Thursday, March 15, 2007

Is the AMT Worth Fixing

Greg points us to an AEI piece demonstating why democrats have been so keen on "fixing" the Alternative Minimum Tax (AMT).

As it turns out states that tax their residents, particularly their high income residents, heavily tend to be hit hardest by the AMT. Thats, of course because the AMT doesn't allow you to dedcuct state and local taxes. If you pay a lot of state and local taxes then you are more likely to have a high burden under AMT rules.

Which leads us to ask - is allowing state and local deductions a good thing?

THe quick retort of most economists is no. Why should someone get a tax break just because they choose to buy more things using the government rather than the private market place? An often repreated example is public vs. private pools. One community decides to build a public pool and tax its residents for it. They get a tax break.

The other community decides to build a private pool and charge member fees. They don't get a tax break.

However, I ask - do state and local taxes really pay for pools? What exactly is high local spending subsituting for?

The more accurate answer may be charitable contributions. Here in NC for example the state does three things, pays for public school instruction, Medicaid, and prisons. Everything else is pretty much rounding error. Local governments pay for school and road construction.

Now public roads may in some sense subsititute for toll roads. Medicaid and public schools, however, are largely transfer programs. Yes, most parents will send their kid through the public school system. So, perhaps on some level they substitute for private schools. Funding, however, for schools is not equally borne by all tax payers.

High income tax payers, end up putting in far more for schools than they take out. Those are precisely the people who are getting hit most by the AMT. So, in many ways state and local taxes on the wealthy subsitute for charity. It makes sense given that high AMT states also tend to be highly urban states.

Charity doesn't work as well when there are a lot of other rich people to free ride off of. Instead the state opts for higher taxes on high income residents. So, as long as we think the charitable deduction is a good idea, then it stands to reason that the state and local tax deduction may be worth keeping too.

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