Alternative Minimum Tax?

Author: Kevin Adler and Annette F. Simon

Published: November 1, 2003

Here's an idea: Let's devise a politically inept income tax policy. We'll begin by eliminating tax breaks people have been accustomed to for decades, such as those for qualified retirement accounts, and state and local taxes. Next, we'll negate the child tax credit so that families with young children will be hit especially hard. Then, we won't adjust for inflation, so that our tax will affect more people each year as their incomes grow along with the economy and inflation. We'll tell people that they must calculate their taxes twice, using two different formulas -- and finally we'll add insult to injury by requiring them to pay whichever amount is higher.

Think we're just making this up? We're not. Welcome to the very real world of the Alternative Minimum Tax, or AMT. Designed more than three decades ago to ensure that the handful of people in America who earn CEO-class incomes would be certain to pay some amount of federal taxes each year, the AMT will be the de facto income tax for about 3 million not-especially-super-wealthy American households this year. For many of them, it will negate the tax cuts that President Bush has signed into law, and could mean that their taxes will go up rather than down. The Congressional Budget Office estimates that by 2010, 35 million households, or one-third of the public, will pay the AMT instead of the lower tax generated by the traditional income-tax formula.

How did we get into this situation? Through the deadly combination, it seems, of a burst of congressional conscience followed by decades of legislative neglect of the unintended consequences of the tax policy that resulted. The AMT can be fixed before it really balloons out of control and touches millions of middle- to upper-middle-income households in a few years. But it won't be easy.

Today, the IRS instructions on Form 6251 state that you should calculate your AMT "if your taxable income for regular tax purposes, combined with certain adjustment and tax preference items, is more than: $49,000 if you are married filing a joint return, $35,750 if you are single or head of household, or $24,500 if you are married filing a separate return." Stop for a moment and let those numbers sink in. The adjustments make each taxpayer's situation unique, but translated into English, this generally means that if your household income is more than about $75,000 per year, you should calculate your AMT.

Contrast that to January 1969, when then-Treasury Secretary Joseph Barr stepped before television cameras and waved a list of 155 taxpayers who had earned more than $200,000 in 1966 and paid no federal income tax, and decried the outrage. It wasn't exactly Sen. Joseph McCarthy and his list of alleged communists, but it was effective political theater. Barr's display generated the momentum that culminated in the creation of the AMT late in 1969.

The idea behind the AMT was for a taxpayer to calculate his or her income taxes twice -- once allowing for a variety of adjustments, the second time without most of them -- and pay the higher figure. It still works this way. You start with the traditional calculation, taking into account all the exemptions and tax breaks to which you are entitled, such as home mortgages and home equity loans, child tax credits, charitable gifts, qualified retirement accounts and state and local taxes. Then, to produce your AMT obligation, you set aside the previous calculation and start over. You strip out all your tax breaks except for mortgage interest and cash gifts to charity, but take a larger personal exemption and a slightly lower tax rate for your bracket.

The new tax was viewed as a matter of equity. It certainly didn't seem fair that some of the wealthiest Americans, who used countless loopholes to avoid taxes, paid less than people of middle-income or modest means. But the AMT has drifted far from its original intent. It has marched down the income brackets -- or, more accurately, incomes have increased over the past three decades, while the AMT calculation method has not been adjusted sufficiently to counter the effects.

Here's how a family can get caught in the AMT's web. We know a Washington working couple with three young children and an adjusted gross income of $139,000 a year. This is substantial, but far from unusual for two-income families in metropolitan areas across the country. The 2000 Census identified 13 million households with annual incomes of $100,000 or more nationwide.

Our taxpayer couple has a mortgage of $300,000; both partners maximize their 401(k) contributions. In other words, these taxpayers are prosperous but not ultra-rich, and unlike the 155 on Barr's 1969 list, they are not using exotic tax-avoidance strategies. Assuming their income will not go up, we ran their tax numbers for the years 2003-2010. Courtesy of the 2003 tax cuts, this family's federal income tax bill will be about $16,500 in both 2003 and 2004, and it will not pay any AMT. This is due in part to an adjustment made in the personal exemption for AMT in tax legislation in 2001.

However, in 2005 the AMT adjustment expires, and the family is due for a surprise. In that year, even with its income unchanged, its AMT obligation will exceed its federal income tax obligation by nearly $1,800, and it will have to pay that higher amount. By the year 2009, it will be paying an extra $3,700 thanks to the AMT. During the second half of this decade, even if this family does everything "right" -- paying local taxes, saving for retirement, and so on -- its federal income taxes will rise every year because of the AMT. This will completely offset the income tax cuts and other tax breaks that it has been promised in the 2003 tax act.

D.C. residents like this couple are especially vulnerable. Because the AMT negates the tax break for paying state and local taxes, District residents won't be able to take advantage of the federal deduction for paying a 9.9 percent income tax to the city. Montgomery County takes a cumulative maximum of 7.7 percent in state and county income taxes -- again, irrelevant in the AMT formula.

To test how truly warped this system has become, we ran the numbers for an imaginary couple, but this one earning $739,000 per year during the same period. It owed a lot more in taxes each year than the upper-middle-income family above (about $200,000 per year), but in only one of those years did it fall prey to the AMT.

The lesson here is not that the AMT is a failure. For more than 30 years, it has more or less worked as intended: reducing the attractiveness of some of the tax dodges dreamed up for the rich. It was tweaked a few times when it was discovered that some high-income taxpayers were finding creative ways to avoid taxes, but today most people accept the fact that having a high income means paying more taxes. However, we are now reaching a tipping point at which the AMT affects millions of taxpayers who do not engage in sophisticated tax planning.

As the AMT works its way down the income ladder, it poses challenges not only for individual families but also for the U.S. economy. First, the AMT taxpayer will not get the full tax cuts that he or she was promised. That's simply bad public policy. Second, with a higher tax bill than anticipated and few avenues for reducing taxes, an upper-middle-income taxpayer might not save as aggressively as he or she would have otherwise, since the AMT negates the tax break you get from putting money into an Individual Retirement Account or a 401(k). A lower national savings rate -- and it's already pathetically low -- will hurt our economy and further stress our already-stretched retirement system. Similarly, the AMT may reduce borrowing against home equity because it negates the tax break for interest on home equity loans. Economists have pointed out that home equity spending was a major factor in cushioning the recession of 2000-2001 and spurring our economic recovery.

Third, the tax breaks that the AMT ignores are among the most valuable to parents who are homeowners. Americans for Tax Reform estimates that by 2010, 85 percent of homeowners with two or more children and family incomes of $75,000 or more will have to pay the AMT instead of the regular income tax because they are simultaneously losing tax breaks for their kids and their property taxes.

Clearly, something needs to be done. Prominent critics from across the political spectrum have suggested that the AMT system has outlived its usefulness. A report issued by the Urban Institute and Brookings Institution Tax Policy Center in September 2002 stated that "the AMT must be reformed, if not eliminated, even though fixing [it] will be expensive." Even the IRS has serious reservations about the tax. Nina Olson, the IRS's National Taxpayer Advocate, made this declaration last month: "It's a horrible provision. We are really sorry about the impact of this tax, but it is not for us to rewrite the laws; it's for Congress to act."

Will Congress get the message? We're not so sure. There are strong factors working against a major revision to the tax code. Foremost, the government needs the money. The AMT will raise more than $15 billion in 2003, and the CBO estimates that it will surpass $130 billion -- or slightly more than half of projected federal income tax revenue -- in 2010. It's hard to imagine Congress giving up a large portion of that revenue stream.

Instead, Congress is most likely to make incremental adjustments to the AMT, which is the path of least resistance. We anticipate that it will raise the AMT exemption, as it did in 2001, so that fewer upper-middle-income taxpayers are affected. Yet even such tweaking will require Congress to find offsetting revenue sources, perhaps by raising income taxes on the uppermost income brackets or repealing this year's capital gains tax cuts -- actions Congress is loath to take.

A full repeal of the AMT can be justified in the name of simplicity, but it would be almost impossible to recoup financially. A study published in the National Tax Journal last year estimated that repealing the AMT would cost the U.S. Treasury $1 trillion between 2003 and 2012.

It's hard to see a ready solution. So far, the AMT has remained below the radar, in part because it is hard to understand, and in part because it has affected few of us. But we taxpayers, it appears, are about to get an education in the most direct way possible -- through our checkbooks.