IV. The Increasing Scope of the Alternative Minimum Tax47
1. The Alternative Minimum Tax (AMT) for individuals was created to reduce horizontal inequity in the personal income tax system.48 Minimum taxes in the United States date from 1970, and have been formulated with the stated objective of ensuring that high-income taxpayers pay their “fair” share of taxes, in particular by reducing the number of high-income filers with no income tax liability.49 This objective is pursued by limiting the extent to which tax preferences (deductions, exemptions, and credits) are allowed to reduce taxable income.
2. The AMT has had a small but growing impact on U.S. taxpayers. Through the mid-1990s, fewer than ½ percent of individual taxpayers were subject to the AMT. In recent years, this share has increased to 1½ percent, and is projected to exceed 20 percent by 2010 (Figure 1).50 The share of revenue obtained from the AMT has similarly increased from less than 1 percent of personal income tax revenues in the 1990s to about 2 percent at present, and is projected to reach about 9 percent by 2010.51
Figure 1.The Expansion of the AMT, 1980 - 2010
3. The AMT’s reach to middle-income households has expanded partly as a result of cuts in marginal income tax rates. The decline in ordinary tax liabilities has contributed to an increasing number of households falling below the threshold for filing AMT returns. While recent budgets have temporarily raised AMT exemption amounts by almost 30 percent, AMT relief is slated to expire at the end of 2004, pending further legislation. However, even providing permanent relief would only slow, not stop, the AMT’s spread to middle-income taxpayers.
4. Without reform, the AMT will increasingly complicate and distort the personal income tax system. While AMT revenues are projected to offset about one third of the cost of recent tax cuts over the medium-term (Burman, Gale, and Rohaly, 2003), their growing reach would add to the already considerable compliance cost for U.S. taxpayers. Moreover, most taxpayers would eventually fall under the AMT by reason of claiming exemptions for dependents and deducting state and local income taxes, which could lead to questions about the design of the U.S. tax system. Indexing tax brackets and exemption amounts to inflation therefore remains central to AMT reform, but additional spending cuts or revenue-raising measures would be necessary to offset the associated revenue loss.
A. AMT Design
5. The AMT has been designed as a parallel tax liability for high-income taxpayers (Box 1). Taxpayers fulfilling AMT criteria are required to calculate both their regular income tax and a tentative minimum tax liability. Their final tax payment is determined by the higher of the two amounts. If the minimum tax exceeds the regular income tax, the difference between the two is counted as AMT liability.
6. The AMT is designed to tax a broader income base than the regular income tax. While the standard deduction under the AMT is larger than that for the regular income tax, most of the other provisions of the AMT limit deductions taken under the regular income tax. The AMT can also limit a taxpayer’s eligibility for tax credits.
7. Statutory marginal tax rates are intended to be lower under the AMT than under the regular income tax. The AMT has a flat rate structure with only two brackets, 26 and 28 percent, while brackets in the regular income tax currently range from 10 to 35 percent. It was designed to have a lower marginal rate than the regular income tax, while still yielding higher revenues from taxpayers who would otherwise claim large amounts of deductions and exemptions. However, Burman, Gale, and Rohaly (2003) show that many taxpayers face a higher effective marginal tax rate under the AMT than under the regular tax, due to the AMT’s expansion to middle-income taxpayers and rate reductions in the regular income tax. Moreover, the phase-out of the AMT exemption pushes the statutory marginal rates to 32.5 and 35 percent for some incomes.
8. The scope of the AMT has expanded because its parameters are not indexed to inflation, unlike the regular income tax. The tax brackets, standard deduction, and personal exemptions in the regular income tax were indexed in 1981. The AMT’s lack of indexing has led to bracket creep, which pushes taxpayers into the AMT even if their real incomes have not significantly increased.
B. Experience with the AMT and Recent Developments
9. Calculating the AMT imposes significant costs on taxpayers and complicates tax policy. All taxpayers have to fill out a worksheet to determine whether they should file the AMT form, and over 75 percent of those required to file end up owing no AMT (NTA, 2001). Lack of knowledge about the system and difficulties in estimating AMT liability before all tax records are collected have led to increased audits and AMT-related tax penalties, especially among taxpayers who make estimated payments (NTA, 2004), although these costs are diminishing with the growing use of tax-preparation software. For policymakers, estimates of the revenue effects of budget provisions are more complicated because of interactions between the AMT and regular income tax. For example, it has been estimated that by 2010, one-third of the benefits provided by the 2001 tax cuts will be taken back by increased AMT liabilities (Burman, Gale, and Rohaly, 2003). The implicit assumption that the AMT would continue in its present form led to lower estimates of the tax cuts’ revenue impact than if AMT reform had been taken into account.
Box 1.Calculating the AMT
The AMT has received a great deal of criticism for its complexity (see, for example, JCT, 2001; Joint Economic Committee, 2001; and NTA 2001, 2004), but for many taxpayers, AMT calculation can be straightforward (Feenberg and Poterba, 2003). The following are the steps in calculating the AMT:
Calculate regular income tax liability (before credits).
Determine whether filing the AMT form is required. A taxpayer is automatically required to file the AMT form if claiming certain preferences, including accelerated depreciation, exercise of stock options when the stock is not disposed of in the same year, and investment interest expense. Other taxpayers fill out a twelve-line worksheet and may be required to file under the AMT depending on their income and size of their regular income tax liability. Most taxpayers required to submit an AMT form end up owing no AMT (NTA, 2001).
Calculate Alternative Minimum Taxable Income (AMTI). AMTI includes 26 adjustments, called AMT preferences, to the definition of adjusted gross income (AGI) used by the regular income tax. Seven of these preferences require entering the amount from a line found on another form or schedule, and another two of the adjustments are simple transformations of amounts found elsewhere. The remaining 17 preferences differ from the regular income tax because the AMT applies different treatments to various income types, capital gains, and asset valuations. These provisions require more advanced record-keeping and calculations but tend to affect only a small number of taxpayers with relatively complex business and investment arrangements. The AMT also treats personal exemptions and the standard deduction as de facto preference items, because AGI, and not taxable income, is used in computing AMTI.
Determine the applicable AMT exemption. For 2004, the exemption is $29,000 for married filers filing separately, $40,250 for single filers and heads of households, and $58,000 for married filers filing jointly. The exemption phases out at a rate of 25 cents per dollar, beginning at income levels of $75,000, $112,500, and $150,000 respectively.
The allowable exemption is then subtracted from AMTI, with the tax rates of 26 percent and 28 percent (for AMTI over $175,000) being applied to the difference. The phase-out of the AMT exemption results in effective rates of 32.5 percent and 35 percent over the phase-out range (ending at over $380,000 for married filers filing jointly).
A taxpayer’s tentative minimum tax is calculated by further subtracting any foreign tax credit for which the taxpayer is eligible. If the amount remaining exceeds the regular income tax liability, the difference is owed as AMT liability. If regular income tax liability exceeds the tentative minimum tax, then no AMT is owed.
Apply tax credits to find final tax liability. Prior to 1999 and after 2003 nonrefundable tax credits can only reduce regular income tax liability to the level of the tentative minimum tax. For example, a taxpayer with regular income tax liability of $10,000, tentative minimum tax of $9,000, and credits of $3,000, would be able to apply $1,000 of the credits to the regular income tax liability to reduce it to the level of the tentative minimum tax, but would lose $2,000 in credits. Between 1999 and 2003, the taxpayer could have used all $3,000 in credits to reduce total tax liability to $7,000. The child, adoption, and IRA credits will continue to receive this treatment through 2010, whereas refundable credits (the earned income credit and refundable portion of the child credit) are available regardless of whether a taxpayer has AMT liability (in the unlikely event that the AMT would apply to someone eligible for those credits).
10. That said, the AMT appears to have reduced the number of high-income taxpayers with zero income tax liability in any given year. An estimated 90 percent of AMT taxpayers and 95 percent of revenues in 2003 came from taxpayers with Adjusted Gross Income (AGI) of over $100,000. IRS data on high-income tax returns shows that only 0.1 percent of taxpayers with AGI over $200,000 pay zero income tax in a given year (Balkovic, 2003). The CBO (2004b) found that 1,100 taxpayers with AGI over $500,000 paid federal taxes in 2001 only because of the AMT. However, taxpayers with an AGI between $100,000 and $500,000 are the most likely to fall under the AMT, because its lower marginal rates generally imply that taxpayers with higher incomes have a larger regular income tax liability.
11. Although the AMT was originally intended to target excessive use of tax preferences, most AMT revenue now comes from preventing the use of personal exemptions and state and local tax deductions. The minimum tax system was originally targeted at recipients of capital gains and other investment income, which received preferential treatment under the regular income tax. However, the Tax Reform Act of 1986 removed these items as AMT preferences. Rebelein and Tempalski (2000) find that a growing proportion of the difference between AMTI and AGI is accounted for by state and local tax deductions, personal exemptions, and the standard deduction (Figure 2), which would not suggest the excessive use of tax preferences. The lack of indexation has, over time, increased the importance of these tax preferences in determining a taxpayer’s AMT liability.
Figure 2.AMT Preference Items
12. High-income taxpayers have also been able to reduce their tax liability significantly by using tax preferences not targeted by the AMT. Many taxpayers without income tax liability claim deductions for investment interest paid or unlimited miscellaneous deductions that reduce their taxable income by over 60 percent, or use a combination of credits to achieve an equivalent reduction in their tax liability (Balkovic, 2003). High-income taxpayers are also more likely to use large deductions as a result of non-cash charitable contributions and the carryover of cash charitable contributions from previous years, while deriving a higher percentage of their income from sources with more favorable tax treatment, including capital gains, dividends, and tax-exempt interest (Campbell and Parisi, 2003).
13. Recent legislation has temporarily lessened the AMT’s impact on middle-income taxpayers (Figure 3):
Provisions allowing all personal nonrefundable credits to reduce AMT liability were in effect from 1999 through 2003.52 Subsequently, AMT liability can only be reduced by the child, adoption, and IRA credits until 2010.
The 2001 and 2003 tax cuts temporarily increased the exemption amounts from $45,000 to $58,000 for married joint filers and from $33,750 to $40,250 for single filers. The FY 2005 budget proposes to extend this relief through 2005 (Figure 4). However, the exemptions would revert to their pre-2001 values in 2006.
Figure 3.AMT and the Middle Class, 1996-2003 Figure 4.Impact of FY 2005 Budget Proposals on AMT Participation Rates by Income in 2005
Source: Burman and others (2004).
14. These changes have helped to reduce the AMT burden of taxpayers with AGI below $100,000. For example, the number of taxpayers in this group declined by 25 percent between 2000 and 2003, and the group’s share of total AMT liabilities dropped from 11 percent in 1997 to 5 percent in 2003.53 However, these trends would likely reverse if the temporary relief were allowed to expire.
C. Medium-Term Outlook and Pressures for Reform
15. The impact of the AMT is projected to increase significantly over the coming years. Various studies project the number of AMT taxpayers to jump to 30–35 million in 2010, with the AMT contributing around 9 percent of income tax revenue at that time (Table 1). Burman, Gale, and Rohaly (2003) estimate that the effects of inflation will add about 10 million taxpayers to the AMT between 2003 and 2010, and that an additional 18.8 million taxpayers would face the AMT because of marginal rate cuts enacted in 2001. Without the tax cuts, these estimates suggest that the AMT would have accounted for only 2½ percent of income tax revenue, instead of 9 percent. Even if the 2001 and 2003 tax cuts were not made permanent, the AMT’s expansion would continue over the long term due to the lack of indexation. In that case, the CBO (2003a) projects that 70 percent of households would be subject to the AMT by 2050, contributing over 18 percent of personal income tax revenue, equivalent to 3 percent of GDP (Figure 5).
|AMT Revenue as Percent of Total|
Personal Income Tax Revenue
|AMT Taxpayers - Millions|
|2010||9.1||8.6||8.8||33.1||29.5||37.1||30.0||32.0|Figure 5.The Expansion of the AMT, 2003 - 2050
Source: CBO (2003a).
16. Under current law, middle-income taxpayers would bear an increasing proportion of the AMT. The CBO (2004a) estimates that the number of AMT taxpayers would jump by 9 million if AMT relief was withdrawn in 2005, increasing AMT revenue by 50 percent. The number of AMT taxpayers with AGI below $100,000, expressed in 2002 prices, is projected to swell from 225,000 in 2003 to over 17 million in 2010, or over half of all AMT taxpayers (Figure 6). The share of AMT revenues paid by middle-income taxpayers would also rise sharply from 5 percent in 2003 to 23 percent in 2010.
Figure 6.Distribution of AMT by Income
Source: Burman, Gale, and Rohaly (2003).
1/ Income levels expressed in thousands of 2002 dollars
17. By 2010, most taxpayers would be paying the AMT by reason of claiming personal exemptions for dependents and deducting state and local taxes from income. These two factors would account for 90 percent of the difference between AMTI and AGI by 2010 (Rebelein and Tempalski, 1997). Feenberg and Poterba (2003) show that, by 2010, taxpayers with two or more dependents would be twice as likely to pay AMT as the general population, and the likelihood of owing AMT would be much higher for residents of states with high income taxes and for married taxpayers. Even taxpayers not making itemized deductions will be affected—the share of AMT filers claiming the standard deduction is projected to grow to 30 percent, compared to 6 percent in 2001 (CBO, 2004b).
D. Policy Options
18. Given the increasing number of middle-income taxpayers falling under the AMT, many analysts expect that the system of minimum taxation will be reformed over the coming years. Five policy options are commonly suggested:
Extend recent changes. As discussed earlier, the increased exemption amount and the ability to use nonrefundable credits to reduce AMT liability have lessened the impact on middle-class taxpayers. Maintaining the current exemption amount would cost about 0.2 percent of GDP in 2014, while allowing all credits to reduce AMT liability would cost about a fourth that much (CBO, 2004a).54
Remove personal exemptions, the standard deduction, and state and local tax deductions as AMT preference items. Their removal would mean forgoing about 90 percent of AMT revenue, or ⅓ of a percent of GDP by 2014, with two-thirds of the cost accounted for by the removal of state and local tax deductions (CBO, 2003b, 2004b). Since personal exemptions are phased out for taxpayers with AGI over $104,625, allowing them to reduce taxable income under the AMT would largely benefit middle-income taxpayers, while high-income taxpayers would benefit the most from removing state and local tax deductions.
Index to inflation. Indexation would be essential to slowing the long-term growth of AMT revenues, whether or not the 2001 and 2003 tax cuts are extended (Figure 7). This option would be less progressive in the short-run than extending the higher exemption amounts and use of personal nonrefundable credits, but would limit the AMT’s long-term spread to middle-income families. Adding indexation to the extension of the higher exemption amounts would cost less than 0.1 percent of GDP per year (CBO, 2004a).
Repeal. Some observers have argued that AMT revenues are worth less than the cost of complexity created by the tax, and that the AMT should therefore be repealed (e.g., JCT, 2001; NTA 2001, 2004). Repeal would be the most expensive option, costing 0.4 percent of GDP by 2014 (CBO, 2003a). It would imply an immediate 2 percent reduction of personal income tax revenues, a 9 percent cut by 2010, and a cut of over 18 percent in the long-term (CBO, 2003a). A repeal would be regressive, as households with AGI over $100,000 would receive over 90 percent of the immediate benefit. Repeal could also increase incentives to use tax preferences more aggressively, offsetting some of the benefits of a simpler tax system.
Target common tax avoidance practices. The AMT attempts to balance conflicting objectives—providing preferential tax treatment to certain activities but limiting the excessive use of tax preferences. Targeting deductions and exemptions that are more indicative of tax avoidance would broaden the tax base while still allowing taxpayers to maximize their legitimate use of preferences. More attention could also be given to the income side of the equation, a more costly source of tax avoidance (Brown and Mazur, 2003).
Figure 7.AMT Revenue Scenarios, 2003 - 2050
Sources: CBO (2003a); and Fund staff calculations.
19. AMT reform could provide a useful opportunity for restoring the tax to its original purpose—curbing the excessive use of tax preferences—and simplifying the U.S. tax system. Reducing the AMT’s impact would enhance the efficiency of the tax system, in part by eliminating the need for a growing number of taxpayers to calculate two different tax returns. However, AMT reform would also result in substantial future revenue losses, which would need to be offset by expenditure cuts or revenue increases that could introduce new inefficiencies. This suggests that AMT reform should be included in a broader review of the U.S. tax system, aimed at maintaining strong growth incentives while potentially securing additional revenues through base-broadening and other measures.55
BalkovicB.2003“High-Income Tax Returns for 2000” Statistics of Income BulletinSpring10–62 (Washington: Internal Revenue Service).
BrownR. and M.Mazur2003“IRS’s Comprehensive Approach to Compliance Measurement” National Tax Association Spring SymposiumMay 2003. Available on the Internet at http://www.irs.gov/pub/irs-soi/mazur.pdf.
BurmanL.W.Gale and J.Rohaly2003“The AMT: Projections and Problems” Tax NotesJuly7105–17.
BurmanL.W.Gale and J.Rohaly and B.Harris2002 “The Individual AMT: Problems and Potential Solutions,” Urban-Brookings Institution Tax Policy Center Discussion Paper No. 5 (Washington).
BurmanL.W.GaleM.Hall and M.Saleem2004 “AMT Relief in the FY 2005 Budget: A Bandaid for a Hemorrhage,” Urban-Brookings Tax Policy Center (Washington). Available on the Internet at http://www.taxpolicycenter.org/publications/template.cfm?PubID=1000601.
CampbellD. and M.Parisi2003“Individual Income Tax Returns 2001” Statistics of Income BulletinFall8–45 (Washington: Internal Revenue Service).
Congressional Budget Office (CBO)2004aThe Budget and Economic Outlook: Fiscal Years 2005 to 2014 (Washington: U.S. Government Printing Office).
Congressional Budget Office (CBO)2004b“The Alternative Minimum Tax” (Washington). Available on the Internet at ftp://ftp.cbo.gov/53xx/doc5386/04-15-AMT.pdf.
Congressional Budget Office (CBO)2003aThe Long-Term Budget Outlook (Washington: U.S. Government Printing Office).
Congressional Budget Office (CBO)2003bBudget Options (Washington: U.S. Government Printing Office).
FeenbergD. and J.Poterba2003 “The Alternative Minimum Tax and Effective Marginal Tax Rates,” National Bureau of Economic Research Working Paper No. 10072 (CambridgeMA).
HarveyR. and J.Tempalski1997 “The Individual AMT: Why it Matters,” National Tax Journal Vol. 50 No. 3453–73.
Joint Committee on Taxation (JCT)2003“Estimated Budget Effects of the Conference Agreement for H.R. 2”JCX-55-03 (Washington). Available on the Internet at http://www.house.gov/jct/x-55-03.pdf.
Joint Committee on Taxation (JCT)2001“Recommendations of the Staff of the Joint Committee on Taxation to Simplify the Federal Tax System”JCS-3-01 (Washington). Available on the Internet at http://www.house.gov/jct/s-3-01vol2.pdf.
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LyonA.1997Cracking the Code: Making Sense of the Corporate Alternative Minimum Tax (Washington: Brookings Institution Press).
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RebeleinR. and J.Tempalski2000“Who Pays the Individual AMT?” Office of Tax Analysis Paper 87 (Washington: U.S. Department of the Treasury). Available on the Internet at http://www.ustreas.gov/offices/tax-policy/library/ota87.pdf.
Prepared by Andrew Swiston.
This paper focuses on the AMT for individuals. There is also an AMT for corporations; see Lyon (1997) for a detailed study.
Unless otherwise noted, estimates for 2003 and projections are from Burman, Gale, and Rohaly (2003). Their findings are broadly consistent with estimates in CBO (2003a, 2004a, 2004b), Feenberg and Poterba (2003), JCT (2001, 2003), and Rebelein and Tempalski (2000).
Revenues attributed to the AMT only relate to the tax liability in excess of that determined by the standard personal income tax system.
The FY 2005 budget proposes an extension for 2004 and 2005 of the provision that allowed all credits to reduce AMT liability. Nonrefundable personal credits are those that are only allowed to reduce a positive tax liability, while refundable personal credits like the earned income credit are counted as payments, can be refunded to taxpayers with no tax liability, and are available regardless of a taxpayer’s AMT liability.
The share of AMT liability owed by this group peaked in 1997 because, starting in 1998, nonrefundable credits were allowed to reduce regular income tax liability but not AMT liability (Burman and others, 2002).
Estimates of the costs of interaction with other policy measures and debt service costs associated with each policy change are unavailable. CBO (2004a) estimates that the debt service costs in 2014 of indexing the AMT’s parameters and maintaining the higher exemption would amount to 0.1 percent of GDP. Extending the 2001 and 2003 tax cuts along with AMT reform would result in an added 0.1 percent of GDP revenue loss in 2014, due to interaction effects between the regular income tax and AMT and additional debt service costs.
Chapter III discusses possible revenue-raising measures among other options for fiscal consolidation.