Tax ritual underscores need for reform

Postal worker Michelle Linton puts out tax forms at the main post office in New York, April 15, 2003. A last minute scramble by U.S. lawmakers to prevent millions of unsuspecting middle income families from being hit with a tax for the very rich shows just how broken the U.S. tax code has become.

WASHINGTON (Reuters) - A last minute scramble by U.S. lawmakers to prevent millions of unsuspecting middle income families from being hit with a tax for the very rich shows just how broken the U.S. tax code has become.

Couple the alternative minimum tax with the looming expiration of President George W. Bush's tax cuts in 2010, which one analyst said would raise taxes by $246 billion in one year, and you have a "perfect storm for tax reform," Wisconsin Republican Rep. Paul Ryan says.

Added Marc Gerson, a tax analyst at Miller and Chevalier in Washington, "The tax code is just about to implode on itself."

Many analysts agree with that assessment. But with Bush entering his last year in office and politicians unable to deal with complex issues in an election year, it is likely to fall to the winner of the November 2008 presidential vote to tackle the problem.

"Who wants to be sitting in the White House when a $246 billion tax hike is thrust onto American taxpayers?" said Alex Brill, a research fellow at the American Enterprise Institute.

The AMT is a parallel tax system that throws out most of the deductions and credits allowed by the regular income tax code. People have to calculate their taxes under the two systems and pay the higher of the two bills.

The AMT was enacted in 1969 to make sure rich people did not take advantage of so many breaks that they paid no income tax. But inflation has exposed more middle income people to the tax.

Most lawmakers agree the AMT is bad policy, but having it on the books obscures the severity of the budget deficit and eliminating it would cut an $800 billion income stream over 10 years that lawmakers would have to make up elsewhere.

But if Congress does nothing, about 30 million taxpayers would be hit with the levy by 2010, some earning as little as

$67,000.

So lawmakers find themselves unable to strike the tax from the books or allow it to go fully into effect. Instead they engage in an annual ritual of trying to shield a growing number of taxpayers by enacting a one-year fix.

ANOTHER LAYER OF COMPLEXITY

The AMT adds another layer of complexity to U.S. tax laws, which creates a sense of unfairness among many taxpayers, said Leonard Burman, a senior fellow at the Urban Institute and director of the Tax Policy Center. It also has spurred a growing number of accounting firms to seek U.S. patents on tax avoidance strategies.

"The idea you could patent something that only exists because of government is ridiculous and gives people windfall gains from everything that is wrong with the tax system," Burman said.

A number of presidential hopefuls have put forward ideas to change the system, but tax reform has yet to take hold as a major campaign issue.

That could change if Congress fails to enact temporary AMT relief and an estimated 25 million taxpayers end up paying it when they file their 2007 tax returns next year. Many people do not know they owe the AMT until they hear from the Internal Revenue Service.

Republicans in general support lower tax rates and call for spending cuts to eliminate the deficit. A few have offered comprehensive tax plans.

Presidential candidate Mike Huckabee wants to eliminate the complex tax code and replace it with a national sales tax that he calls the "fair tax." He would allow for monthly rebates that would offset the cost of the tax for poor people.

Jason Furman, a senior fellow at the Brookings Institution, said Huckabee's plan was unworkable and would be subject to massive fraud and abuse.

Republican candidate Fred Thompson's proposal, which is based on one developed by Congressman Ryan, would give taxpayers a choice of tax codes.

Under Thompson's proposal, taxpayers could either stick with the traditional system with its credits and deductions or opt for a flat tax with two rates, 10 percent for incomes up to $100,000 and 25 percent over that amount.

Democratic presidential candidates in general have called for rolling back some of Bush's tax cuts, but favor continuing some popular middle class tax breaks, while creating new ones to encourage savings and education. Sen. Hillary Clinton has proposed some new tax breaks for health care and retirement.

(Editing by David Alexander and Mohammad Zargham)