A Taxing Time for Democrats

It's been a while since taxes were a potent political issue. It was almost 20 years ago that George H. W. Bush invited voters to "read my lips" and a baker's dozen years since Republicans captured Congress by decrying the Clinton tax increases. George W. Bush did promise to cut taxes, but it didn't help him much in 2000, and the ensuing economic recovery didn't help him much in 2004.

The federal tax structure is poised to change in the next few years.

But taxes could be an issue in 2008, as the federal tax structure is poised to change in the next few years. First, the Bush tax cuts are scheduled to expire in 2010, and the Democrats, who seem almost sure to hold or expand their majorities in the next Congress, seem determined not to extend some or all of them. So taxes at least on high earners are likely to rise. Secondly, the alternative minimum tax, passed in 1969 to prevent a handful of millionaires from avoiding income tax altogether, is now slated to hit more than 20 percent of taxpayers. And that percentage is due to rise every year because the AMT is not indexed for inflation.

The paradox is that the same Democrats who want to increase top-bracket income and capital-gains tax rates are desperately eager to spare relatively high earners from the AMT. So desperate that Senate Democrats agreed to waive the "paygo" rule they reinstated when they took control. Paygo requires that a tax cut be offset by a tax increase or a spending cut of corresponding dollar amounts. But when the Senate early this month passed its $50 billion AMT "patch" exempting 23 million taxpayers from the AMT for one year, it waived the paygo rule. House Democrats are simmering, but they will probably have to go along. There's a process argument for waiving paygo, which is that future AMT revenues are fictitious because no Congress will allow the tax to go into effect. But it's nonetheless embarrassing for Democrats to renounce a rule they adopted as a guarantee of their fiscal responsibility.

The reason Democrats risked this embarrassment is that the AMT tends to fall on voters in places with high state and local government spending and taxes, Democratic places like Massachusetts, Connecticut, New York, New Jersey, Maryland, and California. Taxpayers hit by the AMT can't deduct state and local taxes from their federal income tax bill. Sooner or later, that puts downward political pressure on state and local spending. And that, in turn, threatens the vested interest of a key Democratic constituency, the public employee unions. Democratic voters in suburban New Jersey, for example, who feel far from rich face a substantial tax increase if they're suddenly covered by the AMT. They may take their revenge on Democratic candidates and on New Jersey public employee union members.

Broader reform. The Democrats' need to get rid of the AMT suggests the possibility of broader tax reform. House Ways and Means Chairman Charles Rangel has put forth such a proposal, with a cut in the corporate tax rate and huge tax increases on very high earners. But it's a nonstarter as long as George W. Bush is in office. Another approach with more bipartisan appeal would be to combine AMT repeal and extension of the Bush tax cuts with a mass repeal of tax exemptions, along the lines of the 1986 bipartisan tax law.

Meanwhile, in this election cycle, the AMT remains largely invisible to the voters who are threatened by it, and it will remain so unless Congress somehow fails to patch it this year. The more visible issue is whether or to what extent taxes will go up in 2010. Democrats, conscious of the popularity of some recent governors who have raised taxes (like Mark Warner of Virginia), seem on the surface unfazed about the political risks of tax increases and are preparing to argue that they'll raise taxes only on the rich. But this may be awkward at a time when the budget deficit is rapidly declining and when we face the nontrivial possibility of a recession. A tax increase in a recession is usually not a good idea. And Republicans will say that when Democrats promise to tax the rich, they end up raising taxes on the ordinary person, as Bill Clinton and the Democratic Congress did in 1993. The Democrats' desperation to patch the AMT and their willingness to break their own paygo rule suggest that they fear the wrath of those New Jersey suburbanites more than they let on.