Cutting a Campaign Trail Worth Running On

Presidential candidates have three options on taxes — raise ’em, reform ’em or cut ’em.

John Edwards has publicly embraced the first option, suggesting much higher rates on small businesses, for example. That position makes him the leading candidate for the Walter Mondale Award for Honesty en Route to Defeat. Candor appreciated; thanks for visiting, senator.

Option 2, tax reform, is good. And it’s needed, given the complexity and anti-growth features of our tax system. But reform is messy, hard to explain and highly divisive — poor attributes for a winning political issue.

That leaves the competitive candidate with one option: cutting taxes. And that option is really appealing because, unless Congress acts to stop it, the American people will soon face the largest tax increase in their history.

It’s already on the books. The 2001 and 2003 tax relief measures will expire after Dec. 31, 2010. In 2011 alone, taxes are slated to jump by $147 billion, and by $211 billion in 2012. Such a tax hike would flatten the economy for years.

Higher tax rates are as unnecessary as they are undesirable. Despite the significant ongoing funding related to Hurricane Katrina and the costs of the War on Terror, the budget deficit is low enough that the debt to GDP ratio is projected to fall every year for the next five years, even with current tax law extended. The only possible justification for raising taxes is to jack up government spending.

Liberal lawmakers have long opposed the Bush tax cuts and hope to spend the cash brought in by higher taxes. They argue that allowing the tax cuts to expire isn’t a tax hike. Heavens, no!

Tell that to the mother of two who just saw her tax bill go up by $1,000 because the child tax credit was halved. Tell that to the retired couple relying on dividend income to pay the bills as the tax on dividend income jumps from 15 percent to 28 percent (or 35 percent). The liberals’ motto might be: Do you believe me or your Form 1040?

Taxpayers will judge whether their taxes have gone up or down. By 2011, current law will have been the law of the land for eight to 10 years. It is what families and small businesses have come to expect. Congress is responsible for changes in the level of collections arising from any change in the tax law. So here’s one simple test: If the tax burden changes due to a change in the tax law, then Congress has raised taxes.

Making today’s tax law permanent is the first step, but it’s not a tax cut. It merely prevents a tax hike. Presidential contenders should vow to prevent a tax hike and to cut taxes in ways that improve economic incentives, starting with the Alternative Minimum Tax (AMT).

In recent years, the AMT has been held at bay with a “patch,” a temporary increase in the AMT exemption amount. The patch was simple and suitable when first proposed. Today, a more thoughtful approach is needed.

AMT repeal enjoys bipartisan support, but at well over $1 trillion over 10 years (assuming the tax cuts are extended), it’s also pricey and would do little for economic growth.

For starters, correcting the AMT treatment of dividends and capital gains offers greater promise. The 2003 tax reform cut the dividends and long-term capital gains tax rates for regular and AMT filers to 15 percent, but for many AMT filers the effective rate remains above 20 percent.

The problem is the $45,000 AMT exemption amount begins to phase out at $150,000 of income for married filers. The phase-out rate is 25 percent. Dividends and capital gains income can push AMT taxpayers into the AMT phase-out range, raising their effective tax rate on this income to 21.5 percent.

There is no policy justification for the AMT phase-out surprise. Presidential candidates should propose exempting dividend and long-term capital gain income from the calculation of the AMT phase-out, thereby preserving the 15 percent tax rate for all taxpayers. This would be a strong, pro-growth policy, and it would help prevent the number of AMT filers from ballooning this year.

Imposing a heavier tax load on families with children has never been an identified policy purpose for the AMT. Yet the AMT lacks exemptions for children similar to those found in the regular income tax. Presidential candidates should propose raising the AMT exemption by $2,500 for families with one dependent and by $5,000 for families with two dependents. This would make the tax code more family friendly and significantly reduce the number of AMT filers.

Keeping the AMT at bay is important, but candidates should also pursue tax relief for non-AMT payers. The 2003 dividend and capital gains rate reductions were excellent tax policy, but we should eliminate these taxes altogether. They penalize prosperity itself.

Short of repeal, a useful next step would allow a $10,000 annual exclusion for married filers for dividend income and realized long-term gains. This would encourage saving, especially among modest-income taxpayers, greatly simplify the tax system for millions of taxpayers and give the economy a solid supply-side push.

An American president should convey a substantive vision for a more prosperous future. Raising taxes through action (as Sen. Edwards suggests) or inaction (by letting tax cuts expire) won’t lead to prosperity any more than becoming a better thief leads to virtue. And holding the line on taxes is simply treading water.

Many tax cuts would advance tax reform through simplification while strengthening incentives to work, save, invest, start new businesses and take the economic risks necessary to prosper. We can debate their relative merits and hope the candidates will do likewise. The starting point is to set out on a campaign trail toward lower taxes and a more competitive economy capable of paying higher wages.

JD Foster, Ph.D., is the Norman B. Ture Senior Fellow in Tax and Entitlements at The Heritage Foundation (heritage.org).