An AMT Idea

There has been some more talk about fixing the Alternative Minimum Tax since the Democrats took over Congress (also see my earlier post). Maybe we can actually get some tax reform in the next couple years? That would be a real miracle. The Bush administration’s failure to get Social Security reform and failure to get any tax reform loom large in my evaluation of its overall success.

So here is a free idea for the Democrats. From this point on I start charging.

The issue of revenue neutrality is not being looked at creatively. Discussion has focused on making sure that if some people gain from tax reform, others will have to lose, if we are to maintain revenue neutrality. This ignores the fundamental inefficiency of taxes, which is that they drive a wedge between what one individual earns and what that individual takes home. The wedge causes individuals to forego income-earning possibilities that do not yield enough after-tax income to compensate for the opportunities sacrificed as a result of earning the income (e.g., leisure). If the tax wedge is reduced, then individuals will earn more, yielding more tax revenue, and making themselves better off.

The problem has always been that if you reduce taxes to reduce the wedge, you lose a lot of revenue on income that would have been earned and taxed anyway. This makes tax reduction costly from the point of view of the government’s treasury. The point is very similar to the concept of marginal revenue in the economics of pricing: if a company reduces its price to sell more product, it picks up some additional revenue from the new units sold, but if it has to reduce price on all the units that would have been sold anyway, then total revenue could actually decline.

But the principle remains: tax rate reduction is mutually beneficial, between individuals and the government. In principle, we should be able to strike a bargain that makes both entities better off.

So here is how we might do that. Now all the details of this are not worked out, but I am rather intrigued by the idea.

Right now, I don’t really know if my marginal tax rate for income earned in 2007 is going to be around 42% or around 26%. It will be 42% if I don’t get caught by the AMT and it will be 26% if I do get caught by the AMT. So let me choose at the beginning of the year how I want to be taxed. I will promise the IRS that, so long as my income is at least as high as it was in 2006, then I will pay at least the same amount of taxes that I paid in 2006. But, and this is the kicker, for any additional income that I earn over and above my 2006 income, I will pay only the AMT marginal tax rate, i.e., 26%.

Imagine that I have an opportunity to make an additional $10,000 in 2007. If my marginal rate were 42%, my take-home pay would only be $5800. At that rate, I might choose to spend that time out at my camp instead of earning the income. But if my marginal rate were only 26%, I would forego $7400 by going to camp instead of to work.

So promise me a lower rate on only my incremental income, and I will earn more. The IRS will take in more revenue than it did before, and possibly more than it would have without this tax innovation (I say possibly more since some people would have taken the income earning option even with the higher tax rate).

The point of this scheme is to make tax reform revenue neutral at the level of the individual, not necessarily across individuals. And we define revenue neutrality relative to the prior year’s tax payments.

To make this even more attractive, you could let me “buy down” my marginal tax rate on new income by foregoing some deductions such as mortgage payments. So I would agree to pay 26%, say, on more of my income (I won’t deduct mortgage interest) if you lower the rate of taxation on new income I earn to, say, 24%.

This idea is very similar to health insurance plans that require us to choose at the beginning of the year what kind of plan we want, and how much money we want to put into a reimbursement account. Let’s extend that principle to taxation, remove some inefficiency, and make everyone better off.