The Individual AMT: Problems and Potential SolutionsLeonard E. Burman, William G. Gale, Jeff Rohaly, Benjamin H. Harris The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.
TPC Discussion Paper No. 5
The Urban-Brookings Tax Policy Center
The Tax Policy Center (TPC) aims to clarify and analyze the nation's tax policy choices by providing timely and accessible facts, analyses, and commentary to policymakers, journalists, citizens and researchers. TPC's nationally recognized experts in tax, budget and social policy carry out an integrated program of research and communication on four overarching issues: fair, simple and efficient taxation; long-term implications of tax policy choices; social policy in the tax code; and state tax issues.
A joint venture of the Urban Institute and the Brookings Institution, support for the TPC comes from a generous consortium of funders, including the Ford Foundation, the Annie E. Casey Foundation, the Charles Stewart Mott Foundation, and the George Gund Foundation.
Views expressed do not necessarily reflect those of the Urban Institute, the Brookings Institution, their boards of trustees, or their funders.
I. INTRODUCTION
II. THE INDIVIDUAL AMT: AN OVERVIEW
Current Rules
Evolution of Minimum Tax Rules
III. PROJECTIONS OF AMT PARTICIPATION AND REVENUES
IV. ECONOMIC ISSUES
Potential Justifications
Equity
Efficiency
Complexity
V. POLICY OPTIONS
Reform Options
A Constant-Revenue, Distributionally-Neutral AMT and Income Tax Change
Changes in the AMT and EGTRRA: Revenue effects
Revenue-Neutral AMT Reform
VI. CONCLUSION
VII. APPENDIX: MODEL AND METHODOLOGY
VIII. REFERENCES
In January 1969, Treasury Secretary Joseph W. Barr reported to Congress that 155 individual taxpayers with incomes above $200,000 paid no federal income tax on their 1967 tax returns.1 The news created a political firestorm. Members of Congress received more constituent letters in 1969 regarding the 155 taxpayers than concerning the Vietnam War (Graetz 1999). Later that year, the Tax Reform Act of 1969 created a minimum tax designed to ensure that individuals with high incomes did not take what was deemed undue advantage of tax laws to reduce or eliminate their federal income tax liability.
Although the original minimum tax and its successor, the individual alternative minimum tax (AMT), have historically had limited scope and applied only to a small minority of high-income households, the AMT is now on the verge of switching from a "class tax" to a "mass tax." In 2001, for example, fewer than 2 percent of taxpayers paid AMT. These taxpayers had substantial incomes, accounting for 7 percent of all adjusted gross income (AGI). Nevertheless, the tax accounted for just 1 percent of income tax revenue. Under current law, by 2010 the AMT will affect one-third of all taxpayers, who account for 55 percent of all AGI, and raise 10 percent of income tax revenues. The AMT will encroach significantly on the middle-class, affecting a majority of taxpayers with AGI between $50,000 and $100,000. It will become the de facto tax system for taxpayers with AGI between $100,000 and $500,000, 95 percent of whom will pay AMT. Among married couples with two or more children and income between $75,000 and $500,000, the AMT participation rate will approach 100 percent. Indeed, by 2008, it would cost less in lost revenue to repeal the regular income tax than to repeal the AMT.
These projected increases raise a host of issues because the AMT is notoriously complex, its effects on efficiency and equity are questionable, and its underlying purpose is controversial. The purpose of this paper is to provide information on the AMT, its economic effects, and potential reform options.
Section I describes the calculation of AMT liability and the historical evolution of minimum taxes. The AMT tax base is essentially the sum of regular taxable income plus a variety of factors that are not included in the regular tax base, less the AMT exemption. The base is taxed at flatter rates than under the regular tax. AMT liability is the difference, if positive, between a taxpayer's overall liability under the AMT and a measure of tax liability based on the regular income tax.
The history of AMT reforms suggests that legislators intend for the tax to address broad issues of vertical and horizontal equity as well as the desire that every high-income person pay at least some income tax. Most major tax reforms since 1980 have involved AMT changes that broadly conform to the changes introduced in the regular tax. Two notable exceptions—the 1981 tax cuts, which indexed the regular income tax for inflation without indexing the AMT, and the 2001 tax cut, which slashed ordinary income taxes while leaving AMT rates and brackets unchanged (but for a temporary fix through 2004)—are the main culprits behind the predicted explosion of AMT coverage and liability. In section II, we use a new tax policy simulation model developed at the Urban-Brookings Tax Policy Center to document the projected AMT expansions noted above and relate the expansions to the lack of indexing for inflation and the 2001 tax cut.
Section III analyzes economic issues related to the AMT. Although tax policy trade-offs and constraints imposed by budgets, political factors, and public opinion might rationalize the existence of some form of minimum tax, the existing AMT is difficult to justify formally. In equity terms, the AMT is more progressive than the regular tax, but AMT progressivity will decline markedly over the next decade, as more middle-class households fall prey to the AMT. The number of high-income people who pay no income tax has been roughly constant over time, but would have increased if not for the AMT.
The efficiency effects of the AMT are complicated. Observers typically characterize the AMT as having a broader base and lower marginal tax rates than the regular income tax. We show, however, that as of 2010, the opposite characterization will generally hold. For the vast majority of AMT taxpayers, the AMT will apply to less income and will be assessed at higher marginal tax rates than the regular tax. Interactions between the regular tax and the AMT have ambiguous effects on efficiency.
The AMT is complex. Rules regarding the timing of recognition of income and deductions require taxpayers to keep separate books for the regular tax and the AMT. The revenue gains of these rules are largely offset by another complicated set of rules that allow future tax credits for the tax benefits lost through the first set of rules. Thus, these two sets of rules are doubly complex and raise little revenue. The rules do, though, serve a recognizable policy goal: they reduce the number of high-income filers that pay no income tax in a given year. The potential value of other sources of AMT complexity is not readily apparent. Most people who are required to fill out the AMT forms end up owing no additional tax. The tax will impose increasing compliance burdens over time on middle-class taxpayers, who have never been the main target of the AMT. Interactions between the AMT and the regular tax present taxpayers with complex planning problems.
Section IV examines reform options. Indexing the AMT for inflation after 2002 would reduce the number of AMT taxpayers in 2010 by 70 percent, and the number with AGI between $15,000 and $100,000 by 90 percent. But it would cost $440 billion through 2012 under current law, and $100 billion more if last year's tax cut—which is currently slated to expire in 2010—is extended. With a few additional changes that would not increase tax sheltering, AMT participation would be cut by 99 percent by 2010 relative to current law. These changes include eliminating the phase-out of the AMT exemption, allowing exemptions for dependents and deductions for state and local taxes and miscellaneous expenses, and permitting the use of personal nonrefundable credits. This reform package, however, would cost $725 billion over the next decade, and $880 billion if EGTRRA is extended.
Repealing the AMT after 2002 would add $790 billion to the public debt by 2012 under current law, and $950 billion if EGTRRA is extended. Despite the growing share of middle-class taxpayers who are slated to pay at least some AMT, 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.
We also examine the financing of AMT reform. If the AMT were repealed and income tax rates changed to hold aggregate tax liability constant in each tax bracket, the resulting rate structure would require higher marginal tax rates for low- and middle-income taxpayers, much higher rates for most upper-income taxpayers, but lower rates for taxpayers in the top bracket.
Because projected AMT growth is due in large part to EGTRRA, freezing the tax cuts enacted in 2001 is a natural way to finance AMT reform. We show that freezing all of the cuts in upper income tax rates and in the estate tax in EGTRRA at their 2002 levels would be just sufficient to finance indexing the AMT after 2002, but would fall about $300 billion short of financing AMT repeal. The AMT could, however, be retargeted at high-income households in a revenue-neutral fashion that spared most of the middle class, but significantly increased taxes on the very affluent.
Section V provides concluding remarks. The Appendix describes our microsimulation model in more detail.
This report is available in its entirety in the Portable Document Format (PDF), which many find convenient when printing.
Note
1. Barr (1969). Adjusted for inflation, $200,000 in 1966 is equivalent to about $1.1 million in 2001.
Acknowledgments
We thank Al Davis, John O'Hare, Peter Orszag, Samara Potter, Dan Shaviro, Gene Steuerle, Frank Sammartino, Jerry Tempalski, David Weiner, Rob Williams, and participants at the National Tax Association Spring Symposium for helpful discussions, Deborah Kobes for expert research assistance, and the Ford, Casey, Mott and Gund Foundations for research funding through grants made to the Tax Policy Center. A version of this paper will be published in the September 2002 issue of the National Tax Journal. Any errors or opinions are our own and should not be taken to represent the views of our funders or the officers, trustees, or staff of any of the Institutions with which we are affiliated.
About the Authors
Leonard E. Burman is a senior fellow at the Urban Institute and co-director of Tax Policy Center. William G. Gale is the Arjay and Frances Fearing Miller Chair and Deputy Director of the Economic Studies Program at the Brookings Institution and co-director of the Tax Policy Center. Jeffrey Rohaly is a research associate at the Urban Institute and director of tax modeling at the Tax Policy Center. Benjamin H. Harris is a research assistant at the Brookings Institution.
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