Thursday, April 14, 2005

When This Tax Hits, There's No Alternative

When This Tax Hits, There's No Alternative

As Americans' earnings rise, more are facing this costly levy first aimed at the very rich. The outlook for ending or reducing it is unclear.

By Joel Havemann
Times Staff Writer

April 14, 2005

WASHINGTON — As Friday's tax filing deadline approaches, more Americans are finding that a little-understood feature of the tax code called the alternative minimum tax is forcing their tax bills higher than expected.

And though cutting taxes has been a defining characteristic of President Bush and GOP congressional leaders, prospects for change are uncertain.

Instituted in 1969, the alternative minimum tax was designed to keep the richest of the rich from sheltering all their income from taxes. But due to inflation-generated wage increases, that tax has reached into the ranks of middle-income Americans, and is on course to raise the tax bills of millions of additional taxpayers in future years.

"The people who are hit by the alternative minimum tax are wage-earning salesmen, teachers, pharmacists, people that have lots of children or paid lots of local taxes — real estate, income and property taxes," said Patrick O'Malley, owner of Tax Help, a tax preparation service in Omaha. "They are not typical high-income people. And so they are shocked that their country would do this to them."

For the moment, Congress is waiting for the recommendations of the panel that President Bush has assigned to study changes to the nation's tax system. The President's Advisory Panel on Federal Tax Reform will almost surely propose eliminating or scaling back the tax, but whether its recommendations will go anywhere in Congress is uncertain.

"I would think that addressing the alternative minimum tax will be part of all the options the panel identifies," said Jeff Kupfer, the chief of the panel's staff. "It is one of the biggest problems that we've found in the tax code, and we'll certainly aim to fix it."

One option is to kill the tax. But that would deprive the government of more than $50 billion in revenue next year and $670 billion over the next decade, says the Tax Policy Center, a joint enterprise of the Brookings Institution and the Urban Institute, two nonpartisan think tanks in Washington.

Bush asked his advisory panel to structure its recommendations so that they would neither gain nor lose revenue for the government.

When combined with Bush's proposal to extend a variety of his first-term tax cuts that are due to expire, abolishing the alternative minimum tax would require the panel to find $1.2 trillion in revenue from other sources over the next 10 years, the Tax Policy Center estimates.

Lawmakers could raise about that same amount by eliminating the deduction for charitable contributions and the deduction given to homeowners on mortgage interest payments. But Bush has already ruled out those options.

Another approach would be to raise regular income tax rates. The Tax Policy Center calculates that rates would have to rise by 4% overall. For example, today's 10% bracket would rise to 10.4%, and the 35% bracket would increase to 36.4%.

The alternative minimum tax operates alongside the income tax. Taxpayers who meet certain income and deduction thresholds must calculate their taxes both ways and pay whichever is greater.

To determine what they would owe under the alternative minimum tax, taxpayers add up their income, subtract a $58,000 exemption (if they are married and filing jointly) and pay taxes on the difference — 26% on the first $175,000 and 28% on the rest. The alternative minimum tax allows no personal exemptions, and so, as O'Malley said, families with many children lose a substantial tax break. It also disallows most deductions, including those for state and local taxes.

Unlike most features of the tax code, the $58,000 exemption does not automatically rise each year with inflation, so routine wage increases have pushed increasing numbers of taxpayers into the grasp of the alternative minimum tax.

The 132,000 taxpayers who paid the alternative minimum tax in 1990 paid about $830 million more than they would have if subject to the traditional income tax, the IRS says. By 2002, the last year for which numbers are available, 1.9 million taxpayers owed $6.9 billion more than their bill would have been under the traditional income tax.

Congress has taken steps to limit the number of people affected by the tax. But those measures expire next year, and complaints from taxpayers are sure to follow. Burman estimates that the number hit by the alternative minimum tax is scheduled to soar from 3.4 million in 2005 to 18.4 million in 2006. The amount collected by the tax — beyond what people would owe if they were subject to the traditional income tax — is set to rise from $19.8 billion to $53.3 billion, he said.

Californians pay a disproportionate share of the alternative minimum tax, largely because it does not allow deductions for California's high state and local taxes. In 2003, 3.1% of federal income tax returns from California included alternative minimum tax payments, compared with 1.8% nationally. The alternative minimum tax accounted for 2.1% of Californians' tax payments, compared to 1.3% nationally.

Times staff writer Elise Castelli contributed to this report.