'Minimum tax' maximizes pain

Author: Dave Beal

Published: September 25, 2002

A generation ago, U.S. Treasury Secretary Joseph W. Barr shocked America with his disclosure that 155 individual taxpayers with incomes exceeding $200,000 paid no federal income taxes.

Elected officials responded to their constituents' outrage with a "minimum income tax" designed to catch the wealthy tax avoiders.

It worked, but now another shock is in the making. Today, this levy is smacking more and more middle-income households. Acting as an unlegislated tax increase year after year, it is now ready to metastasize into a taxation monster.

Now known as the "Alternative Minimum Tax," the levy is reaching far beyond the wealthy because of two factors: the Bush tax rate cuts, which will force many middle-income taxpayers onto the alternative tax, and the failure of Congress to index the tax for inflation.

A new study from the Tax Policy Center outlines the astonishing scope of this looming transformation.

The center's analysis shows that by 2010, nearly 36 million federal income taxpayers will pay the higher alternative levy instead of the regular federal income tax -?unless Congress changes the law.

By 2010, the study concludes, 85 percent of all households with two or more children will be forced onto the higher alternative minimum tax.

Also by then, 43 percent of all filers with incomes between $50,000 and $75,000 will be required to use alternative returns compared to just 1.4 percent in 2002. And 79 percent of those with incomes between $75,000 and $100,000 will have to file these returns in 2010 compared to 3 percent this year.

The new analysis also found that the alternative tax soon "will hammer families with children and those that live in high-tax states."

This tax, decidedly family-unfriendly, does not allow parents to claim exemptions for their children.

In one example in the center's analysis, a hypothetical "Brady family" ? with six children and a household income of $75,000 this year ? must file an alternative return. Their federal tax bill: $6,760 vs. $5,873 for a regular income tax return.

The Tax Policy Center, a joint venture of the Brookings Institution and the Urban Institute, asked four economists to look into the alternative minimum tax.

The economists flunked this tax on the most widely accepted measures of any tax levy's effectiveness: simplicity, fairness and efficiency.

"It's just a model of a bad tax," says William Gale, one of the four economists who did the study.

Gale calls the tax a classic example of a well-intended policy gone awry.

"How do you go from 155 (people) to 36 million without unintended consequences?" he asked.

It gets worse. The Tax Policy Center didn't include state alternative minimum income taxes in its study.

A state-level version of unintended consequences is occurring in Minnesota. That's because this state levies an alternative minimum tax, which like the federal minimum tax, is not indexed to inflation.

According to the Minnesota Department of Revenue, about 5,300 of the state's individual income taxpayers filed alternative tax returns in 1995, generating $8.4 million for the state.

In 2000, 17,600 such filers paid $23.5 million. In 2005, the state expects 44,000 taxpayers to pay $47 million.

Harley Duncan, executive director of the Federation of Tax Administrators, says 10 other states ? California, Colorado, Connecticut, Iowa, Maine, Maryland, Nebraska, New York, West Virginia and Wisconsin ? also levy alternative minimum taxes.

Duncan says his "gut feeling" is that these states, too, don't index their alternative taxes to account for inflation.

So what should be done?

In Minnesota, legislative analyst Joel Michael thinks the 2003 Legislature should raise the amount of income exempted on alternative returns, allow exemptions for dependents and index the tax for inflation.

Matt Smith, the state's outgoing revenue commissioner, generally agrees. He thinks both the state and the federal government ought to keep the tax, but overhaul it soon.

The problem, of course, is that the alternative minimum tax is generating rising revenue for the federal government and the states. Many will likely say that proposals for curbing the take from this tax must be accompanied by ways to make up the lost revenue.

Still, the longer the politicians put off an overhaul, the larger the crowd of angry taxpayers will grow.

So, taxpayers, watch out: Some spring in the not-so-distant future, you might find yourself paying more taxes because you have suddenly slipped into "alternative minimum income status."