Backgrounder on the Individual Alternative Minimum Tax (AMT)

10 min readBy: Patrick Fleenor, Andrew Chamberlain

Fiscal Fact No. 26

Overview
 Reforming the Alternative Minimum TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. (AMT) is a key issue facing the President’s Advisory Panel on Federal Tax Reform. The following brief provides an overview of the AMT and why it matters for taxpayers.

The AMT is a tax system that is parallel to the regular income tax. It was originally designed to capture a small number of wealthy taxpayers who were avoiding income taxes, but the AMT’s reach has ballooned in recent years.

Until recently, the AMT affected less than 1 percent of taxpayers. Since 2000 the AMT has steadily grown, hitting roughly 3 percent of taxpayers in 2005. If left unchanged, the AMT will penalize nearly 20 percent of taxpayers by 2010—some 30 million Americans in total. (See Figure 1.)

Figure 1. Projected Impact of the Individual Alternative Minimum Tax

a) Calendar year basis.
b) Fiscal year basis.
Source: Congressional Budget Office.

Why Was the AMT Enacted?
 Congress enacted the AMT in 1969 following testimony by the Secretary of the Treasury that 155 people with adjusted gross incomeFor individuals, gross income is the total pre-tax earnings from wages, tips, investments, interest, and other forms of income and is also referred to as “gross pay.” For businesses, gross income is total revenue minus cost of goods sold and is also known as “gross profit” or “gross margin.” above $200,000 had paid zero federal income tax on their 1967 tax returns. (See Appendix for the AMT’s legislative history.) In inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. -adjusted terms, those 1967 incomes would be roughly $1.17 million in today’s dollars.

This tax avoidance by a few high-income taxpayers was widely perceived as unfair. Rather than directly addressing the problem by eliminating the deductions and credits in the tax code that were leading to the tax avoidance, Congress laid an additional layer of complexity over the regular income tax in the form of the AMT.

Who Is Affected by the AMT?
 Under the current system, taxpayers who file using the 1040 form at tax time fill out a special worksheet to determine if they pay the AMT. In addition to the worksheet, certain deductions serve as red flags that might signal suspicious tax avoidance activities, and these automatically throw taxpayers into the AMT. (See Table 1.) Essentially, taxpayers calculate their tax liability under both the regular income tax and the AMT, and then pay the higher of the two amounts.

Table 1. List of Deductions Perceived As Likely to Be Abused For Tax Avoidance that Automatically Push Taxpayers into the AMT

• Accelerated depreciation
• Income from incentive stock options
• Tax-exempt interest from private activity bonds
• Intangible drilling, circulation, research, experimental, or mining costs
• Amortization of pollution-control facilities or depletion
• Income or (loss) from tax-shelter farm activities or passive activities
• Percentage-of-completion income from long-term contracts
• Interest paid on a home mortgage not used to buy, build, or substantially improve your home
• Investment interest expense reported on Form 4952
• Net operating loss deduction
• Alternative minimum tax adjustments from an estate, trust, electing large partnership, or a cooperative
• Section 1202 exclusion

Source: IRS 2004 1040 form instructions, line 44.

The AMT consists of two tax bracketA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. s—26 percent for incomes below $175,000, and 28 percent for incomes above. It allows a standard exemption that exempts most low-income taxpayers—$45,000 for those who are married filing jointly and $33,750 for most other taxpayers in 2005. It disallows many of the deductions and tax preferences allowed by the regular income tax, including deductions for state and local income taxes, unreimbursed business expenses, and certain medical expenses. As a result, taxpayers with many deductions and credits are most likely to be caught up in the AMT.

The AMT primarily affects middle- to upper-middle income taxpayers. This should not come as a surprise, since most tax preferences Congress writes into the regular income tax code are aimed at benefiting this group of taxpayers for political reasons. Low income taxpayers are largely unaffected by the AMT because of its standard exemption, while the wealthiest taxpayers are unaffected because they already face the nation’s highest effective tax rates under the regular income tax system.

Factors Causing the AMT Crisis
 The expansion of the AMT will add unnecessary complexity to the tax code, increase tax compliance costs, and complicate taxpayers’ decisions about when to earn income and incur deductible expenses. Two factors are causing the expansion: the non-indexation of the AMT for inflation, and the federal income tax cuts enacted in 2001 and 2003.

Unlike the regular income tax, the AMT’s parameters are not indexed for inflation. That means that over time economic growth and inflation cause a steady increase in the number of taxpayers drawn into the AMT—commonly known as “bracket creepBracket creep occurs when inflation pushes taxpayers into higher income tax brackets or reduces the value of credits, deductions, and exemptions. Bracket creep results in an increase in income taxes without an increase in real income. Many tax provisions—both at the federal and state level—are adjusted for inflation. .” As nominal incomes rise along with inflation, the AMT’s standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act (TCJA) as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. shrinks in relative terms, affecting more middle-income taxpayers.

A far more important factor causing the AMT’s recent expansion is the effect of the 2001 and 2003 Bush tax cuts. Ironically, by reducing regular income tax liabilities without substantially changing the AMT, the Bush tax cuts will be responsible for most of the expansion of the AMT through 2011 (see Figure 1). Since taxpayers must pay the greater of either their AMT or regular tax liability, the decline in income tax liability without any change in the AMT pushed many taxpayers into the AMT.

Middle- and upper-middle-income taxpayers are most at risk in the coming years. The AMT’s standard deduction shields most low-income taxpayers, while its top rate of 28 percent means few wealthy taxpayers pay the AMT because they typically face much higher effective tax rates. According to Congressional Budget Office estimates, taxpayers earning between $50,000-$200,000 will be hardest hit by the AMT in coming years, especially those in high cost of living areas with high per-capita incomes and high state and local taxes.

Nationwide, 1.8 percent of the approximately 131,357,000 tax returns filed in the U.S. were subject to the AMT in 2003, or roughly 2,359,000 returns. However, as illustrated in Figure 2, taxpayers in some states were far more likely to be affected by the AMT.

Figure 2: Number of Tax Returns Affected by the Alternative Minimum Tax as a Percentage of All Tax Returns, by State, 2003

Source: Internal Revenue Service, Tax Foundation calculations.

Perhaps a more instructive measure of the AMT’s reach is the percentage of tax returns with a positive tax liability that pay the AMT. Figure 2 divides the number of AMT payers by the roughly 131 million total tax returns filed in 2003. However, more than 40 million of those tax filers paid zero income tax in that year, as they have been removed from the income tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. thanks to various credits and deductions.

Figure 3 below shows the percentage of tax filers who pay some income tax in each state who are affected by the AMT.

Figure 3: Number of Tax Returns Affected by the Alternative Minimum Tax as a Percentage of Tax Returns With Positive Tax Liability, by State, 2003

Source: Internal Revenue Service, Tax Foundation calculations.

What Should Be Done?
 Among the options for reform—including indexing the system for inflation, adding more deductions and exemptions, and outright repeal of the AMT—only repeal accompanied by reductions in tax preferences in the regular income tax provides a stable long-term solution to the AMT’s flaws.

One advantage of repeal is that it would help refocus tax reform efforts on broadening the tax base and lowering rates in the regular income tax system. Congress’ original goal of enacting the AMT was to ensure that very wealthy taxpayers do not escape tax liability through the abuse of tax preferences. However, the most economically sound way to achieve that was not to graft additional complexity onto the tax code. It was to eliminate the very tax preferences that were the source of the abuse.

Eliminating the AMT while broadening the current tax base would achieve two main goals. First, by broadening the definition of income and eliminating tax preferences it would preserve the AMT’s goal of minimizing tax avoidance by wealthy taxpayers. Second, a broader tax base would allow revenue-neutral reductions in marginal rates. Since high marginal rates provide the main incentive for tax evasion, rate reductions reduce the incentives for tax evasion to begin with.

Further Resources on the AMT
 The following resources provide additional background on the AMT:

Appendix. Legislative History of the Alternative Minimum Tax, 1969-Present

Tax Reform Act of 1969 (P.L. 91-172)

Introduced the “add-on” minimum income tax of 10% in excess of an exemption of $30,000.

Excise, Estate, and Gift Tax Adjustment Act of 1970 (P.L. 91-614)

Allowed deduction of the “unused regular tax carryover” from the base for the minimum tax.

Revenue Act of 1971 (P.L. 92-178)

Imposed minor provisions regarding foreign income.

Tax Reform Act of 1976 (P.L. 94-455)

Raised rate of minimum income tax to 15% and lowered exemption to $10,000 or half of regular taxes.

Tax Reduction and Simplification Act of 1977 (P.L. 95-30)

Reduced minimum tax preference for intangible costs of drilling oil and gas wells.

Revenue Act of 1978 (P.L. 95-600)

Introduced AMT alongside minimum income tax and moved certain itemized deductions and capital gains to AMT. AMT had graduated rates of 10%, 20%, and 25%, and an exemption of $20,000.

Economic Recovery Tax Act of 1981 (P.L. 97-34)

Lowered AMT rates to correspond with reductions in rates of regular income tax.

Tax Equity and Fiscal Responsibility Act of 1982 (P.L. 97-248)

Repealed “add-on” minimum tax. Made AMT rate a flat 20% of AMT income after exemptions of $30,000 for individuals and $40,000 for joint returns.

Deficit Reduction Act of 1984 (P.L. 98-369)

Made minor changes concerning investment tax credit, intangible drilling costs, and other items.

Tax Reform Act of 1986 (P.L. 99-514)

Raised AMT rate to 21%. Made high-income taxpayers subject to phase-out of exemptions. Increased number of tax preferences. Allowed an income tax credit for prior year AMT liability.

Revenue Act of 1987 (P.L. 100-203)

Made technical corrections related to Tax Reform Act of 1986.

Technical and Miscellaneous Revenue Act of 1988 (P.L. 100-647)

Made technical corrections related to Tax Reform Act of 1986.

Omnibus Budget Reconciliation Act of 1989 (P.L. 101-239)

Made further technical amendments.

Omnibus Budget Reconciliation Act of 1990 (P.L. 101-508)

Raised AMT rate to 24%.

Energy Policy Act of 1992 (P.L. 102-486)

Changes regarding intangible costs of drilling oil and gas wells.

Omnibus Reconciliation Act of 1993 (P.L. 103-66)

Introduced graduated AMT rates of 26% and 28%. Increased exemption to $33,750 for individuals and $45,000 for joint returns. Changed rules about gains on stock of small businesses.

Taxpayer Relief Act of 1997 (P.L. 105-34)

Changes regarding depreciation and farmers’ installment sales.

Tax Technical Corrections Act of 1998 (P.L. 105-206)

Adjusted AMT for new capital gains rates.

Tax Relief Extension Act of 1999 (P.L. 106-170)

Changed rules about nonrefundable credits.

Source: Joint Economic Committee, U.S. Congress.

(For more information, please contact Bill Ahern at (202) 464-5101.)

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