Some Taxpayers Don’t Owe a Penny

Today, as Californians face the April 15 income tax deadline, some of the most well-to-do will feel the sting less than millions of lowly wage earners.

In fact, they will feel no sting at all. They are the 0.2% of the state’s high-income filers who have worked the system so well that they don’t owe a penny.

And they remain untouched even as lawmakers in Sacramento contemplate new income taxes and other ways of raising money to close a shortfall that Gov. Gray Davis has estimated at $35 billion between now and July 1, 2004.

In 2000, the last year for which records are available, 784 individuals with incomes of $200,000 or more paid no income tax, according to the state Franchise Tax Board. That was up a third from the prior year.

Although a tiny fraction of the state’s overall tax roll, that group’s exemption from income taxes highlights a contradiction in U.S. tax policy that has nagged lawmakers for more than 30 years -- and that continues to simmer in the debate over how California should resolve its budget shortfall:

A tax law enacted specifically to ensure that every wealthy person pay at least some taxes has never been able to achieve that, and, instead, is raising the tax bills of a growing number of middle-class Americans.

Warned of a potential taxpayer revolt during the late 1960s if the rich were not universally forced to pay taxes, Congress enacted a special system, today known as the alternative minimum tax, to catch wealthy filers who would otherwise get off free. California, known for its progressive tax structure, was one of a handful of states that followed suit.

But credits enacted to stimulate business activity are being used by sharp accountants to override the alternative tax.

Now, as the wealthy increasingly elude the snare of the alternative minimum tax, more middle-class taxpayers are being trapped in its complex and costly rules.

One estimate suggests that by the end of the decade, 36 million Americans will be paying higher taxes because of laws meant to ensure that the rich pay some.

Yet, there is little move to do away with the alternative minimum tax it because it is now responsible for a growing share of state and federal revenues, and lawmakers are not inclined to cut from any reliable revenue source in such tight times.

In California, the taxpayers who are most likely to legally avoid taxes are business owners who register their companies under the increasingly popular provisions of so-called S corporations. Those firms pay only a nominal 1.5% corporate income tax, and the profit or loss then passes to the owners’ personal returns.

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S Corporations Popular

Owners of profitable S corporations can reduce personal income tax by using state tax credits adopted in the 1990s to stimulate business. The Franchise Tax Board’s annual report for 2001 identifies credits for manufacturing investment and doing business in enterprise zones -- together totaling about $500 million -- as the two largest factors in zero-tax returns filed by the wealthy.

Taxpayers who invest in businesses located in certain areas of Los Angeles, for instance, would be entitled to write off some expenses as deductions. That’s because policymakers want to encourage the development of new businesses in areas that otherwise have trouble attracting money. Similarly, taxpayers can deduct investments in manufacturing because the state wants to protect and encourage manufacturing industries.

At the federal level, different write-offs apply. A 1998 IRS report identified tax-exempt bond interest, interest deductions, some miscellaneous itemized deductions, casualty losses and medical expenses as the major shelters reducing the tax bills of high earners.

The author of the report, economist Brian Balkovic, found that the high-income earners could avoid the alternative minimum tax by piling up deductions.

Whether nationally or in California, tax avoidance by legal means stirs deep emotions.

“It’s simply outrageous that we’re continuing tax credits for the wealthy when we’re talking about cutting services, cutting health care, cutting education,” said Carmen Balber, a consumer advocate with the Foundation for Taxpayer and Consumer Rights in Santa Monica. “We would certainly support closing a loophole that is benefiting a few individuals at the expense of the average Californian.”

Some tax specialists counter, though, that society benefits from tax credits that stimulate hiring and production.

“I’ve got $200,000 income, I put a couple hundred thousand into one of these enterprise zone investments, that doesn’t make me a bad person,” said Ron Hegt, a partner in Hays and Co. of New York and a member of the tax committee of the American Institute of Certified Public Accountants.

The roots of today’s debate over the alternative minimum tax date to a 1969 speech delivered by retiring Treasury Secretary Joseph W. Barr in the waning days of the Lyndon Johnson administration.

In that speech, Barr disclosed that shelters had allowed 155 high-income Americans to zero out their taxes in the previous year. He warned Congress that the unfairness of it would not sit well with Americans.

“The middle class are likely to revolt against income taxes,” Barr said, “not because of the level or amount of taxes they must pay, but because certain provisions of the tax laws unfairly lighten the burdens of others who can afford to pay.”

Though the number of rich Americans who paid nothing was tiny, Barr pinpointed the contempt so deeply felt for the presumptuous rich, who would be epitomized by hotel queen Leona Helmsley. She once told a housekeeper, “We don’t pay taxes. The little people pay taxes.”

According to a history of the alternative minimum tax by the Tax Policy Center of the Brookings Institution and the Urban Institute, Barr’s speech touched off a letter-writing campaign that inundated Congress with more constituent protests that year than the Vietnam War.

Congress answered with a 10% tax on items such as capital gains, depreciation, stock options and depletion allowances. Five years later, however, the Treasury Department reported that the number of wealthy filers who paid no income tax had jumped to 244.

The alternative minimum tax evolved in the early 1980s. Under its provisions, high-income earners must calculate a second income tax return, with its own set of rules and deductions. They must pay the highest tax amount of the two methods.

Despite the tax rule, some wealthy filers still manage to legally avoid paying anything each year. A federal study found that 1,467 high-income filers paid nothing in 1998.

The alternative minimum tax has been criticized for its complexity, as well as the confusion over to whom the law applies.

Taxpayers will soon learn more about its requirements.

Treasury analysts Robert Rebelein and Jerry Tempalski concluded in a 2000 study that by 2010, nearly 30% of taxpayers earning $75,000 to $100,000 will have to pay the higher rate of the alternative minimum tax, while only 6% of those with incomes of more than $1 million will be affected by it.

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Taxation Is Uneven

The federal alternative minimum tax will not affect the middle class evenly, they said. Large families and single heads of households will be hit by the higher taxes sooner than couples with the same income, and it will be harder on Californians and residents of other high-tax states than Alabamans and Texans, whose state taxe rates are relatively low.

The Tax Policy Center report also predicted that President Bush’s 2001 tax cut would accelerate the alternative minimum tax’s incursion into the middle class by lowering the regular tax rate and therefore pushing more taxpayers into the alternative minimum tax. As a result, many middle-class taxpayers would not receive the benefit of the administration’s proposed tax cut.

But the obvious solution -- simply eliminating the alternative minimum tax -- is fraught with problems too, concluded the Tax Policy Center. Repeal, the center said, would add $790 billion to the public debt by 2012.

And one more wrinkle -- it would let a lot more wealthy Americans off the hook. That’s because the alternative minimum tax accomplishes some of its purpose, if not all.

“Despite the growing share of middle-class taxpayers who are slated to pay at least some AMT,” Tax Policy Center economists wrote, “repeal would be regressive, and would raise the number of high-income taxpayers who pay no income taxes by a factor of four or more.”