Acronyms come and go in America. Take the ATM.
Twenty five years ago, few people had heard of Automated Teller Machines. Today, they are found on just about every street corner, and ATM is one of the most widely recognized acronyms in the world.
Over the next few years, Americans will begin hearing more about another acronym with those same three letters. But rather than being known as something that puts money into people’s pockets, this acronym could soon become known for the money it removes.
It’s the Alternative Minimum Tax – or AMT for short. As it stands now, the AMT is a mandatory second method for calculating a taxpayer’s tax liability under the current income tax. Because of the AMT, taxpayers are required to pay the larger of the taxes calculated under the two methods.
The original objective of the AMT was to ensure that the highest income taxpayers were not able to avoid paying taxes by using large amounts of exclusions, deductions and credits. Over time, though, the number of taxpayers affected by the AMT has steadily increased – from 140,000 in 1987 to more than 3 million in 2004.
At the same time, the AMT has increasingly come to affect moderate income taxpayers while leaving many of the highest income taxpayers unscathed. According to the Joint Committee on Taxation, 30 million taxpayers will be affected by the AMT by 2010, and AMT liability will skyrocket from $13 million in 2004 to $108 million in 2010.
Of course, as with everything else related to the American tax system, the whole thing is rather complicated to figure out.
For example, the tax base of the AMT – referred to as alternative minimum taxable income, or AMTI – is calculated by adding deductions and other tax preferences back to the taxpayer’s taxable income under the regular income tax. AMTI in excess of the AMT exemption amount is taxed at a rate of 26% on the first $175,000 and 28% on the remainder, with the exemption amount phased out over the income range from $150,000 to $420,000 for married taxpayers and $112,500 to $282,500 for unmarried ones.
A temporary AMT “patch” was approved that increased the exemption amount for taxable year 2006 to $62,550 for married tax filers (who file a joint return) and $42,500 for unmarried tax filers. However, under current law, for taxable years beginning after 2006 the exemption amounts revert to $45,000 for married tax filers and $33,750 for unmarried tax filers. The tax rates on net capital gains and dividends are the same as under the regular income tax. The most popular deductions (and the most significant in terms of revenue) that are not allowed under the AMT include deductions for state and local taxes, personal exemptions, and the standard deduction. In addition, a host of other tax preferences and deductions are reduced or not allowed under the AMT.
The net result of all of this is not only confusion, but an increasing number of taxpayers who are affected by the AMT. This is primarily because the AMT exemption amount and the AMT rate bracket are not indexed for inflation. Consequently, purely inflationary increases reduce the value of the AMT exemption amount in relation to personal income and push taxpayers into the higher tax bracket. By comparison, such “bracket creep” is not much of a problem under the regular income tax, as the personal exemption, the standard deduction, and rate brackets are all indexed for inflation.
As one might imagine, questions abound regarding the AMT. Is the AMT a serious problem that needs to be fixed? If so, should the AMT be repealed or reformed? What are the most efficient reform options and how much revenue must be raised to pay for reform? These are important questions that must be addressed in the very near future.
The first question has a straightforward answer. The AMT is unquestionably a problem that needs to be fixed. The AMT imposes significant costs on taxpayers and the economy. The most obvious cost is the added complexity in calculating taxes since the AMT requires a substantial number of taxpayers to calculate taxes under two different tax systems. Note that many taxpayers who are not affected by the AMT must also calculate their AMT liability. More subtle but arguably more important is the problem that individuals and firms must predict whether they will be subject to the regular income tax or the AMT in all their long term economic decision making.
Some commentators have argued that the AMT should be made permanent and the regular income tax should be repealed because the AMT is an efficient broad-based tax with a virtually flat rate structure. However, by taxable year 2010 most taxpayers who are affected by the AMT would face higher tax rates under the AMT than the regular income tax because effective tax rates under the AMT are increased by the phase out of the AMT exemption amount. For example, effective tax rates for married taxpayers under the AMT are 26% up to $150,000, 32.5% from $150,000 to $175,000, 35% from $175,000 to $420,000, and 28% for taxpayers with incomes above $420,000. Given this, it is unlikely that adopting the AMT would increase economic efficiency.
Given current budget projections, it is reasonable to assume that any AMT reform would have to be paid for by either increasing revenues from other taxes, adopting new taxes, or reducing federal spending.
The AMT also raises equity concerns. The highest income taxpayers, currently subject to a 35% rate, would pay a lower 28% marginal tax rate under the AMT. In addition, married couples are more likely to be subject to the AMT than unmarried couples since the AMT does not distinguish between married and unmarried taxpayers in terms of the size of the exemption amount or the size of the rate brackets as under the regular income tax. This implies that large marriage penalties result under the AMT. Furthermore, larger families are more likely to be affected by the AMT since the AMT exemption amount does not differ by family size. All of these features are arguably undesirable on equity grounds.
There are numerous options for reforming the AMT. Several of the most common suggestions include repealing the AMT, increasing and indexing the AMT exemption amounts and rate brackets, allowing personal exemptions under the AMT, or allowing state and local tax deductions under the AMT. However, such reforms would be associated with a significant decline in revenues. For example, JCT estimates that repeal of the AMT would reduce federal income tax revenues by $872 billion from 2007 to 2017 and that allowing personal exemptions against the AMT would reduce federal income tax revenues by $509 billion from 2007 to 2017. Given current budget projections, it is reasonable to assume that any AMT reform would have to be paid for by either increasing revenues from other taxes, adopting new taxes, or reducing federal spending. This raises complicated political issues.
In my view, AMT reform should be consistent with the following three principles. First, any new reform should include inflation indexing of key structural tax parameters to avoid the problems associated with bracket creep. Second, our goal should be to create a simple tax that minimizes compliance costs for taxpayers. Third, we should avoid increasing tax rates in a manner that will induce taxpayers to make behavioral changes or devote more resources to avoiding taxes. This is especially important for the taxation of capital income given the increasing globalization of world capital markets.
Haphazard reforms, such as proposals that would raise tax rates on some taxpayers to finance tax relief for others under an inherently flawed tax, are unlikely to create a simple, fair and efficient tax system and should be avoided. In fact, broadening the tax base by limiting deductions almost always dominates increasing statutory tax rates in terms of creating efficient economic incentives. Sweeping reforms like those put forth by the President’s Advisory Panel on Federal Tax Reform should also be considered.
However, there is currently a lack of political will to implement sweeping reforms that are necessary to deal with the problems presented by the AMT and the regular income tax. This is unfortunate given the imminent budget crisis facing the U.S., which increases the importance of implementing a simple, efficient and fair tax system that could help stimulate U.S. economic growth over the next century.
Dr. John W. Diamond is the Kelly Fellow in Tax Policy at the James A. Baker III Institute for Public Policy at Rice University in Houston. He previously served on the staff of the U.S. Joint Committee on Taxation.