doesn't exist, and it's just our regular income tax system. Now imagine that a new law is passed that says when you fill out your tax forms, you also have to fill out Canada income tax forms as if you were Canadian, and then if the Canada amount is more, you have to pay that to the IRS instead. Such a law would make figuring your U.S. tax much more complicated -- nearly twice as much. Does that mean Canada's income tax is way too complicated? Does it mean Canada's income tax laws are even more convoluted than ours? No, what makes it complicated is the fact that you have to do your taxes twice and compare the two answers.

I don't actually know if Canada's income tax is simpler than America's. I'm pretty sure it is, but I can't say for sure. I do know for sure that the AMT is less complicated than the regular U.S. income tax.

So let's turn it around. Suppose the AMT is the normal income tax. By April 15, everyone has to fill out their AMT tax form and pay the tax due to the IRS. As a special rule, you have the option of calculating your tax by the 1040 method instead, and if your 1040 liability is less, you can claim the difference as a tax credit. Then instead of a mysterious extra tax that affects mostly high-income taxpayers tacked on top of the usual complicated tax form, we would have a mysterious and very convoluted special tax break that mostly affect low-income and middle-income taxpayers which can be claimed as a credit against the regular not-so-complicated tax form.

What Would Milton Do?

This weekend I had a chance to watch a bit of C-Span. In celebration of the life, recently ended, of great economist Milton Friedman, they aired a rerun of a 2001 Book TV interview with him. (By the way, my opinion of Dr Friedman aligns very closely with this one from Richard Posner, particular the last three paragraphs.) One of the callers asked Friedman what he would do to reform the income tax. Darn C-Span for making me hunt through the video clip rather than search in a text transcript, but I found his answer. (It's at 1:31, if you want to listen.)

That's easy to answer. I think the tax system I would design would be a simple flat tax on all the income above a minimum from whatever source derived. Period. It would be a single flat rate. Unfortunately, given how much government spends now, it would have to be a flat rate around 25 or 30 percent which is much too high but that would be better than this incredibly complex system that we have now.

It's easy to see why a free-marketer like Friedman would favor this. He isn't interested in social policy, class warfare or redistribution. He really isn't even very interested in fairness per se. He just wants a way to raise the money with the least possible government intereference in the market. The qualities that make an income tax complicated are the same ones that interfere with a a free-market economy: oodles of little credits and exemptions that encourage citizens to buy this instead of that, and preferential tax rates for certain types of income that inspire businesses and brokers to invent clever ways to have your income classified as the less-taxed kind.

Now the AMT doesn't quite meet Milton Friedman's description of the AMT, but it's damn close. Instead of a single rate, there are two rates, but they aren't too far apart (26% for the first $175K and 28% for the rest; as opposed to six rates ranging from 10% to 35%). As with the regular income tax, there is an exemption (ie, a minimum amount which is untaxed); it's larger than the regular exemption and it favors unmarried individuals more than the regular one does. The preferential rate of 15% for long-term capital gains -- an enormous distorter of the free market, which inspires all sorts of financial monkeying around for the sake of tax benefit -- was made to apply to AMT at the same time it was introduced to the regular income tax. Last but not least, although it does not attain the no-exceptions goal that Friedman longs for, the AMT has drastically fewer exceptions than the regular income tax.

The last one is the key point. The fundamental difference between AMT and regular income tax, aside from the simple difference in rates and exemption amount, is that in the AMT world a whole heck of a lot of deductions, credits and other tax breaks aren't allowed.

This brings me (finally) to the second item on my list. Whenever people talk about AMT, they always talk about the various and numerous ways in which AMT adds a special tax burden: AMT hits you if you have high medical expenses, AMT hits you if you have a second mortgage, AMT hits you if your employer gives you stock options, etc, etc. But it isn't AMT that addresses these things at all; it's the regular tax code. All AMT does is say, "Nope, sorry, your 1040 might accept that excuse, but I don't."

The Internet is abuzz with lists of things that might make you subject to the AMT. Nine out of ten items on the list (10 out of 11 on this one) are simply tax breaks that you get to claim on your regular tax form that you don't get under AMT rules. Milton Friedman doesn't like these tax breaks, and neither do I. Why should the government subsidize you for renting a safety deposit box? for seeing a chiropractor? for buying a hybrid car? for giving old clothes to Salvation Army? for going to college? for putting money in an IRA?

Stock Options

The item on the list that anti-AMT activists are most excited about is possibly the most egregious, and that is ISOs. ISO's -- incentive stock options -- are what has otherwise leftist Rep Zoe Lofgren up in arms against the AMT. Rep Lofgren represents Silcon Valley, so a lot of her constituents work for companies that like to compensate their employees with ISOs. The idea behind an ISO is that the company grants you an option to buy their stock, at some specified time in the future, at some specified price X. If the company's stock goes up higher than X, then you get an immediate profit, because you get to buy the stock at a discount from its market value.

That discount represents a benefit paid to you by the company that employs you. In other words, it's compensation, and income ought to be taxed no matter what form it takes. That's what I say, anyway, but in this case the tax code doesn't quite agree.

The sob stories you hear are about someone who paid cash to buy the stock at the option price and then held the stock. This poor guy, they say, didn't make any money -- in fact, he spent money -- and the mean old government makes him pay income tax when he didn't even get any income. But that's bosh. If you pay $5,000 for $10,000 worth of stock, that's income. If you're smart enough to hang on to stock bought at below market price, you're smart enough to understand that you realize a gain on purchase and you owe tax on it. And even if you don't understand that, your broker should. You used cash to buy the stock, so set aside a portion for taxes, for heaven's sake. Or sell a few shares to collect the gain if you need to.

Everyone I know who receives employer stock options doesn't hold the stock at all. They just exercise the option and cash out all in one transaction. Do that, and there's no fuss with AMT or anything else. It's all done through the company payroll, your extra profits shows up on the W-2, the company withholds against it, and everything is normal. The difference is if you exercise the option then hold the stock for a year. In that case, the IRS doesn't tax you at all until you sell the stock, and then it taxes the entire profit at the capital gains rate.

The theory behind paying employees with ISO's is that it gives employees an incentive to improve the company: if their work makes the company more valuable, they share in the reward of a higher stock price. The reality is that companies give ISOs for the same reason they provide health benefits: because thanks to a loophole in the tax code it's way to provide employees compensation tax-free.

(The tax-free nature of employer health benefits, by the way, is another huge distortion of the free-market, and it's a big part of why health care financing is so screwed up in the United States. For that matter, make a list of the everyday expenditures where markets are most screwed up -- health care, housing, college education -- and it's pretty much identical to the list of the biggest tax breaks. That's not a coincidence.)

When you buy a stock at below market value, thanks to an stock option granted by an employer, you have been paid. It ought to be taxed as ordinary income, and that's exactly what the AMT does. It's a tax break, and it ought to be squashed. AMT squashes it, as well it should.

Nancy's Middle-Class Tax Cut

I'm getting ready to close up, so I should allow this caveat: Yes, I'm well aware that I'm breezing over some important details here. But I've already run on longer than I intended, and I know this shop talk is reminding long-time readers of issue #51 of Benzene 3 in which I devoted page after page to insurance regulation.

In particular, I haven't mentioned the way in which the AMT exemption is phased out at higher income levels, which makes it somewhat less simple than I'm making it out to be (and creates the one exception in my 10 out of 11 list). That, in almost apophatic way, leads me to the third item on my list of things that everyone always says about AMT.

The most current of the AMT complaints tells us that AMT was originally designed to catch wealthy taxpayers who are getting too much benefit out of unfair tax breaks. Now, thanks to the way in which the phaseout level was not tied to inflation, it's starting to catch more and more upper middle-class taxpayers who are getting too much benefit out of unfair tax breaks. And that's just not right.

This, ultimately, is the reason why suddenly everyone wants to reform AMT. And by everyone, I mean the new Democratic leadership. AMT may well have been designed to "catch" rich people, but that doesn't necessarily mean it shouldn't be allowed to catch the rest of us as well. The AMT is an alternative system of determining tax liability. Either it's better than the regular system or it's not. If you think it's worse, fair enough; tell me why. But if it's better, then why shouldn't it apply to everyone? It's certainly simpler. It's much much closer to Milton Friedman's ideal of one rate with no exceptions. Unlike so many of the proposals out there, it has the advantage that it already exists in law.

If I there's any conclusion to this meandering polemic of mine, it's this: In considering tax reform, stop thinking of AMT as the problem and start thinking of it as the solution. The AMT is the better tax. It's not perfect, but it's better. So let it continue to creep down the income ladder and encompass more and more of the populace. Let AMT become the real tax and let it eventually make the regular income tax obsolete. Let it be the silver bullet that dispatches 90% of economy-distorting tax breaks in a single stroke.

Turn the tax forms upside-down so that instead of totting up all the deductions and credits only to subtract them back out again for AMT, you just start with the AMT and can skip all the other stuff. Put tax accounting firms like my employer out of business. I won't mind.

He won't mind either. One of the comments near the beginning of Neal Boortz's book about the Fair Tax is that in spite of the fact that it aspires to put an end to the tax accounting industry, real-life tax accountants are near uniform in their support of proposals like his. In my experience, that's absolutely true. We know better than anyone how stupid the tax code is. If it were to magically become rational and simple, we would welcome that as surely as teachers would welcome it if all children magically become smart and well-adjusted, or police would welcome it if criminals magically stopped committing crimes.

11:43:38 PM  [permalink]  comment []