This is the sixth 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, the status of the current debate about AMT reform including legislation that may come up for consideration this fall, and my own recommendation that the AMT be retained but with a "total income" threshold that protects ordinary taxpayers (e.g., single taxpayers with incomes of $50,000 or less and married taxpayers with incomes of $100,000 or less) from AMT applicability. In this post I discuss additional changes that must accompany the threshold rule.
A. "Ability to pay" deductions.
First, for taxpayers that must calculate their potential AMT liability because their income exceeds the proposed exemption threshold, it is necessary to establish a new "ability to pay" exemption amount parallel to the standard deduction and personal and dependency exemptions in the regular tax. There are various alternatives. One would be to continue the current AMT exemption amount, that sets only two "one-size-fits-all" exemptions--one for single taxpayers and one for joint filers. That approach disregards the number of dependents in a family and eliminates the additional head-of-household status that is used for the regular tax. This approach is problematic. It is complicated, since it means that taxpayers will have to use different exemption amounts in their regular and AMT calculations. It has the potential for catching taxpayers with large families unawares, causing taxpayers to feel a "gotcha" effect that leads inevitably to generalized resentment of federal income taxation. It suggests capriciousness: if the standard deduction and personal/dependency exemptions are appropriately set to provide an "ability to pay" protection from income tax, it seems that those amounts should be approximately the same under both systems. (Arguably, the amounts could be adjusted upwards somewhat, because the AMT taxes a broader base with fewer rate brackets.) Instead, the one-size-fits-all approach of a standard exemption means that some taxpayers will luck out while others will draw the short straw.
Another alternative would be to create an entirely new set of AMT exemption amounts for different status taxpayers with the amounts varying by number of dependents. This appears fairer than the one-size-fits-all approach, since it would permit the system to provide roughly parallel protection even taking into account the base broadening and rate flattening effects of the AMT. However, it would considerably complicate the AMT system. The inconsistency on these items used by all taxpayers might also cause considerable confusion among taxpayers regarding appropriate deductions across the two systems.
A better approach would be to harmonize the AMT and the regular tax in this respect, once the total income threshold is enacted to eliminate AMT applicability to those who are in the lower quintile income distributions. The standard deduction and personal exemptions should apply as before, indexed for inflation in both systems. If a taxpayer uses the standard deduction for the regular tax, the taxpayer would automatically use the standard deduction for the AMT. Similarly, if the taxpayer itemized in the regular tax system, the taxpayer would be required to itemize in the AMT system, subject to the various limitations on specified itemized deudctions in the AMT system. The taxpayer would have the same number of personal and dependency exemptions under the AMT as under the regular tax. To the extent any income phaseouts are retained in the regular tax system, those same phaseouts should be applied in the AMT system.
The medical expense deduction can be understood as extending the ability-to-pay concept to account for medical situations that lead to extraordinary personal expenditures for medical care. Our regular tax system treats those extraordinary expenditures similarly to casualty losses, in that we are permitted to deduct them (subject to a 7.5% gross income threshold limitation) even though they are not expenses that aid in producing income. The AMT permits the medical expense deduction, but increases the threshold to 10%. Like the other ability-to-pay deductions, the medical expense deduction should be harmonized with the regular tax. If 10% is a more equitable cut-off point, then the 7.5% threshold should be changed to 10% for the regular tax and AMT. The deduction should be the same, so that a taxpayer is not put in the position of suddenly being in the AMT for other reasons and finding that regular medical care costs add to the tax burden.
B. Retention of the AMT preference for state taxes
State and local taxes have a strongly personal element. Permitting a deduction rather than a credit, as currently provided under the regular tax, provides a significantly larger tax benefit to the wealthiest taxpayers. They will tend to have much larger amounts of deductible state and local taxes (property taxes on multiple residences that are assessed at the higher rates because of their value and higher state incomes) and they will receive a significantly greater benefit from a deduction, which increases with the taxpayer's marginal tax rate. Therefore, the current AMT treatment of state and local taxes as a preference should continue. If any respite is provided, I suggested in my article that it should be limited to an amount equal or less than the average per capita state taxes.
C. Gain on incentive stock options.
As discussed in an earlier posting, there is little merit in providing for wholesale exclusion of gain from ISO exercise under the AMT by eliminating ISO gain as an add-back AMT preference item. As I stated in my 2004 article,
"Removal of the preference would undermine the coherence of the AMT's targeting, since many receipients of incentive stock options are highly paid managers and CEOs. Elimination of the AMT preference would also disregard the special status given incentive stock options compared to other compensatory plans as well as the monetary and non-monetary benefits accruing to those who acquire large blocks of highly valued stock under option grants. It would thus go against the distributive justice values that underlie the argument for retaining the AMT system." Congress Fiddles, 6 Fla. Tax Rev. 811, 883 (2004).
"Taxpayers who accept stock option grants rather than salary and retain the stock rasther than selling on exercise, in hopes of cashing in on the growth of a start-up firm, are essentially making a risky investment with compensation income in the hopes that they will win on both counts--avoiding ordinary income rates on their compensation and have significant gains from their ownership of the stock." Id. at 884.
I proposed in the article that the AMT preference item for stock option gains should be restricted to prevent AMT taxation of the "phantom" income from exercise only if two conditions hold:
- the taxpayer exercised the ISOs when there was a significant gain (exercise gain) and
- all (or all but a very de minimis portion) of the exercise gain is lost because of a decline in stock value before the end of the filing perod for the return for the taxable year of exercise. Id. at 884.
If the conditions hold, only the portion of the exercise gain reflected in the return date value would be includible, but later stock increases would result in additional value being "recaptured" under a mark-to-market methodology in the year of such increase.
D. Addition of a new AMT preference item for preferential capital gains rates
Perhaps one of the most worrisome trends in current tax legislation is the shifting of the tax burden away from capital and onto wage income. As noted in an earlier posting, ordinary taxpayers are essentially subject to a consumption tax under the current system, because their wages are their sole or primary source of income and the little savings that they can accomplish can be saved tax-free under one or another of the special savings vehicles.
The income tax system is intended to tax the returns to capital investments and not merely the returns to labor. However, the 2001-2004 tax acts have eroded significantly the system's ability to reach capital investment income by reducing the preferential rates on capital gains even further (to 5% (eventually 0%) and 15% for the most general type of capital gains) and extending that reduction to income that wealthy owners of corporations receive through their corporate ownership. The latter is particularly egregious, because corporate profits are frequently taxed at rates much lower than the statutory rate or untaxed altogether through the use of aggressive tax shelters and movement of intangible assets created in the United States offshore to avoid U.S. taxation on worldwide profits. Even with the low effective tax rates on corporate profits and the low preferntial tax rates on capital gains frolm sales of corporate shares, individuals have engaged in a number of super-aggressive tax shelters to avoid tax when they sell their shares and reap a large capital gain.
This failure to tax capital gains and dividends appropriately is a windfall to the superwealthy. Remember that much of wealthy individuals' income is never taxed--it is held and "used" to gain power and status and then passed on at death to heirs with a stepped up basis. Since wealthy individuals own disproportionate amounts of the nation's assets and receive disproportionate amounts of the aggregate net capital gains, they enjoy the lion's share of the benefits from the preferential capital gains rate.
Under current law, with low capital gains rates under both the regular tax and the AMT, wealthy individuals with considerable tax-excluded income (like tax-exempt municipal bond interest) and preferentially taxed income (like capital gains and dividends) may end up paying tax at an effective tax rate significantly lower than the effective rate paid by those who have considerably less income but all in the form of taxable wages. See the hypothetical example in my article contrasting a wealthy owner of investment assets and multiple properties with a middle-income worker who has few investment assets. Congress Fiddles, supra, at 864-65.
A reasonable source of revenue for instituting the AMT income threshold would be to treat the net capital gains preferential rate (for gains on dispositions and qualified dividends) as a tainted preference. Net capital gains would be included in the AMT base and taxed at the AMT rate. This preference would ensure that high-income taxpayers with substantial investment gains and dividend income, who may have very little wage income, would pay a rate of tax greater than 15%. To protect ordinary taxpayers who are just above the threshold income level yet who have relatively small financial investments, the AMT provision could exclude up to $3000 of capital gains.
Note that this is a return to the way the AMT treated capital gains prior to the tax reform act of 1986 when the capital gains preference was removed from the regular tax and therefore also removed as a tainted preference for purposes of the AMT. The legislative history behind the treatment of capital gains as an AMT preference notes specifically that Congress enacted the provision based on its belief "that every noncorporate taxpayer with capital gains should pay a minimum amount of taxes with respect to those gains." Id. at 893.
This change, along with institution of the income threshold for AMT applicability, is the most important from the perspective of democratic egalitarianism. If we continue to move in the direction this current Congress has charted, of shifting the tax burden from capital to labor and professing to believe that the increased wealth enjoyed by those who own most of the capital resources of our nation will "trickle down" to the middle class and lower income classes, we will condemn this great country to continued ghettoization and increasing inequality. We will have turned the original aim of the income tax on its head. It has essentially been intended as a highly progressive tax that reaches the capital wealth of those who would otherwise be a ruling oligarchy.
The current pattern of unsupportable favoritism for capital income, echoed in the Republican party's drive to eliminate the estate tax, favors the wealthiest of the wealthy. They will pay less into the government to fund its workings, and continue to demand more out of the government to support their own enterprises and prevent any means of redress from those who are hurt by consolidation, as we have seen in the action on so-called "bankruptcy reform" and "tort reform" and "financial institutions reform" bills that have essentially stripped off protections for low income people and built in protections for large corporations. The Wal-Mart story (if interested in the Wal-Mart film, see here and here) is a good example of the way a corporate giant can wield its might to pay its laborers less, prevent unionization, and yet force its employees to rely on government safety nets for health care and other benefits that the employer should provide.
If Congress does only one thing beyond instituting an income threshold to establish exemption from AMT applicability, it should add this preference for all items subject to the preferential net capital gains tax rate. (Even better would be to return to the 1986 reform model and eliminate the capital gains preference altogether from the regular tax as well.) That would be the single best way to restore fairness to a lopsided tax system that now favors wealthy corporate investors over ordinary workers.
E. Addition of a new AMT preference item for certain charitable contributions
Another new preference that would help pay for protecting the middle class from the AMT is elimination of the charitable contribution deduction for unrealized appreciation. Under current law, wealthy taxpayers can contribute appreciate property, such as art works, to a museum and deduct the full fair market value as a charitable contribution (subject to certain limitations). High income individuals are by far the major beneficiaries of the charitable deduction. According to the Joint Committee on Taxation's reports on tax expenditures, the top 7.7% of returns garner about 50% of the charitable contribution deductions. See, e.g., JCT Estimates of Tax Expenditures.
These deductions are especially lucrative since they do not represent a donation of after-tax investment where there is considerable unrealized appreciation that has never been subject to tax. For example, suppose Mr. Wealthy bought a painting from a struggling young artist in 1955 for $500. That painting may now be worth $1.5 million. If Mr. Wealthy contributes the painting to an art museum that will add the painting to its permanent collection (perhaps for display in a hall to be named after Mr. Wealthy in appreciation of his 'generosity'), Mr. Wealthy may deduct $1.5 million (assuming that the limitations do not apply).
Congress originally enacted an AMT preference for untaxed appreciation on charitable contributions in the 1986 tax reforms, but ultimately eliminated the preference item in 1993 with a conclusory statement that elimination would encourage charitable giving. See Congress Fiddles, supra, at 890-91.
Taking democratic egalitarianism as the guiding principle for setting tax policies, it is clear that the federal income tax system demands some reform of the AMT. That reform has to be pragmatic, given the mood in Congress and the changing mood of the American public. While the best reform would likely be to eliminate many of the tax expenditures and special breaks for wealthy anjd corpoate taxpayers from the regular tax system, one suspects that too much talk and discussion has gone on to permit that approach at this time. Yet Congress's piecemeal approach to the AMT problem of extending an enlarged exemption amount on an annual basis forces Senators and Representatives to repeat each year a difficult balancing act between addressing the harms of the downward creep of the AMT and the various corporate and investor tax breaks being pushed by a coalition of government-bashing libertarians and self-protecting wealthy and corporate interests. The piecemeal approach plays into the hands of those who want to "starve the beast" to eliminate New Deal safety nets for ordinary Americans--they hope that new "victims" of the AMT will raise a harsh anti-tax cry that will allow them to enact their entire package of tax changes to shift the burden entirely to the working classes. That approach is also ultimately unsustainable, because it will create a tax system that favors institutional paralysis, indefinite deficits as military spending continues to spiral out of control, and a huge debt burden that depends on sustained foreign purchase of US treasuries whose repayment will significantly reduce the standard of living of future generations and likely stunt economic growth for decades.
Instead, we should deal courageously with the problem by thinking about what we want our tax system to do and how we can approach the system that currently exists to best deal with the increasing tax burden on the lower and middle quintiles as well as the increasing inequality between the haves at the top of the income distribution table and the rest of America. Let's have a regular tax system that can be simplified considerably by using the AMT system to impose a more significant tax on the wealthy investor class. Let's protect ordinary taxpayers by using a simple income determination to exclude almost all of them from even having to think about the AMT. Then we can also simplify the AMT by harmonizing it with the regular tax wherever it makes good tax sense, as in the treatment of ability-to-pay deductions. Finalloy, let's pay for that indexed income threshold and harmonization by changing the way we tax net capital gains. Leave them as a preference in the regular tax system, if we must, but add them as a tainted preference requiring adjustment in the AMT system, if we can. That would be the best way to ensure that the wealthy investor class pays its fair share of the tax burden. Who knows, with the revenue gains, we might even be able to pay off some of that debt and move away from being the biggest debtor country of the developed world today.