Dr. Martin Regalia

While worries over the impact of the subprime debacle, a credit crunch, increasing oil prices, and the possibility of a recession grab the headlines, two ticking time bombs in the tax code go largely undiscussed: namely, the impending expiration of the Bush tax cuts and the creeping encroachment of the AMT (alternative minimum tax). 

While the problems in the subprime market are certainly troubling, it is ironic that so much effort is expended on these issues, which are predominantly cyclical in nature, when the impact of these impending tax increases will likely have a significantly larger and long-lasting effect. What may be even more important is that these tax increases are on an automatic timer. They will occur if Congress fails to take specific action to avoid them.

The Bush tax cuts that have played such an integral role in our emergence from the last recession and our admirable growth over the last six years will expire at the end of 2010. That event, if allowed to occur, will represent the largest tax increase in American history-as much as $2 trillion over 10 years by some estimates. This compares with the Clinton tax increase that was scored at $240 billion over five years.

Expiration of the tax cuts would raise marginal tax rates on all income levels, increase the current 15% rate on dividends to the higher regular income rate, raise the capital gains rate to 20%, and reinstitute the death tax at the rates and exemption levels that existed in 2002-namely, 55% and $1 million!

The second time bomb is even more insidious because it is less transparent and triggers sooner. It is the creeping AMT. This tax was originally instituted as an add-on tax in 1969 to catch about 150 high-income individuals who were able to legally avoid any tax liability. It was changed in 1982 to something more closely resembling its current form, which is a completely parallel tax system with its own calculation of taxable income, rate structure, and set of deductions and exclusions. Individuals must calculate their income taxes under both the regular tax system and the AMT and pay whichever is higher. Because AMT rates and brackets are different from, and not integrated with the regular tax system, anything that tends to reduce taxes under the regular system forces more taxpayers into the AMT and triggers additional payments under it. Moreover, under this tax, since the basic exclusion is not indexed for inflation, as nominal incomes rise, an increasing number of taxpayers are caught by the AMT.

As a result, when the Bush tax cuts were passed and lowered taxes for all taxpayers, even more taxpayers were caught by the AMT. Many of these were not high-income tax avoiders but, rather, everyday upper-middle class Americans. Further, as each year passed, more and more middle class Americans were caught by the lack of indexation! To address this problem, Congress passed a series of "patches" over the past few years that raised the AMT exclusion amounts and largely reduced the number of taxpayers falling into the AMT trap. But Congress has failed to act this year, and the AMT now threatens to ensnare another 18 million taxpayers in 2007 and raise an additional $50 billion. Over the next 10 years, it could trap almost 30 million more taxpayers and collect around $1 trillion more in taxes.

So what's the problem? Can't Congress just pass another patch and renew the Bush tax cuts when they expire? Well, the answer is just not that simple because we have a new Democratic Congress, and it has adopted an overly simplistic approach to taxing and budgeting called PAYGO (pay-as-you-go).

Role of PAYGO
When the Democrats took over both houses in the 110th Congress, they instituted a requirement that every spending proposal or tax cut that results in higher spending or lower revenue (i.e., has a budget impact) must be offset with a corresponding spending cut or tax increase. Unfortunately, as it is applied, tax cuts are "paid-for" only with tax increases, not with spending cuts. While paying attention to budgetary impacts may appear prudent, rigid application of PAYGO is overly restrictive, fails to prioritize government spending proposals (instead, assuming that all spending is appropriate as long as it doesn't affect the budget), and stands in the way of pro-growth tax reform.

These artificial rules completely ignore the overall size of the government, and the tax revenue needed to finance it, as a policy goal. The rules, which are applied within an arbitrary and artificial time horizon of either 5 or 10 years, also ignore the dynamic response of the economy to changes in the tax code. Rigid adherence to PAYGO virtually ensures that every discussion of tax policy becomes mired in the rhetoric of class warfare.

What is even worse is that PAYGO is applied to a budget "baseline" that treats revenues differently than spending. Revenues are estimated under "current law," which means that expiring tax provisions such as the Bush tax cuts and the expiration of AMT patches are counted as positive revenues. Thus, extending these provisions "lose" revenue and must be offset by other tax increases. Spending, on the contrary, is estimated under "current services." This means that programs such as SCHIP (State Children's Health Insurance Program), which under current law expire, are assumed to be reauthorized at current levels. Thus, a reauthorization of the current program is scored at "no cost," and no offset is required. Only increases in the program require offsets. This approach clearly biases policy in favor of spending and against extension of current tax policy.

Economic Impacts
So what happens if Congress does nothing and the creeping AMT ensnares more taxpayers and the Bush tax cuts expire? In a Wall Street Journal article, Steve Entin of the Institute for Research on the Economics of Taxation describes life (or lack thereof) without the Bush tax cuts. The Bush tax cuts not only spurred consumption but also significantly cut the service price of capital for both corporations and small businesses. As a result, businesses invested, jobs were created, the economy soared, real wages grew, and tax receipts increased substantially.

Allowing the cuts to expire would reverse these positives. Businesses would disinvest, the capital stock would shrink, wages would fall, jobs would be lost, and even an economy growing at 2.5% prior to such a tax increase would be flirting with recession. If Congress allowed a voracious AMT to sap another trillion dollars from the economy, that outcome would be inevitable.

The impact on our worldwide competitiveness also would be devastating. The United States now has the second highest corporate tax rate among our trading partners. While many countries in the world have moved to lower tax rates to enable their businesses to compete in world markets, allowing the Bush tax cuts to expire would be an enormous step in the wrong direction.

Current Proposals
At this time, our "Nero-like" Congress has failed to act. One recent proposal passed by the House would reauthorize a one-year patch to the AMT and extend some expiring provisions such as the R&D credit. Unfortunately, the patch is paid for by onerous tax increases.

While short-circuiting the AMT is certainly laudable, the accompanying tax increases have significant negative effects. The Senate is debating a one-year patch without payfors. While avoiding the negative impacts of such creeping tax increases is certainly laudable, a one-year patch is only a short-term, temporary solution.

Another more expansive bill was proposed by Congressman Rangel (D-NY), chairman of the Ways and Means Committee. While this so-called "mother of all tax reforms" proposal would permanently repeal the AMT, reduce the top corporate income tax rate from 35% to 30.5%, and permanently extend the higher small business expensing limits, those purported tax reforms come at a high price for some other taxpayers. To pay for these reforms, the chairman's bill imposes a surcharge on high-income individuals, repeals the domestic production activities deduction, the worldwide allocation of interest rules and the LIFO accounting rule, raises the tax rate on partnerships, and codifies the economic substance doctrine.

While Rangel has labeled this bill a tax cut and tax reform, it is neither. It is a tax shift that sacrifices one taxpayer for another, punishes success, and flies in the face of our nation's values. A recent study by William Beach and Guinevere Nell of the Heritage Foundation has estimated that this bill would cause the economy to fall significantly short of its potential, job growth would be lowered by more than 100,000 jobs per year, and household income would be lowered by more than $30 billion per year. If coupled with an expiration of the Bush tax cuts, GDP would fall by an average of $60 billion per year; the economy would lose more than 1 million jobs in 2013 and 600,000 per year over the next 10 years; household disposable income would fall short of potential by more than $200 billion per year; and saving, investment, and our economic well-being would suffer.

The mother of all tax reforms, when coupled with the expiration of the Bush tax cuts, is, in fact, the mother of all tax hikes-an increase of more than $3 trillion-and a bad idea. Instead, we should eliminate the AMT, extend the Bush tax cuts, and cut taxes on American businesses, our engine of growth.