- The individual alternative minimum tax (AMT) operates parallel to the regular income tax, with different rates and definitions of income and deductions. The AMT grew out of a minimum tax that was first enacted in 1970 after it was revealed that some high-income households had paid no income taxes in prior years. Although it has historically applied to few taxpayers, the tax is projected to grow rapidly over the next decade under current law. In addition to increased complexity, this will create problems for the transparency, equity, and efficiency of the tax code.
- Although the IRS’s National Taxpayer Advocate reported earlier this month that the AMT was the most serious problem faced by taxpayers, President Bush’s 2004 State of the Union address did not mention the AMT. The AMT problem has been a consequence of bipartisan neglect, so the President is not alone in that regard. But the tax cuts that he has championed threaten to double the number of AMT taxpayers after some small temporary fixes expire in 2005, and the President advocates making those tax cuts permanent, which will significantly increase the number of families subject to the AMT over the long term.
- This note provides information to help assess the AMT problem and options for reform. For details, see “The AMT: Projections and Problems,” Tax Notes, July 7, 2003.
- Under current law, AMT coverage will skyrocket. By 2010, the AMT will affect 33 million taxpayers—about one-third of all tax returns—up from 1 million in 1999. This would make the AMT almost as common as the mortgage interest deduction is today. The AMT will be the de facto tax system for households with income between $100,000 and $500,000, 93 percent of whom will face the tax. It will encroach dramatically on the middle class, affecting 37 percent of households with income between $50,000 and $75,000 and 73 percent of households with income between $75,000 and $100,000 (compared to less than 3 percent for each group in 2002).
- The expansion occurs because the AMT is not indexed for inflation and because of the 2001 tax cut. Because it is not adjusted for inflation, AMT liability tends to increase every year, even if real income does not change. At the same time, the tax cut reduces regular income tax liabilities without providing permanent AMT relief. The 2001 tax cut will more than double the number of people subject to the AMT in 2010 (from 14 million to 33 million). If the AMT had been indexed when the regular income tax was and had the 2001 tax cut not been enacted, only about 300,000 households would face the AMT in 2010.
Links between the AMT and Making the 2001 Tax Cuts Permanent
- Making the tax cuts permanent would greatly increase AMT coverage. If the tax cuts were made permanent, a projected 44 million taxpayers would face the AMT in 2014. In contrast, if the tax cuts are allowed to expire as scheduled, “only” 26 million would face the AMT in 2014.
- The AMT masks the true cost of tax cuts. Making the tax cuts permanent would reduce revenue by $330 billion in 2014 if the AMT is not fixed—but in that case, 44 million people would be on the AMT. Protests from unhappy taxpayers are likely to require reform long before that. If the AMT exemption increase were extended and indexed so that only 5 million people faced the AMT in 2014 (compared to 3 million in 2003), then making the 2001 tax cuts permanent would reduce revenues by $435 billion in 2014. The combined cost of the AMT change and making the tax cuts permanent would reduce revenues by $487 billion in 2014—almost 50 percent more than the myopic estimate.
- For details on making the tax cuts permanent, see “Key Points on Making the Bush Tax Cuts Permanent,” “Sunsets in the Tax Code,” Tax Notes, June 9, 2003 and “The Budget Outlook: Analysis and Implications,” Tax Notes, October 6, 2003.
Complexity, Fairness, Incentives
- The AMT reduces the number of high-income filers who pay no income tax. In 2001, an estimated 100 tax filers with income over $1 million avoided all income tax, but at least 700 would have if not for the AMT. Even so, this goal could be accomplished more simply in the regular income tax.
- The AMT is notoriously and pointlessly complex. The Internal Revenue Service and the Taxpayer Advocate have flagged the AMT as one of the most complicated tax provisions to comply with and administer. Most people required to fill out the AMT forms end up owing no additional taxes. The AMT also creates complicated interactions with the regular income tax.
- The AMT raises marginal tax rates. By 2010, the AMT will impose higher marginal tax rates than the regular income tax does for 93 percent of AMT taxpayers. High marginal tax rates encourage tax avoidance and penalize work and saving.
- The AMT is poorly targeted. Although originally intended to curb tax sheltering, the AMT raises less than 5 percent of its revenue from anti-sheltering provisions, such as accelerated deprecation or oil depletion allowances. In 2010, only about 1 percent of AMT taxpayers will be subject to the tax due to anti-sheltering rules. A key reason why the AMT does not target shelters very well is that the preferential treatment for capital gains—the lynchpin of most individual tax shelters—is not curtailed by the AMT.
- The AMT imposes penalties on marriage and having children. Couples will be more than 20 times as likely as singles to face the AMT in 2010. Because the AMT prohibits deductions for dependents, 85 percent of married couples with two or more children will face the AMT, 97 percent among such couples with income between $75,000 and $100,000. About 6 million taxpayers will face the AMT in 2010 simply because they have children.
- Repeal would be expensive and regressive. Repealing the AMT in 2005 would reduce revenues by $660 billion through 2014 if the 2001 tax cut expires as scheduled in 2010, and about $1,090 billion if the tax cut is extended. By 2008, it would cost more to repeal the AMT than to zero out the regular income tax. More than 75 percent of the benefits of repeal would go to households with income above $100,000 in 2010.
- Sensible reforms could spare the middle class. Indexing the AMT for inflation, allowing deductions for dependent exemptions, and allowing personal credits against the AMT would reduce the number of AMT taxpayers in 2010 by 88 percent, including over 98 percent of those with incomes under $100,000.
- Paying for reform is a key issue. Without revenue offsets, the reform above would reduce 2005-14 revenues by $450 billion if the tax cuts sunset, $780 billion if they are extended.
- The AMT could be retargeted at high-income tax avoiders by combining the reforms above with treating the lower rates on capital gains and dividends as a “preference item” (as capital gains were treated before 1987). This pays for most of the cost of the reforms mentioned above, reduces sheltering, and exempts most middle income households from the tax.