This is the fifth 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, its origins as a backup system to the regular tax system intended to ensure that wealthy taxpayers pay at least some tax on their economic income in spite of their ability to aggregate substantial "preferences" (or tax expenditures) that significantly reduce their taxable income, the fiscal context against which any changes to the AMT must take place, including especially the long term fiscal damage caused by the 2001-2004 Bush tax cuts, and the status of the current debate about AMT reform including legislation that may come up for consideration this fall. In this post, I suggest that the AMT should be retained but with significant changes that protect ordinary taxpayers.
Since my last posting on the AMT, the Tax Reform Panel has published its report, see the Panel's website here and I have addressed the home mortgage deduction proposal of the tax reform panel here. The Panel proposes repeal of the AMT, whichever type of tax system is ultimately approved. That repeal, of course, would be very costly, especially given the framing assumptions for the Panel's work that all of the 2001-2004 temporary tax cuts would be made permanent.
While the proposal for elimination of some tax expenditures and the conversion of others to credits subject to limitations has merit, the repeal of the AMT will nevertheless tend to benefit primarily those in the uppermost income brackets. As discussed in an earlier post, the AMT primarily affects those with incomes greater than $100,000. It also captures more than one thousand very high income taxpayers who otherwise would pay no federal income tax whatsoever. Without the AMT, many of the wealthiest taxpayers will pay considerably less federal income tax.
Furthermore, the cost of repealing the AMT will ultimately be borne by lower-income Americans, as evidenced by the budget and tax cut discussions now underway in Congress. The repeal of the AMT accompanied by cuts to Medicaid, food stamps, low-income housing and other programs for the needy (while offering additional tax cuts to the wealthy) is like robbing Peter to pay Paul. It does nothing to alleviate the growing inequality in the country, and lets wealthy taxpayers aggregate tax benefits that are unavailabe to those in the lower income brackets.
Another alternative provides a better solution. Consider the AMT as a backstop tax system that is intended to prevent any one taxpayer from aggregating too many deductions of the type that we view as inherently personal and preferential in nature or that are provided solely as incentives to encourage certain types of economic behavior, such as investing in new equipment. A prime example of a deduction that is both personal in nature and intended to incentivize a particular type of investment activity is the home mortgage interest deduction, as discussed in this post. Another example of an expenditure intended to incentivize investment is accelerated depreciation--by permitting taxpayers to deduct amounts that should be capitalized under a normatively optimal tax, Congress thought to encourage them to invest in depreciable assets. The deduction for private activity bonds is another example.
If one taxpayer aggregates many of these incentives, they may be able to avoid taxation altogether. That represents a challenge to the system's fairness, since other taxpayers may not be in a position to take advantage and Congress can reasonably be seen as not having enacted these various incentives with any view of individual taxpayers availing themselves of so many of these incentives that they would ultimately owe little or no tax. Thus, Congress can be understood to have reasonably decided to limit taxpayers' ability to use those preferences. Rather than limit each preference, which would fail to reach the abusive aggregate situation, the limitation is on preferences in the aggregate through the AMT.
This suggests an alternative to repeal may be retention of the AMT with corrective changes. (This is particularly true if Congress does make permanent many of the 2001-2004 tax cuts.) If Congress is not willing to repeal the various AMT preferences in their entirety, retaining the AMT may actually be the least complex way to limit their use when they aggregate to an unreasonable benefit to a single taxpayer. For one thing, the AMT and regular tax systems already exist: it would not be necessary to pass a "tax increase" bill that would be anathema to those in the current Congress who are intent on cutting taxes. Retaining the AMT provides a ready mechanism for dealing with tax preferences in the aggregate, whereas the regular tax system does not. As economic behavior changes or new technologies develop, Congress can add new preferences with relative ease, or can remove old preferences. Since no one taxpayer is likely to benefit from every preference and since taxpayers may sometimes be within the AMT system and in other years pay regular tax, taxpayers may be less likely to identify a particular change as negative.
Perhaps more importantly, since the two systems already exist side-by-side (the regular tax and the AMT), Congress can protect "ordinary" taxpayers who do not have substantial economic income entirely from the burden of performing any of the extra AMT calculations. The regular tax system essentially provides a consumption-base tax for most Americans in the lower four quintiles whose income consists primarily of wages and whose limited savings are easily accommodated by the IRAs and other savings mechanisms provided. Since 60% of taxpayers use the standard deduction, it is likely that most of the group that would be excluded from the AMT would not itemize. The regular tax could perhaps be simplified further, once the AMT system is considered the appropriate system for reaching more sophisticated, higher-income taxpayers for whom the complexity is less of a concern.
The exemption of ordinary taxpayers can be done by setting a gross income threshold for application of the AMT (probably using the "total income" determination on the return, with two adjustments for private activity bond income and bargain value of incentive stock options). For taxpayers with income below the threshold amount, no AMT calculations would be required beyond the single determination of adjusted total income. Once the threshold test is satisfied, the taxpayer would automatically be exempt from AMT liability. For taxpayers with income above the threshold amount, the mechanism for determining applicability of the AMT would remain essentially the same as under current law.
What would be a reasonable income threshold? As I stated in my earlier article
"It should not be so high that it exempts taxpayers who would pay a significant tax when AMT adjustments were taken into account. Nor should it be so low that it requires ordinary taxpayers to run the AMT calculations. The primary goal of the income threshold test is to provide a convenient and easily determined line for those who on fairness grounds should not have to worry about the AMT."
Possible measures include median earnings per worker ($36,000 in 2004) or per household ($45,000 in 2004). The original 1970 exemption level of $30,000 would translate today into an exemption level around $150,000, so that likely should serve as the upper limit. The threshold should probably be around $50,000 for individual taxpayers and $100,000 for others. It should be indexed for inflation, so that it continues to exclude lower-middle and lower income taxpayers even when incomes change with inflation. For all practical purposes, the majority of taxpayers would continue to file the regular tax and be able to disregard the AMT in its entirety.
Setting a "total income" threshold would protect ordinary taxpayers from the AMT and eliminate the problem of "downward creep" that has threatened to turn many middle-income taxpayers against the tax system. That change alone would not be sufficient, however. Further changes to the preferences included in the AMT are necessary to make the overall system fairer. My next post will discuss these further changes.