The Alternative Maximum Tax

The flat tax has lost some of its appeal with voters for three reasons. First, although most Americans are hugely attracted to the concept of a simple postcard flat tax, they are not enthusiastic about parting with all of their sacred-cow deductions, such as popular write-offs for mortgage interest, charitable donations, and health benefits. Special-interest groups with a stake in preserving the current system–from H&R Block, to the housing and insurance industries, to Wall Street’s municipal bond traders, to K Street corporate lobbyists who make their living chiseling out tax shelters–have successfully cultivated voters’ inclination to stick with the devil they know. Second, although the flat tax would be a source of rocket fuel for the economy, it still creates winners and losers. Some industries–such as high-technology companies and start-up firms–would do exceptionally well under the flat tax. But others, such as life insurance companies, banks and accounting firms, might get hurt in the short term. Similarly, some taxpayers would pay less tax; others, with large deductions, would owe more. Any policy proposal that creates large identifiable losers is regarded as poison in Washington.

Finally, many Americans are rightly suspicious of another Washington bait-and-switch ploy–we give up our few remaining tax shelters in exchange for lower tax rates, only to discover in a few years that Congress has turned around and raised the tax rates again. This is precisely what has happened in the decade following the passage of the 1986 Tax Reform Act. There is one tax system worse than high rates and lots of loopholes: high rates and no loopholes.

Fortunately, these objections can be very easily trumped with one simple alteration to the flat tax. The feature that is missing from the flat tax is the right to choose. If some Americans don’t want to give up the current system, why force them to? Why not allow every taxpayer to choose between the current income tax system or an alternative post maximum tax (MAXTAX) with a flat rate of 25 percent of gross income that could be filled out on a postcard return? Only one deduction would be permitted under the MAXTAX: a credit for the payroll tax paid–7.65 percent for a salaried worker and 15.3 percent for a self-employed worker.

Corporations would also be permitted to bypass the byzantine corporate income tax laws and pay a 25 percent maximum tax on their gross income with a credit for any payroll tax paid. Corporations must now comply with an alternative minimum tax (AMT), which places a floor on their tax burden. The MAXTAX would establish a reasonable ceiling on the taxes any individual or business must pay.

The MAXTAX has several advantages over other current tax reform proposals. First, unlike the flat tax, the MAXTAX would not require complex transition rules or costly phase-outs of current deductions. Rather, Congress could implement the alternative maximum tax immediately with an amendment tacked on to the end of the 9,000 page Internal Revenue Code: “Any individual or business has the option of bypassing all the preceding requirements, regulations, and instructions, and instead paying a tax of 25% of gross income earned during the year, minus a tax credit for any payroll tax paid.” This single sentence is all that is required for a truly revolutionary simplification of America’s income tax system.

Unlike the flat tax, the alternative maximum tax produces only winners–no losers. Not a single American family or business would be required to pay even a penny more tax than they do now, because the MAXTAX is entirely voluntary.

The MAXTAX should incite less opposition from special interest groups, because it does not end a single deduction, loophole, or credit in the tax code. All deductions in the current system would be retained–for taxpayers who chose to take them. Homeowners could still take advantage of the mortgage interest deduction; tax-oppressed New Yorkers and Californians could still deduct their steep state and local income taxes; large families could deduct their children, and so on. If these and other tax write-offs are as indispensable to taxpayers as H&R Block, the National Association of Realtors, and the Clinton Treasury Department say they are, then Americans will surely not choose to give them up.

What is more likely, however is that millions of taxpaying workers and businesses would enthusiastically opt for the MAXTAX alternative–even many who might face a slightly higher tax liability. Hong Kong’s celebrated flat tax system is really a 15 percent alternative maximum tax. The vast majority of Hong Kong residents opt voluntarily to short-circuit the complexities of the normal tax system and pay the simple flat tax instead.

Americans now spend an estimated 5.5 billion hours a year complying with the income tax code–more hours than are worked by every resident of the state of Indiana in a year. The non-partisan Tax Foundation estimates that compliance costs extract an estimated $157 billion a year from the U.S. economy–or the equivalent of a week’s worth of national output down the drain.

Assuming that the MAXTAX might slash these economy-wide compliance costs by at least two-thirds, the annual windfall gain of $100 billion or more could be shared by the government–in the form of higher voluntary tax payments–and taxpayers–in the form of lower compliance costs and immeasurably less aggravation. For example, in 1993 Mobil Oil Company paid $15 million in tax preparation costs. In theory, Mobil should be willing to pay up to $15 million in extra tax to the government in exchange for avoiding these compliance costs.

Finally, in an era when the guiding orthodoxy of economic policy in Washington is class warfare, the MAXTAX can be easily defended on “tax fairness” grounds. A 1995 Reader’s Digest poll asked Americans: “What is the highest percentage of income that is fair for a family of four making $200,000 to pay in all taxes?” The median response–across racial, economic, age, sex, ideological, and educational lines–was 25 percent. A subsequent GrassRoots Research poll last March discovered that a majority of Americans would favor a constitutional amendment that would prohibit federal, state, and local taxes from taking “a combined total of more than 25 percent of anyone’s income in taxes.” The MAXTAX would partially codify Americans’ definition of tax fairness–although not entirely because the MAXTAX puts a 25 percent cap only on federal payments.

Because the MAXTAX creates a credit for the regressive payroll tax (which expires after $62,000 of income), it lowers marginal tax rates for virtually all taxpayers. For example, the current income tax rate of 28 percent for middle-income households earning $40,000 a year would fall to 17.5 percent (25% — 7.5% payroll tax) or 10 percent if the worker were self-employed. The top income tax rate of 39.6 percent, the 28 percent capital gains tax, and the confiscatory 55 percent estate and gift taxes would all fall to 25 percent, thus increasing the rewards for work, saving, and investment.

Tax reform enthusiasts (including myself) have talked longingly of burning and burying the Internal Revenue Code forever. That is precisely what invites all of the heavy-artillery opposition from defenders of the status quo. Milton Friedman predicted with great prescience on these very pages just over a year ago that although the flat tax has great merit, “there is next to no chance that Congress will enact this tax system” over the ferocious opposition of Washington’s army of special interests. In a contest between Washington and America, Washington almost always prevails.

Dick Armey, Steve Forbes, Bill Archer and others have heroically advanced the cause of a simple, fair, and pro-growth tax system. What is needed to jump-start their proposals is one final principle for tax reform: the freedom to choose. The MAXTAX does not burn and bury the tax code. It simply renders it irrelevant.

HOW TO CALCULATE YOUR ALTERNATIVE MAXIMUM TAX