As the Democrats begin to plot their legislative agenda for next year, they are finding that the unpopular alternative minimum tax may crowd out most of their plans.

Resident Scholar Kevin A. Hassett

People who may be liable to pay the AMT are required by the U.S. Internal Revenue Service to calculate their taxes under both the normal and the alternative codes, and pay whichever liability is higher. Since the AMT isn't indexed for inflation and the normal code is, the alternative tax is catching more and more people each year.

The AMT was created almost four decades ago to make sure affluent Americans pay their fair share of tax, yet millions of middle-class people are now exposed. As a result, Congress has been passing temporary fixes--called “patches”--each year to fend off the AMT. The latest patch was approved in May.

The dilemma for Democrats is that the AMT is so unpopular that they have to do something, but the patch is getting costly because it forces the government to give up billions of dollars in projected tax revenue. The Democrats rose to power promising voters pay-as-you-go budgeting. If they try to fix the AMT, they will have no money left for any other initiative.

How Bad?

To illustrate how bad it is, consider what would have happened if Congress hadn't passed the patch. In 2005, a married couple with an income of $150,000, three children, and normal state and local deductions would have faced the alternative minimum tax in only eight states--those with the highest state taxes.

Without the patch for the 2006 tax year, things would have changed dramatically. This family would have faced the AMT regardless of what state it lived in.

While the AMT hit was going to be big everywhere, it varies significantly across the states. A family in New York would have paid the most, $4,058, while the same family in Tennessee would have paid the least, $1,243. Right now, there is no patch for next year, so a similar story awaits unsuspecting taxpayers.

In 2005, about 4 million tax returns were hit by the levy. Absent the recent patch, 23 million would likely have been hit in 2006.

The Democrats don't traditionally oppose tax increases, so why not let this one go? There are two reasons they won't sit idly by and let the AMT run wild.

Tax on Democrats

First, the levy kicks in when you have lots of deductions under the normal tax code; many of those deductions don't count under the AMT, including those for state and local income and property taxes. So, a big state tax bill can push you into paying the alternative tax. But guess who has the biggest such bill? Somebody who lives in a blue state. The AMT is largely a tax on Democrats.

Second, the AMT is an economic abomination. It increases tax complexity and compliance costs for the many millions of taxpayers who must calculate their taxes according to two different sets of rules each year.

It often increases marginal tax rates for those who fall under it. A recent study by Daniel Feenberg of the National Bureau of Economic Research and James Poterba of the Massachusetts Institute of Technology found that for 81 percent of taxpayers, wages face a higher marginal tax rate under the AMT, with 18.6 percent of them experiencing an increase of 10 percent or more.

Repeal It

The increase occurs because the lowest AMT bracket rate is higher than the income-tax rate of middle-income Americans who are swept onto the AMT, especially in future years. On average, the AMT is projected to increase marginal income-tax rates by 1.5 percentage points by 2010.

So what should Congress do? The complexity, high marginal rates and uneven reach of the AMT make total repeal the best option. Repeal was impossible for the Republican Congress, because it would cost more than $1 trillion over 10 years, and those lawmakers were hooked on big government.

But it should be easy to repeal the AMT and keep the budget on a sound path. Congress just needs to reduce spending growth a bit to offset the cost of eliminating the tax.

The current projected average annual growth in total outlays from 2006 to 2016 is 4.7 percent. To pay for AMT repeal under current law, growth in total outlays, including entitlements, would have to be reduced by a mere 0.4 percentage points a year.

If you don't want to touch entitlements, then you can cover the costs of AMT repeal with a reduction in discretionary spending of only 1.2 percentage points.

Even with that reduction, spending in 2009 would be about 29 percent higher than was projected in the budget outlook when President Bill Clinton left office.

So the AMT can be fixed in two easy steps. First, erase it from the tax code completely. Second, cut spending growth a modest amount.

If Democrats are serious about running the country from the center, such a policy move would be a great start.

Kevin A. Hassett is a resident scholar and director of economic policy studies at AEI.