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The Individual Alternative Minimum Tax
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Leonard E. Burman is director of the Tax Policy Center and a senior fellow at the Urban Institute.
A precursor to the current individual alternative minimum tax (AMT) was originally enacted in 1969 to limit the amount of tax sheltering that taxpayers could pursue and to assure that high-income filers paid at least a minimal amount of tax. However, the current AMT has strayed far from those original goals and threatens to grow from a footnote in the tax code to a major component affecting tens of millions of taxpayers every year. This testimony outlines how the AMT works, whom it affects, and why it demands attention. It also discusses possible ways of reforming the AMT and why financing AMT reform or repeal is important.
The text below is Burman's oral testimony. Read the written testimony in PDF format.
Chairman Neal, Ranking Member English, Members of the Subcommittee: Thank you for inviting me to share my views on the individual alternative minimum tax.
In January 1969, Treasury Secretary Joseph Barr testified that 155 high-income individual taxpayers had paid no federal income tax in 1966. The news created a political firestorm. Members of Congress received more constituent letters in 1969 about those 155 taxpayers than about the Vietnam War.
Lawmakers could have responded in one of three ways. They could have explained that the non-taxpayers were taking advantage of tax incentives that advanced worthwhile social objectives and thus should not have to owe tax. That would have been a hard sell. They could have closed the loopholes that allowed rich people to avoid tax, but those loopholes had some pretty powerful constituencies, so that didn't happen either.
Instead, Congress decided to create an extra tax for high-income people who didn't pay enough under the regular income tax system to avoid such embarrassing disclosures in the future. Thus was born the AMT.
It was a bad choice. The AMT doesn't do much to rein in tax shelters. Because of poor design, millionaires are actually less likely to owe AMT than middle-income people with kids. It's inefficient. And it undermines support for the tax system because it's the poster child for pointless complexity. Taxpayers can't understand it, but they think it is unfair.
Before getting into how to fix the AMT, I'd like to address some shibboleths:
No. Those are the rates written into the law, but because the AMT exemption phases out with income, the effective rates are actually 26, 32.5, 35, and 28 percent—in that order. The highest rates don't apply to the highest-income people, which is why the AMT hits almost everyone with incomes between $200,000 and $500,000, but not so many millionaires.
The AMT would be a terrible tax system. First, high tax rates apply at relatively modest incomes, and high-income people would get a big rate cut (from 35 percent to 28 percent). Second, there are horrendous marriage and child penalties. Third, it is not indexed, so inflation would cause people's average tax bills to increase every year, even if their real incomes weren't changing.
There are at least three problems with this argument. First, as the AMT consumes the middle class, it will hit more and more people who do their taxes by hand, or try. Second, even with software, it's complex as I explain in my written testimony. Third, you might want people to understand how the tax system affects them. With the AMT, the tax system becomes an inscrutable black box.
Actually, it is both. It's certainly true that the AMT was on a path to cause problems even before the 2001 tax cuts were enacted, but EGTRRA doubled the problem. Without the tax cuts, 16 million people would be on the AMT in 2010, which is way too many. With the tax cuts, the number balloons to 32 million. Cutting the regular income tax without fixing the AMT at the same time is the tax policy equivalent of throwing gasoline on a fire.
Although in 2006, it is true that taxpayers in relatively high-income, high-tax coastal states are more likely to owe AMT than those in the interior, the AMT is going to hit people in all states hard if it isn't fixed. It might be better to call it a "soccer mom tax" or a "swing voter tax." It's in all of your interests to do something about it.
What to do about it?
A serious fix to the AMT would, at a minimum, adjust it for inflation and retarget it at the higher-income people who were intended to pay it. The ideal solution might be to repeal the tax and include any valid anti-tax-shelter provisions in the regular income tax.
The problem, as you are all painfully aware, is that any of these solutions would reduce federal tax revenues dramatically. The JCT estimates that repeal would reduce federal revenues by almost $900 billion over ten years; the cost would nearly double if the President's tax cuts were extended. Indexing alone would reduce federal tax revenues by about $500 billion over ten years, and "broad reform," which includes indexing and allowance of dependent exemptions and standard or itemized deductions against the AMT, would cost about $700 billion.
Repeal would also be a very regressive tax change; 96 percent of the benefits of repeal would go to the top fifth of the income distribution.
We have looked at a number of options to pay for reform, including an increase in top income tax rates, elimination of the AMT tax preference for capital gains and dividends, and repeal of the deduction for state and local taxes under the regular income tax.
Eliminating the tax break for capital gains and dividends would make a lot of sense as a matter of tax policy. Prior to 1987, the tax break on capital gains was the single largest tax preference under the AMT. If the purpose of the AMT is to limit tax shelters, this makes sense since virtually any individual income tax shelter you can imagine involves converting ordinary income into lightly-taxed capital gains or dividends. Taxing gains and dividends under the AMT would also be highly progressive.
The President's tax reform panel recommended eliminating the deduction for state and local taxes. That change, by itself, would raise enough revenue to pay for repealing the AMT and would even allow for a small cut in income tax rates. I know that those of you in high-tax states recoil in horror at the thought, but the fact is that many of your constituents are losing the benefit of this tax break under current law. The 60 percent of households that don't itemize get no benefit from it, nor do the people on the AMT. Increasingly, this is becoming just a tax break for people who are so rich that the AMT doesn't apply any more.
Any of these changes would make the tax system slightly more progressive and would not add to the deficit.
I understand that fixing the AMT is not easy. If it were, it would have been done a long time ago. I applaud the subcommittee for taking the first steps toward what I hope will be a permanent solution.
The written testimony is available in PDF format.
The views expressed are those of the author and should not be attributed to the Urban Institute, its trustees, or its funders.