After a public relations buildup worthy of a consumer product launch, senior Republicans in Washington, D.C, on September 27 released a nine-pagethat sets forth negotiation parameters for the first comprehensive tax reform since 1986.
Broadly, the GOP framework calls for lowering the corporate tax rate to 20 percent, reducing the top 39.6 percent personal income tax rate to 35 percent, doubling the standard deduction (but consolidating it with the personal exemption), repealing the alternative minimum tax or “AMT,” repealing the estate tax, increasing the child tax credit, creating a new dependent credit, and collapsing the current seven income tax brackets into three brackets.
To pay for these tax reductions, the framework eliminates most itemized deductions but specifically retains incentives for home ownership and charitable giving. Although largely overlooked, the framework also states that “[a]n additional top rate may apply to the highest-income taxpayers to ensure that the reformed tax code is at least as progressive as the existing tax code and does not shift the tax burden from high-income to lower- and middle-income taxpayers.”
In an apparent effort to forestall powerful lobbying in defense of the status quo, the framework is deliberately vague. Undaunted by the lack of critical details, however, Washington’s commentariat and K Street are nonetheless on a war footing.
Much of the early commentary has focused on the impact that repealing the deduction for state and local taxes (the SALT deduction) would have on taxpayers living in high-tax, predominantly Democratic-leaning states like New Jersey. Democrats have accused Republicans of seeking to punish Democratic states, while Republicans retort that the deduction amounts to an indefensible federal subsidy for those states’ high taxes and profligate spending.
How would repealing the SALT deduction impact New Jerseyans? Commentators note that repeal would hit New Jersey and other high-tax states especially hard because those states account for the bulk of taxpayers who itemize and claim the deduction. That’s true as a general matter, but the framework’s associated proposal to eliminate the AMT makes the analysis with respect to individual taxpayers much more complicated.
The AMT is an alternative tax calculation that was originally intended to prevent high-income taxpayers from using deductions to wipe out their tax liability. Taxpayers with incomes over an exemption amount must calculate their tax liability under both the regular and AMT regimes and pay the higher amount. Compared to the regular tax calculation, the AMT applies a generally lower tax rate to a much broader definition of “alternative” taxable income that disallows many popular itemized deductions including, notably, the SALT deduction.
Although the top statutory AMT tax rate is 28 percent — typically lower than the equivalent regular tax rate — a phaseout of the AMT exemption results in an effective marginal AMT tax rate offor married couples filing jointly with AMT taxable incomes between roughly $300,000 and $500,000. Higher-income families beyond the phaseout range pay an effective AMT rate of 28 percent, the same as the statutory rate.
This higher effective AMT rate has important consequences for our analysis because higher tax rates increase the value of deductions. Normally, this means that repealing a deduction like the SALT deduction will hit taxpayers subject to higher tax rates harder than it will hit taxpayers subject to lower rates. But what if the taxpayer couldn’t take the deduction anyway, as has been the case under the AMT? In that instance, the AMT taxpayer with a higher effective tax rate has incurred a higher penalty on a relative basis for not being able to take the SALT deduction.
It follows, then, that repealing the AMT should favor the 35 percent AMT taxpayer. Yes, but remember: the framework would eliminate both the SALT deduction and the AMT. If the SALT deduction is no longer available, the 35 percent AMT taxpayer’s relative benefit from AMT repeal disappears.
How does this all play out for current AMT taxpayers? Here’s my best effort:
Many current AMT taxpayers will pay more tax if both the SALT deduction and the AMT are repealed. For these taxpayers, repealing the AMT will mitigate, but not eliminate, the negative impact of losing the SALT deduction.
Current AMT taxpayers with household incomes in the $300,000 to $500,000 range who pay comparatively high property and state income taxes will be among the biggest “losers” on a proportionate basis.
As noted above, taxpayers in the $300,000 to $500,000 range have less to gain from repeal of the AMT than their even-wealthier neighbors. Moreover, these families often pay comparatively more property tax in relation to their income, so losing the SALT deduction will be more significant for them. Lastly, pending finalization of the framework’s proposed tax rates and bracket thresholds, it seems unlikely that this cohort will benefit from the proposed reduction of the top income tax rate from 39.6 percent to 35 percent since they’ve been paying an effective 35 percent AMT tax rate all along.
Quick: Who has been subject to the AMT on incomes of $300,000 to $500,000 and pays comparatively high state and local taxes? You guessed it: high-income families living in comfortable homes located in suburban counties like Hunterdon, Morris, Somerset, Bergen, or Monmouth. In other words, folks who have traditionally made up a core Republican constituency in otherwise “blue states” like New Jersey. They are blue state Republican voters.
This could have interesting ramifications. One the one hand, eliminating the SALT deduction is critical to making the framework’s overall math work. Absent the imposition of a high new marginal income tax bracket — hardly a Republican priority — there’s no practical alternative for raising the revenue needed to pay for the framework’s various tax cuts, including the AMT repeal. On the other hand, dozens of members of the current Republican majority in Congress represent districts with lots of blue state Republican voters. It’s no surprise that many of those members, such Rep. Leonard Lance (R-7) of Somerset and Hunterdon Counties, are already leading theagainst repealing the deduction.
Interestingly, the Republican framework does not actually mention the SALT deduction, let alone call for its elimination. It simply states that most itemized deductions will be eliminated. My suspicion is that this curious lack of specificity served two purposes. First, it “fed the beast” of longstanding red state Republican resentment against the blue state SALT deduction. Second, it signaled that the Republican leadership understood that they might ultimately have to relent. When that happens, pressure to retain the AMT will increase, likely leading to a wholesale unraveling of the broader framework.
What will happen? My guess is not much.