Deficit Reduction: Raising Taxes Should be Part of the Solution
The fight over raising the debt ceiling is a smokescreen. If the Republican extremists in Congress threatening not to raise that cap truly care about deficits, they should be thinking about prospective changes in the tax laws.
I’ve recently become enamored with the idea of expanding the applicability of the alternative minimum tax (AMT). To understand the AMT, we need to start with an appreciation of taxable income, which, by definition, is the amount of income to which the tax rate is applied. It should be clear, then, that deductions to taxable income will necessarily lower a taxpayer’s tax liability, possibly to the point of obviating a tax liability, altogether, as we’ve seen with a variety of Donald Trump’s past tax returns.
In 1969, Congress enacted the AMT in response to a report by the Treasury that cited the fact that 155 taxpayers with incomes in excess of $200,000 had paid no federal income taxes. With this legislation, Congress intended to correct the growing consensus that too many people were being permitted to deduct too much from their taxable income. Rather than adjusting the taxable income definition to address this concern, Congress left that definition unchanged but required a second calculation for an alternative tax liability – one that limited some of the previously allowable deductions to taxable income.
With the provisions for the AMT in place in 2022, two distinct tax liability calculations were required for taxpayers earning in excess of $75,900 for individuals, $59,050 for married couples filing separately, and $118,100 for married couples filing jointly or qualifying widow(er)s. The first calculation asks the taxpayers to generate a figure for taxable income, applying the prescribed tax rate to this amount. Then, for the second calculation, some of the allowable deductions in the taxable income calculation are added back. While not universally defined as such, we can call this figure the alternativetaxable income. The alternative minimum tax derives from multiplying this alternative taxable income by its appropriate tax rate. The resulting tax liability for the taxpayer would be the greater amount between the normal tax calculation and this alternative tax calculation.
As it happens, the minimum alternative tax affects only a tiny portion of taxpayers. According to the Tax Policy Center, as of 2019, the AMT applied to only 0.1 percent of taxpayers. Apparently, the AMT would have applied to more households had Congress not limited its applicability under provisions of the Tax Cuts and Jobs Act of 2017. These provisions are set to expire after 2025; but even so, starting 2026, the Tax Policy Center estimates that only 3.7 percent of taxpayers will have their tax liability determined by the AMT calculation.
It's relevant to point out that the respective tax brackets for the “regular” tax liability differ from those applicable to the AMT calculation. That is, in 2022, we had seven different tax brackets for the original income tax calculation, with the maximum marginal tax rate of 37 percent. On the other hand, the AMT had only two brackets – 26 and 28 percent. Recognition of this divergence suggests to me that one pathway toward a more equitable tax system would be a migration to greater reliance on the alternative minimum tax by (a) lowering the threshold of eligibility for which the minimum tax calculation would be required and (b) significantly increasing the currently allowable deductions to be added back into the adjustable taxable income.
I find it interesting that the alternative minimum tax, with only two applicable marginal tax rates, is not much of a departure from the idea of a flat tax – an idea that was popularized back in the mid 1990s by Stephen Forbes in his bid for the Republican presidential nomination for the 1996 election. Under a pure application of a flat tax, if Person A earned five times as much as Person B, Person A’s tax liability would be five times higher.
While the flat tax isn’t universally favored, it has the attribute of being simple and… dare I say … fair. Clearly, I’m making a subjective judgment that won’t be universally embraced. Some may say that rich and poor enjoy many of the same services equally so a flat tax imposes too large a burden on the rich; while on the other side, others may argue that taxes should be progressive, where the rich should pay not just higher taxes, but higher tax rates than the poor. Still, I tend to think my assessment falls well within mainstream sensibilities.
It’s worth noting that the application of a flat rate tax becomes progressive if the first $X of income are exempt from taxes. In fact, with the current minimum income requirements, progressivity is already included in the AMT design. For instance, assume a flat rate tax of 25 percent applicable to incomes over $100,000, and consider the tax liabilities of two parties with incomes of $200,000 and $300,000, respectively. Given the $100,000 threshold, the first taxpayer’s tax liability is ($200,000 - $100,000) x 0.25 = $25,000 for an effective average tax rate of $25,000/$200,000 = 12.5%. The second taxpayer’s tax liability is ($300,000 - $100,000) x 0.25 = $50,000 for an effective average tax rate of $50,000/$300,000 = 16.7%.
With income disparities growing ever more severe year by year, the problem that motivated the AMT in the first place in 1969 has only gotten worse. A key indicator of income inequality is the ratio of income earned by the top decile of households relative to income earned by the bottom decile. The latest available data cover 2021; and in that year this ratio was 47 percent higher than it was in 1967, the first year in which these data were assembled. Greater reliance on a revised AMT would likely be at least somewhat restorative.
Any resistance to the idea of using the tax code to redistribute wealth or income seems to me to be indefensible, given the existing code’s role contributing to the trend of increased income disparity that we’ve been experiencing. An adjustment to the AMT is long overdue – even more so given our current concerns about inflation and our current reliance on deficit spending.
Ira Kawaller holds a Ph.D. in economics from Purdue University and has held adjunct professorships at Columbia University and Polytechnic University. For the bulk of his career, he focused on financial markets and derivative instruments. He ran the New York office of the Chicago Mercantile exchange from 1980 -1996 before founding three derivatives-related consulting business: Kawaller & Company, LLC, the Kawaller Fund, and Derivatives Litigation Services. In past years, Kawaller served on the board of Hatteras Financial Corp (which merged with Annaly Capital Management, Inc.) and participated on their risk committee and compensation committee. He also served on a variety of professional boards and committees, including the board of the International Association of Financial Engineers (now the International Association for Quantitative Finance) and the Financial Accounting Standard Board's Derivatives Implementation Group.