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.