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The Expanding Reach of the Individual Alternative Minimum

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The Expanding Reach of the Individual Alternative Minimum Journalof Economic Perspectives—Volume 17,Number 2—Spring 2003—Pages 173– 186 PolicyWatch The ExpandingReach of the Individual Alternative MinimumTax Leonard E.Burman, William G. Gale and JeffreyRohaly This featurecontains short articleson topics that arecurrently on theagendas ofpolicymakers, thus illustratingthe role of economic analysis inilluminating currentdebates. Suggestionsfor future columns and commentson past ones should besent toC. EugeneSteuerle, c/ o Journalof Economic Perspectives, The Urban Institute, 2100M StreetNW, Washington, D.C. 20037. Introduction In January 1969,Treasury Secretary Joseph W. Barrinformed Congress that 155individual taxpayers with incomes exceeding $200,000 had paid no federal incometax in 1966. The news created a political restorm.In 1969,members of Congressreceived more constituent lettersabout the155 taxpayers than about the VietnamWar. Laterthat year,Congress created a minimumtax to preventwealthy individualsfrom taking advantage oftaxlaws to eliminatetheir federal income tax liability. Both theoriginal minimum tax and itssuccessor, theindividual alternative minimumtax (AMT), have appliedin thepast toa smallminority of high-income y LeonardE. Burman isSeniorFellow, UrbanInstitute, Co-director, Tax Policy Center,and ResearchProfessor, Georgetown University Public Policy Institute,all inWashington, D.C. WilliamG. Gale isArjay andFrances FearingMiller Chair,Brookings Institution, and Co-director,Tax Policy Center,both in Washington, D.C. Jeffrey Rohaly is a Research Associate,Urban Institute, and Director of Tax Modeling at the Tax Policy Center,both in Washington,D.C. The authors may becontacted at [email protected] . 174Journal of Economic Perspectives households. 1 Butbarring a change inlaw, this “class tax” willsoon bea “mass tax.” Currentprojections show thenumber of AMT taxpayers skyrocketing from one millionin 1999to 36 millionin 2010. 2 Without reform,virtually all upper middle- class familieswith two or more children will be paying the AMT by decade ’s end. TheAMT is notoriouslycomplex, and itsrecord on fairnessand ef ciencyis mixed at best. Butbecause ofits widening reach, xingthe AMT will be expensive. By the end ofthe decade, repealingthe AMT will cost morethan repealingthe regular incometax. This paperexplains how ataxoriginally designed to target 155 taxpayerscould growto cover36 million, discusses economicissues related to the alternativeminimum tax and examinesoptions forreform. 3 How the Alternative Minimum Tax Works Taxpayerswho maybe subject tothealternative minimum tax must calculate theirtax liability twice: once underregular income tax rules and again under AMT rules.If liabilityunder the AMT proves higher, taxpayers pay thedifference as a surchargeto the regular tax. Technically,the difference paid istheir AMT. To calculatethe alternative minimum tax, taxpayersadd totheir regular taxableincome various items that areparadoxically called “AMTpreferences ” and that fallinto two categories. Exemptionpreferences allowtaxpayers a varietyof deduc- tions, exclusionsor credits in the regular tax, but arenot allowedin the AMT. Theseitems include personal exemptions, the standard deduction and itemized deductions forstate taxes and miscellaneousexpenses. Middle-income taxpayers arethe most likely to be hit by exemptionpreferences, which have littleto do with taxsheltering. As aresult,these adjustments aredif cultto justify. Deferralpreferences allowtaxpayers to postpone regularincome tax payments or shelterincome by hastening deductions ordelayingincome recognition. The AMT ruleslimit the extent to which taxpayerscan usedeferrals by, forexample, allowing lessgenerous depreciation deductions. Comparedwith exemption preferences, deferralpreferences are more complex, have agreatertendency to affect high- income lersand generateless AMT revenue. Once ataxpayeradds inallapplicable preferences and talliesincome, the next stepis tosubtract thealternative minimum tax exemption — currently$49,000 for 1 Aseparatealternative minimum tax appliesto corporations.See Lyon (1997). 2 Throughoutthis paper,we compare current or recentdata toprojections for 2010. We choose 2010 becauseall of the provisionsof the EconomicGrowth and Tax ReliefReconciliation Act of 2001 (EGTRRA, the 2001tax cut) arescheduled to expire, under current law, bythe endof 2010. This creates considerableuncertainty aboutprojections after 2010.For example, if EGTRRA wereextended, 43 milliontaxpayers wouldface the AMT in2013. If EGTRRA wereallowed to expire in 2010,26 million taxpayers wouldbe on the AMT in2013. 3 This paperdraws from Burman et al. (2002). Thereader interested in learning more might also start with Graetzand Sunley(1988), Harveyand Tempalski(1997), JointCommittee on Taxation (1970, 2001a), JointEconomic Committee (2001), Karlinsky (1995), Kieferet al. (2002), Rebeleinand Tempalski(2000), Shaviro(2001) and Tempalski(1996). LeonardE. Burman, WilliamG. Gale andJeffrey Rohaly 175 marriedcouples and $35,750for singles. The remaining income is then taxedat atterrates than underthe regular income tax. Thestatutory AMT tax rate of 26percent applies to the rst$175,000 of net income above the exemption. For incomeover that level,a 28percent tax rate applies. Under the regular income tax (in2002), the same income would be taxed at ratesranging from 10 percent to 38.6percent. Many taxpayers ’ effectiveAMT rate, however, is signi cantly higher, because theAMT exemption itself phases out at a25percent rate over higher incomeranges. Thus, effectivemarginal tax rates can beas high as 35percent (1.25 times28 percent). The AMT exemptions and taxbrackets are not indexedfor in ation.4 Class Tax to Mass Tax Undercurrent law, about 36million people will be paying thealternative minimumtax by 2010, almost 14 times as many as in2002, as shown inTable 1. 5 Theincrease in coverage will occur inall but thevery lowest income classes. In 2002,for example, 3 percentof lerswith income between $75,000 and $100,000 (in2001 dollars) faced theAMT; by2010, 79 percent of lersin that incomerange willpay theAMT. TheAMT will become the de facto taxsystem for lers in the incomerange from $100,000 to $500,000, 95 percent of whom will face the tax in 2010.At very high incomelevels, the share oftaxpayers on theAMT falls, because thetop AMTrate is lowerthan thetop marginaltax rate in theregular income tax. As aresult,as incomerises, eventually regular income tax liability overtakes AMT liability.Even so, in2010 more than one-quarterof tax lerswith incomes above $1million will pay theAMT, up from15 percent in 2002. Becausethe alternative minimum tax does not allowexemptions for depen- dents ordeductions forstate taxes, itwill impose particularly high burdens on taxpayerswith children and those inhigh-tax states. Becausethe AMT exemption forcouples is less than doublethe exemption for singles and because thetax bracketsare not adjusted formarital status, theAMT imposes signi cant marriage penalties.In combination, theseissues can raiseAMT participation rates dramatically, 4 Thealternative minimum tax generallypreserves the lowertax rates oncapital gains inthe regulartax. Currentlaw limits tax rates onlong-term capital gains to10 percent for low- and moderate-income taxpayers and 20percentfor others. Thoselimits apply to both the regularincome tax and the AMT. 5 Unlessotherwise noted, all of the projectionsin this paperderive from the Tax PolicyCenter MicrosimulationModel. The model is based on data fromthe 1996public-use leproduced by the Statistics ofIncomeDivision of the Internal RevenueService. The lecontains about112,000 records with detailedinformation from federal individual income tax returns ledin the 1996calendar year. Imputations basedon data fromother sources such as the CurrentPopulation Survey supplement the tax data. Thetax modelhas twocomponents: a statistical routinethat usesforecasts from the Congres- sionalBudget Of ce to “age” orextrapolatethe 1996data tocreate representative samples of tax lers forfuture years and adetailedtax calculatorthat computesthe regularincome tax and AMT liabilityfor all lersin the sampleunder current law and underalternative policy proposals. For additional information,see Burman et al. (2002, appendix). 176Journal of Economic Perspectives Table 1 AggregateAlternative Minimum Tax Projections AMTParticipation Pre-EGTRRA Current Law Law Percentageof EGTRRA IncomeTax Cut Taken 2002 2010 2010 Back by AMT,2010 AMT Taxpayers a Number(in millions) 2.6 35.6 17.9 — As percentageof alltaxpayers b 2.7 33.0 16.1 — As percentageof alltax lers 1.9 24.2 12.1 36.3 As percentageof lers, by AGI (thousands of2001$) 0–30 * 0.2 0.2 * 30–50 0.2 8.7 6.9 1.0 50–75 1.4 43.2 25.6 17.6 75–100 3.0 78.6 34.6 42.3 100–200 10.9 94.0 40.2 71.2 200–500 35.6 96.7 53.2 73.8 500–1,000 19.4 54.1 13.2 18.8 1,0001 15.4 26.9 12.3 8.4 AMT Revenue Dollars(billions) 13.0 141.4 47.0 — As percentageof incometax revenue1.4 9.9 3.0 — Percentageof AGIon AMT returns 8.9 55.5 26.4 — Costof incometax repeal($ billions)204.0 47.0 211.6 — *Lessthan 0.05percent. Source: Urban-BrookingsTax PolicyCenter Microsimulation Model. a AMT taxpayers includethose with AMT liabilityon Form6251 and thosewith lostcredits. b Taxpayersare de nedas returnswith positiveincome tax liabilitynet ofrefundablecredits. as spelledout inTable 2. By2010, among marriedcouples with two or more childrenand incomebetween $75,000 and $100,000,97 percentwill face the AMT. Moregenerally, the expansion ofthe AMT implies that by2010 more than 45percent of tax
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