The AMT: what's wrong and how to fix it.

INTRODUCTION

The original minimum tax was an add--on tax intended to ensure that high-income people paid at least some tax. It has morphed and mutated into what is now the individual alternative minimum tax (AMT), a complex, unfair, and inefficient shadow tax system that threatens to hit 23 million households in 2007, many of them solidly middle class.

Barring a change in law, it will affect 32 million taxpayers in 2010--including half of those with incomes between $75,000 and $100,000, and nearly 75 percent of married couples in that income range with two or more children. It will become the de facto tax system for taxpayers with incomes between $200,000 and $500,000, 94 percent of whom will owe AMT. And, though they were the original target of the tax, the highest-income taxpayers will remain relatively unaffected by the AMT, with only 39 percent of taxpayers earning more than $1 million in 2010 paying the AMT. In 2007, it would cost less in lost revenue to repeal the regular income tax than to repeal the AMT. (1)

Clearly, the AMT has strayed far from the goals of the original minimum tax, but repealing it would be quite expensive. This paper summarizes the current and projected effects of the AMT and considers options to finance repeal. (2) The first section describes how taxpayers calculate AMT liability. The second section documents the projected expansions noted above and examines the driving factors behind the trends. The third section discusses equity, efficiency and complexity issues. The fourth section examines reform options. The fifth section concludes.

THE INDIVIDUAL AMT: AN OVERVIEW

The AMT operates parallel to the regular income tax, with a different income definition, rate structure, and allowable deductions, exemptions, and credits. (3) Taxpayers calculate "alternative minimum taxable income," subtract any applicable AMT exemption, and then calculate tax under the AMT tax rate schedule net of applicable credits to obtain tentative AMT liability, which is what would be owed by someone who paid taxes according to the AMT rules alone. AMT liability is the excess, if any, of tentative AMT above a measure of taxes due under the regular income tax.

Alternative minimum taxable income (AMTI) is the sum of taxable income for AMT purposes, AMT preferences, and AMT adjustments. Taxable income for AMT purposes is adjusted gross income (AGI) less itemized or standard deductions less personal and dependent exemptions. Unlike regular taxable income, taxable income for AMT purposes can be negative. There is no interesting economic distinction between preferences and adjustments in general; we will refer to both as preferences, which come in two varieties. Exemption preferences broaden the AMT tax base. Deferral preferences change the timing of the recognition of income and deductions, typically to accelerate income and postpone deductions; thus, they tend to raise the current--year tax base, but at the expense of future tax bases. The vast bulk of AMT preferences are of the exemption variety. The largest are deductions for state and local taxes, which account for 59 percent of all preferences; exemptions for adults and dependent children (22 percent); and miscellaneous itemized deductions for items such as unreimbursed business expenses and certain legal fees (11 percent) (JCT, 2007). Thus, more than 90 percent of the preference items have little to do with what most people would think of as tax sheltering. In contrast, the deferral preferences are quite small and relate most frequently to the treatment of incentive stock options (ISOs), depreciation of personal property, and passive activity losses.

AMT exemptions, exemption phaseouts, and tax brackets are not indexed for inflation or adjusted for family size. As of this writing (June 2007), the AMT exemption is $45,000 for married couples filing jointly and for surviving spouses, $33,750 for unmarried individuals other than surviving spouses, and $22,500 for married individuals filing separately--the same amounts as applied prior to the enactment of the 2001 tax cuts. Since 2001, Congress has enacted a series of temporary patches that have increased the AMT exemption amount substantially. For 2006, the exemption was $62,550 for couples and $42,500 for single tilers and heads of household. The AMT exemptions phase out for high-income taxpayers at a rate of 25 cents per dollar of AMTI over thresholds of $150,000 for joint returns, $112,500 for singles, and $75,000 for married individuals filing separately. (4) In 2007, the phaseouts end at $247,500 for singles, $330,000 for joint returns, and $165,000 for married individuals filing separately. (5)

The statutory AMT tax rate is 26 percent on the first $175,000 of income taxable under the AMT for married couples or singles ($87,500 for married taxpayers filing separately) and 28 percent on additional amounts. The phaseout of the exemption, noted above, makes the effective marginal tax rate one-fourth larger than the statutory rate through the phaseout range. Thus, taxpayers with only moderately high incomes can face 35-percent effective AMT rates (28 percent times 1.25)--equal to the highest tax bracket under the regular income tax.

Under the AMT rules, long-term capital gains and dividends are subject to the same low rates as apply under the regular income tax. (6) However, as under the regular tax, phaseouts can raise the effective tax rate on gains and dividends (as well as other income) above the statutory maximum rate. Since, as noted, the AMT exemption phases out at a 25 percent rate, the effective tax rate for taxpayers affected by the exemption phaseout is increased by 6.5 percent for taxpayers in the 26-percent AMT bracket (25 percent of 26 percent equals 6.5 percent) and by seven percent for taxpayers in the 28-percent bracket (Leiserson, 2007). Thus, the maximum tax rate on capital gains and dividends is 22 percent (the 15-percent statutory rate plus the seven-percent implicit surtax).

As noted, AMT liability is the excess, if any, of the tentative AMT liability (reduced by any applicable foreign tax credit) over a tax liability measure based on the regular income tax. The latter measure is regular income tax liability before credits (that is, the tax due on adjusted gross income minus allowable exemptions and deductions) less any taxes due because of lump-sum distributions and less any applicable foreign tax credit in the regular tax. For simplicity, we refer to this as "regular tax liability for AMT purposes."

After determining regular tax liability for AMT purposes and AMT liability, taxpayers return to the 1040 to calculate applicable credits. As of June 2007, the AMT does not restrict the use of personal refundable credits--the earned income credit and the child credit--or adoption and saver's credits. (7) Other personal nonrefundable credits, however, are allowed only to the extent that the individual's regular tax liability exceeds the tentative AMT liability. That is, those credits are effectively disallowed against the AMT. (8) A temporary provision that allowed the use of those credits expired at the end of 2006. The general business credit can reduce tax only to the level of tentative AMT liability, but unused portions may be carried backward or forward. Finally, AMT liability that is the result of timing-related preferences or adjustments generates a regular income tax credit that may be used against future income taxes if the taxpayer moves off the AMT.