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The Individual Alternative Minimum Tax
Testimony before the U.S. Senate Committee on Finance
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The AMT threatens to grow from a footnote in the tax code to a major scourge affecting tens of millions of taxpayers every year. The practice in recent years has been to patch the AMT every year or two on a temporary basis so that not too many people are affected. The latest patch expired at the end of 2006. This testimony outlines how the AMT works, whom it affects, why it demands attention, and why financing AMT repeal or reform is important. Burman lays out a number of fiscally responsible options to fix or eliminate the AMT and discusses their effects on the distribution of tax burdens, the number of AMT taxpayers, and marginal tax rates.
Chairman Baucus, Ranking Member Grassley, Members of the Committee: Thank you for inviting me to share my views on the individual alternative minimum tax.
A few years ago, my colleagues and I wrote a paper titled "The AMT: Out of Control." It's really out of control now. If Congress doesn't act, virtually everyone in this room, along with 23 million Americans will owe AMT next April.
A lot of the AMT's victims will be solidly middle class, not the millionaires who were its originally intended target. In my testimony, I show that a family with four kids under age 17, earning $75,000, with no itemized deductions will see their tax double in 2007 because of the AMT. Their tax planning mistake (in AMT world) was having four kids.
Last night, I checked the IRS website to see whether this family would have enough tax withheld to pay the AMT. No. Assuming one parent earns all the income, the IRS advises him or her to claim 11 exemptions on the W-4 form employers use to set withholding, and promises that the family will get a $25 refund at the end of the year. Actually, under current law, that family would be underwithheld by almost $2,000. Talk about a rude shock at tax time.
The smart money says that Congress will patch the AMT for another year or two to make sure that my hypothetical family won't be affected. The latest patch expired at the end of 2006. This stopgap approach leads to endless confusion though. How much estimated tax and withholding should I pay? What is my tax bracket? Would I benefit from the tax credit for hybrid vehicles if I bought one?
Is it safe to ignore the AMT, as the IRS does in its withholding calculator? Is the IRS prescient or just clueless like the rest of us? Why should 23 million Americans have to guess about their tax situation?
Some people say that the AMT isn't such a bad tax system so we should just let it take over. Actually, the AMT is a terrible tax system. The AMT exemption, which you deduct from income to calculate AMT, phases out at a 25-percent rate. This boosts the effective tax rates in the phaseout range by a quarter, so instead of the advertised 26 and 28 percent rates, many AMT taxpayers face effective rates of 32.5 and 35 percent. 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.
What's more, unlike the regular income tax, the AMT is not indexed for inflation so people's average tax bills can increase every year, even if their incomes don't grow at all in real terms. And the AMT hammers married couples and especially families with kids. In 2007, married couples will be 15 times as likely as singles to owe AMT.
Some claim that software and paid preparers make AMT complexity no big deal, but 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.
Some argue that the AMT is a "blue state" tax—only one party's problem. Although it is true that, historically, taxpayers in relatively high-income, high-tax coastal states were 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. And, even back in 2004, lots of red states had AMT hot spots—zip codes where 10 percent or more of the residents owed the tax.
The AMT hits middle and upper income families with kids—soccer moms. It's in all of your interests to do something about it.
What to do about it?Some members of this committee have suggested that the solution would be to repeal the AMT and not worry about the $800 billion in revenues that would be forgone. Those members argue that the AMT would tax people who were never its intended target and thus AMT revenues should never have been counted on. The real baseline, they assert, should assume no AMT.
Those members might have—but didn't—raise that argument in 2001 when large projected AMT revenues greased the skids for the ensuing tax cuts. In fact, the AMT masked much of the cost of the tax cuts since people who pay it do not get the full income tax rate reductions. Eliminating the AMT after it has helped finance the largest tax cuts in history amounts to a major bait and switch if the lost revenue isn't offset.
Fortunately, there are many options to reform or repeal the AMT that would not increase the deficit. My favorite option, and probably one shared by everyone on this panel, would be to eliminate the AMT as part of fundamental tax reform. But given political reality, the best alternative may be a simple surtax of 4 percent of adjusted gross income (AGI) over $200,000 for joint returns and $100,000 for others, which would raise enough to offset the revenue lost from repealing the AMT.
The surtax would be simple and progressive. The vast majority of AMT-paying taxpayers would pay lower taxes. Only the richest 1 percent would pay higher taxes on average. And they would lose far less than they gained from the 2001-2006 tax cuts. Moreover, most of the taxpayers who lost a large share of their tax cut due to the AMT would now receive the full benefit.
Some critics have complained that the surtax would raise effective tax rates and discourage work and saving. But since the current AMT has even bigger implicit surtaxes built into it, most affected taxpayers would face lower rates under the alternative.
Many other fiscally responsible options are outlined in my written testimony.
I understand that fixing the AMT isn't easy. If it were, it would have been done a long time ago. I applaud the Committee for taking the first steps toward what I hope will be a permanent solution.
The views expressed are those of the author and should not be attributed to the Urban Institute, its trustees, or its funders.