This is the third in a series of postings about the alternative minimum tax or AMT. In prior postings, I have discussed the function of the AMT, its expansion to a broader segment of taxpayers due to the changes to the regular tax and lack of indexation, and its origins as a backup system to the regular tax system intended to ensure that wealthy taxpayers pay at least some tax in spite of their ability to aggregate substantial "preferences". This posting will briefly set out the fiscal context against which any changes to the AMT must take place, including the impact of the 2001-2004 Bush tax cuts.
First, the effect of the 2001-2003 tax cuts has been to increase an already growing income disparity in the United States. The gap between rich and poor has been growing steadily over the last quarter century, with the top 10 percent of income earnings gaining while the bottom 90 percent have been losing. The median income of CEOs at public corporations in 2003 was $700,000, while the average income for taxpayers generally was about $44,000. 7 million families lived below the official poverty line in 2002, while top CEOs made as much as $35 million in one year.
The tax cuts enacted under the Bush administration have exacerbated the trend. Between 2003 and 2010, the top 1% of taxpayers will receive an average 15% cut in their tax bills, while the bottom 20% will receive an average cut of only 10%, according to Citizens for Tax Justice. If the tax cuts are made permanent (remember, they were enacted with a sudden death gimmick to hide their real cost), the top 1% of taxpayers will receive a tax cut that is 8000% that of the cut for middle-income taxpayers. Gale & Orszag, 104 Tax Notes 1559 (Sept 27, 2004). If long-term financing of the tax cuts is included, then about one fourth of American taxpayers at the top of the wealth heap get tax cuts that are paid for by the remaining three-quarters of American taxpayers who will have tax increases or benefit reductions. That's effectively a transfer from lower income Americans to wealthy Americans of between 15 and 35 billion dollars a year. Gale, Orszag & Shapiro, 103 Tax Notes 1539 (June 21, 2004).
Changes to the treatment of investment income--in particular, dividends and capital gains--in the 2003 tax legislation (generally known by its acronym as JGTRRA) were of special benefit to the wealthy. JGTRRA reduced the already low rates on capital gains even further--to 5% for net capital gains in the lower brackets and 15% otherwise. Those rates will reach 0% and 15% in 2008. These very low rates for capital gains are a significant benefit for the highest income taxpayers who own a hugely disproportionate share of all assets and in fact may receive most of their income in the form of capital gains rather than ordinary wages. The IRS's Statistics of Income data show that two-thirds of the income of the top 400 taxpayers from 1992 to 2002 was net capital gains. (Americans for Democratic Action notes that "The average income of the 400 wealthiest taxpayers in 2002 was an astounding $174 million." ) Furthermore, before JGTRRA, dividends from corporations were taxed at ordinary income rates, with a maximum rate of 35%. JGTRRA reduced the rates applicable to dividends to the same preferential rates given to capital gains. Since the wealthiest 5 percent receive 60 percent of all investment income, these changes guaranteed that the wealthy received the lion's share of the benefit from the Bush tax cuts.
Second, for all the talk about the need to favor capital to increase investment in productive activity, there is a vital link between the well-being of ordinary American workers and the U.S. economy. In fact, it is the consumption spending of wageearners that powers growth. When wages fall or prices rise, economic growth is endangered. Consumer Prices Increase, Outstrip Wages. Because it is ordinary Americans' daily consumption that drives the economy, we should pay particular attention to the impact of tax policies on ordinary working Americans.
Third, to fill the gap between the growing budget deficits and ongoing expenditures, including the occupation of Iraq and continuing military buildup, the U.S. debt load has grown enormously. At $7.9 trillion now, it is expected to increase to $11.1 trillion in 2010. The U.S. is now in the unenviable position of being the biggest debtor nation in the world. Foreigners hold more than 40 percent of our debt, with China, Japan, the U.K. and the tax haven banking nations in the Caribbean as the largest foreign holders.
Fourth, the Bush tax cuts, coupled with the growing costs of the Bush invasion and occupation of Iraq, have pushed the United States from a 2000 budget surplus to a growing budget deficit. Bush's FY2002 Budget originally justified the tax cuts based on projections of a budget surplus of $5.6 trillion over 10 years. When it was clear that the surplus didn't exist, the tax cuts were passed anyway, with a different rationale--to jumpstart economic growth. The expected deficits followed: $157.8 billion in FY 2002, $375 billion for FY 2003, $412 billion for FY 2004 (an all-time record), and $331 billion for FY 2005.
The Bush administration has made much of the "improvement" in the deficit situation because the 2005 deficit is $100 billion less than last year's. It is, however, still the third-largest budget deficit in U.S. history. If you take into consideration the fact that the Social Security surplus is being used to fund the regular budget, the deficit is actually even larger--$587 billion. The Congressional Budget Office notes that the temporary decline this year (due to a surge in corporate tax) will not be duplicated over the long term. The CBO Budget Outlook projects deficits of $2.1 trillion from 2006 to 2015, more than double the amount forecast just 5 months ago. The deficit for 2006 to 2015 is projected to be a staggering $3.4 trillion if Congress makes the Bush tax cuts permanent.
Because of the deficit, the tax cuts amount to a huge intergenerational transfer to the wealthy of today from American taxpayers in the future, who will have to make good on the massive U.S. government debt. Alan Greenspan, Chair of the Federal Reserve, suggested as early as February 2004 that the United States should make the tax cuts permanent by cutting back on Social Security and Medicare benefits--the insurance program that provides a guarantee to Americans that they will not be broke in their old age and that they will be able to afford basic medical care. One way or another, the debt burden will weigh on future Americans. It cannot be ignored in deciding what to do about the AMT.
Future postings will consider what changes to the AMT to spare ordinary, working taxpayers are reasonable in light of this background information, and whether it may also be necessary to undo some of the less justifiable changes to the regular tax system.
This is the second in a series of postings on the individual alternative minimum tax (or AMT). This post will explain something about the origins of the AMT and the reasons why it is beginning to apply to more taxpayers.
In 1969, the Treasury Department did one of its periodic studies on possible tax reforms. The Treasury study noted that some taxpayers with very high incomes were able to pay far less in tax than ordinary taxpayers with much lower incomes. About 150 very high income taxpayers paid no tax at all. The study attributed that disparity principally to four provisions in the tax system that provided preferential treatment to certain kinds of income: (1) half of net long term capital gains were excluded from taxable income and not taxed, (2) untaxed appreciation on property contributed to charities was not taxed, (3) interest on certain bonds was exempt from tax, and certain extractive industries were permitted to reduce their taxable income by an allowance for depletion of resources.
Treasury proposed a minimum tax to ensure that all taxpayers bore a share of the tax burden that more clearly reflected their economic income. The proposal would put a ceiling on the amount of economic income that any taxpayer could shelter with preferences. The goal was to ensure that taxpayers included in their taxable income at least one-half of their economic income. Thus, if a taxpayer earned $500,000 of economic income and had $400,000 worth of preferences, that taxpayer could not use preferences to reduce taxable income below $250,000. In effect, the taxpayer would simply not be allowed to use $150,000 of preferences. In addition, graduated rates rising from 7% to a maximum of 35% would apply. To protect those with lower incomes, Treasury also proposed an alternative standard deduction.
Congress agreed with Treasury that it was inappropriate for taxpayers with high incomes to exclude much of their income from taxation by overutilizing tax incentives that had been intended to aid some particular limited segment of the economy. Instead of establishing the proposed alternative system, however, in 1969 Congress enacted an add-on minimum tax. After calculating her regular tax liability, a taxpayer had to determine whether a surcharge was payable. She added up the amounts excluded under listed preferential provisions, subtracted a generous $30,000 exemption amount, and then paid a tax of 10% of the remaining amount as a surcharge in addition to her regular tax liability.
Preferences subject to the minimum tax included the following: one-half of a taxpayer's net long term capital gains; any excess investment expense, any accelerated deprecation of personal property subject to a net lease, amortization of pollution control facilities, and depletion in excess of property basis. Accordingly, if a taxpayer had $300,000 of net long term capital gains, $150,000 would be excluded for regular tax purposes. The taxpayer would pay regular tax on his taxable income (the $150,000 capital gains and other taxable income). But he would also owe a minimum tax of 10% times the excluded $150,000 (minus the $30,000 alternative exemption amount). The taxpayer would therefore owe a surcharge of $12,000 (10% times $120,000) in addition to his regular tax liability.
At the time the minimum tax surcharge was enacted, it was expected to reach about one in every 500,000 taxpayers--those with incomes of at least $200,000 (about $1 million in today's dollars). Congress wanted to be sure that those individuals who had high economic incomes were not able to use exclusions, deductions and credits to reduce their taxable incomes to zero and avoid any significant tax liability.
The minimum tax lasted in that form for about ten years. Then Congress supplemented, and eventually replaced, the minimum tax surcharge with the AMT. The AMT was a new tax system that paralleled the regular tax system, with its own base and rate schedules and separate exemption amounts. Unlike the add-on minimum tax, the AMT required taxpayers to determine their tax liability under both systems and pay the one that was greater. But the result was similar: a taxpayer with significant aggregate exclusions and deductions from preferences that were required to be adjusted for AMT purposes might have to pay a higher tax under the AMT than under the regular tax, even though the maximum AMT rate was considerably lower than the maximum regular tax rate at the time. The targeted preferences, at least at the outset, were those enjoyed almost exclusively by the super-wealthy--e.g., the capital gain exclusion. Accordingly, fewer than 1% of taxpayers were subject to the AMT. The AMT effectively limited very high income taxpayers' ability to have preferences wipe out their tax liability.
Several factors have extended the reach of the AMT to a broader population of middle class taxpayers. Within a few years, families earning $75,000 may pay the AMT instead of the regular tax. First, the AMT brackets and exemption amounts were not indexed to inflation. The original $30,000 exemption would be about $150,000 today if it had been indexed from the beginning, and thus would ensure that ordinary taxpayers could continue to disregard the AMT. At just $30,000, however, the exemption inadequately protects families from AMT application. Congress raised the exemption amount temporarily ($40,250 for individuals, $58,000 for joint filers), but that requires annual extensions.
Second, the 2001- 2003 tax cuts lowered rates on both ordinary income and capital gains. The maximum ordinary income rate is 35%, but the marginal rate for many taxpayers is only 25%. The general capital gain rate is 15%. When Congress created these lower regular tax rates, it did not change the AMT rates of 26% and 28%. The fact that the AMT rates are so close to regular tax rates means that taxpayers who have historically paid only the regular tax may now be subject to AMT at the AMT rates (on a broader base) under the AMT system.
Third, Congress has changed the types of items treated as preferences for AMT purposes. The AMT originally focused on the types of exclusions and deductions that would likely be enjoyed predominantly by the very rich because of their ownership of a significantly greater portion of all assets. Those included capital gains and excess depreciation or amortization. Amendments treated a broader group of exclusions and deductions as preferences, such as miscellaneous itemized deductions, the standard deduction, personal exemptions, and the deduction for state and local taxes. They also eliminated the special AMT treatment of other preferences, such as capital gains and untaxed appreciation for charitable deductions. The result is a tax that no longer focuses on the wealthy and in fact may apply to upper middle class taxpayers fairly regularly.
This posting has considered the origins of the AMT and the changes that have made the AMT more likely to apply to a broader group of middle income taxpayers. Future postings will discuss the budget context in which any reform of the AMT must be considered, as well as some ideas for reforming the AMT.
The President's Tax Reform Panel is expected to report soon with a recommendation (among others) that Congress abolish the alternative minimum tax (often referred to as the "AMT") applicable to individual taxpayers. The AMT is a significant part of our federal tax system set out in sections 55-59 of the tax code. In a few years, it is projected to cost more to repeal the AMT than to repeal the regular income tax. Burman et al, The AMT: Projections and Problems, 100 Tax Notes 105 (July 7, 2003). So it is an issue that merits consideration and understanding.
Odds are, though, that ordinary Americans do not know much about the AMT--either its purpose or its effect. That is because ordinary Americans who earn no more than the average salary generally have not been subject to the AMT except under extraordinary circumstances. If they received a stock option grant shortly before the 2000 crash, they may have had a rude awakening to the power of the AMT when they were forced to pay a tax on gains that were lost as quickly as they appeared. Or if they received an award in a defamation or employment discrimination suit where their attorney worked on a contingent fee basis, they may have had little left after paying the taxes on the part of the award they paid over to the attorney. In most cases, however, ordinary Americans have not been required to pay the AMT.
Why, then, is the AMT a subject of particular interest at this point? The answer is that the tax cuts over the last few years of the Bush Administration, with their focus on reducing rates at the upper end of the income scale, have created an anomaly. The AMT, which originally had a broader base and significantly lower rates than the regular income tax, will increasingly impose higher rates on that broader base for many Americans in the middle-income range. Those taxpayers caught in that AMT trap will therefore be required to pay some additional tax under the AMT. Because of the broader reach, even those who do not have to actually pay more under the AMT will have to expend some considerable effort to determine their potential for AMT liability.
What is the individual AMT? It is essentially a "back-up" tax system that exists alongside the regular tax system. It has flatter rate brackets of 0%, 26%, and 28%. The zero bracket is created by permitting taxpayers an AMT exemption amount based on their status as married or single. There is no separate AMT exemption amount for taxpayers who file as heads of household under the regular tax. The current exemption amounts are $58,000 for married taxpayers and $40,250 for other taxpayers. The first $175,000 of income included in the AMT base above the applicable exemption amount is taxed at a rate of 26%. Any included income above that is taxed at 28%.
The AMT also has a broader tax base than the regular income tax. The AMT base includes more items of income than the regular tax base because of various adjustments and disallowances of the regular tax system's preferential treatment of particular items (referred to collectively as "AMT adjustments"). For example, the AMT disallows any standard deduction or personal exemption that a taxpayer may have taken under the regular tax. The idea here is that the AMT exemption amount substitutes for the various specific deductions as the measure of the taxpayer's ability to pay taxes.
The AMT similarly disallows the various "miscellaneous itemized deductions" that a taxpayer may have been able to take under the regular tax system. Those include, of course, the deduction for attorney fees paid by litigation plaintiffs (who have a corresponding income inclusion for the attorney fee award). The AMT also disallows state and local taxes that are deductible under the regular tax. While the AMT permits a deduction for extraordinary medical expenses, it is more restricted than under the regular tax. It is limited to amounts in excess of 10% of adjusted gross income rather than 7.5%. Gain realized on an incentive stock option exercise is includable in the AMT base for the year of exercise, whereas gain is not taxed in the regular tax system until the stock is sold (if certain requirements for the deferral are satisfied).
Some of the AMT adjustments make a good deal of sense and others do not. None can be understood without considering the overall goals of the tax system and the objectives of the AMT, as evidenced in its origins and in congressional development of a more expansive system.
In a series of future postings, I will explore these questions, as well as the rationales for particular AMT adjustments. I will also describe the fiscal context in which any decision about AMT reform or repeal (as well as other tax reforms) must be made. My goal is to suggest ways that the AMT can be reformed to protect ordinary Americans from its reach while simultaneously making the overall federal tax system more progressive in accordance with the consistent views of U.S. taxpayers.
For readers who prefer a more detailed exposition of these ideas, an introduction is available in my recently published article on this subject: Congress Fiddles While Middle America Burns: Amending the AMT (and Regular Tax), published in 6 Fla. Tax Rev. 811 (2004), available on the SSRN network at http://ssrn.com/author=83521.
Social Security has been in the news quite a bit lately.It is an insurance program that protects all of us, rich or poor, from the many risks that can leave us without any income.Social Security protects us from disability, death of the family breadwinner, and market disruptions that can cause loss of retirement savings.It permits even those who work at meager wages to have an adequate income in old age.It is part of our social compact—our agreement to live together in a cooperative society made possible by a system of laws and governmental institutions that we jointly fund through our taxes.
Mr. Bush has been on a campaign to end Social Security as we know it.He wants the money to be invested in Wall Street, subject to the vicissitudes of the market.He claims this will welcome more Americans to his “ownership” society, where they will do better because they can keep “their” money.He’s tried to sell the idea by raising a fear that the U.S. might default on its debt to the Social Security Trust Fund.
Mr. Bush has his facts wrong.His privatization plan would change Social Security into Social Insecurity.The system is not bankrupt.Even using the pessimistic assumptions about the economy used by the Trust Fund, it will still pay more benefits to recipients in twenty years than it does now. Yes, current generations pay for the retirement incomes of older generations.But that’s a fair intergenerational transfer:from parents to children when the children are young and vulnerable, and from children to parents when the parents are elderly and vulnerable. It’s much fairer than the intergenerational transfer that Bush boasts about—bankrolling huge tax cuts for multimillionaires (now) with an enormous debt burden on today’s families, likely to be paid back by huge tax increases on our children and grandchildren (in the future).
My colleague Richard Kaplan has written an article examining the facts about the Social Security system and the trust fund.Here’s an abstract explaining the article, and a link to it on the SSRN network.
"The article begins by addressing the nature of the Social Security program's trust fund and explains how the federal government's ability to pay benefits is a function of political will more than the pecuniary intricacies of governmental trust fund accounting. The article then critically examines the components of the long-term financial situation of Social Security, including the use of economic growth rate assumption's that are extremely low by historical standards. It then analyzes several different possible responses, including reallocating governmental expenditures, changing the formula for calculating initial retirement benefits, increasing the cap on Social Security's payroll tax, and raising the retirement age, among others. Finally, the article notes that folks who would prefer to depend on their own individually managed retirement assets have a mechanism already available in the form of the Individual Retirement Account, a mechanism that is superior to President Bush's proposal for individual Social Security accounts in several dimensions."
Richard L. Kaplan, "The Security of Social Security Benefits and the President's Proposal" . 16 The Elder Law Report pp. 1-5, April 2005, http://ssrn.com/abstract=700323