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How Do the Bush Tax Cuts Interact with the Alternative Minimum Tax (AMT)?

3 min read

The federal individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. is really two 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. systems: the ordinary individual income tax and the much-maligned alternative minimum tax (AMT) system. Individuals are required to calculate their tax liability under both systems and then pay the higher tax.

Over the past decade, the AMT has been in the news because the so-called Bush tax cuts enacted in 2001 and 2003 altered the ordinary system while leaving the AMT largely unchanged. For low- and middle-income people, the AMT was almost always irrelevant. They got their tax cuts as advertised. For upper-income people, the AMT made things more complicated.

During the 1990s, many upper-income people had financial arrangements that resulted in their owing more under the AMT each year than they owed under the regular system. For those people — roughly two percent of taxpayers nationwide — the regular tax cuts enacted in 2001 and 2003 had little effect. They still had to pay the higher of the two calculations, and that was still the AMT.

A much more common situation was that upper-income people (say, between $150,000 and $1 million) had always owed more under the regular system than they did under AMT, and so they were hardly aware of the AMT. But then, during the 2001-2003 period, they got sufficient tax cuts that suddenly their AMT liability was higher than their regular liability. In effect, the AMT “took back” some of their tax cut, usually a fairly small fraction. In no case did anyone owe more under the Bush tax cuts than they would have in their absence, but because many taxpayers were suddenly discovering the AMT, many people who should have known better talked as if their taxes had been raised, that they had been “victimized” or “trapped” by the AMT.

Congress’s response to this mistaken outrage was to enact an annual AMT “patch” so that the number of people who owed more AMT than regular tax did not grow. “Patching” means raising the income level that is automatically exempt from the AMT, usually for one year or two. To enact such a high exemption level permanently would be a large tax cut, and a politically difficult measure. And so throughout the past decade, during the Bush years and continuing in the Obama years, Congress passes and the President signs a one- or two-year patch to prevent AMT from hitting 20 million more taxpayers. The current tax year (2012) is no exception. As of current law, 27 million taxpayers are set to owe more under the AMT than under the regular income tax. But Congress is expected to “patch” AMT for 2012 at some point this year, which would reduce the number hit by AMT to around 5 million.

In his budget, President Obama has proposed curtailing the effect of the AMT in two ways. For people earning over $250,000 ($200,000 for singles), his proposal to restore the Clinton-era tax rates will make the regular tax due higher than the AMT due. And he suggests permanently patching the AMT and indexing its parameters for 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. , which will shield many filers with adjusted gross incomes in the $75,000 to $250,000 range from liability under the AMT. Together, these two measures would cause the AMT to recede, once again, into relative obscurity.

A good policy argument can be made that these changes are detrimental to the economy, that even in its current, absurdly complex state, the AMT is a better tax than the regular tax system. Robert Kennedy first proposed a one-line AMT of 20 percent on 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.” (AGI) in 1968. Each taxpayer would have multiplied his AGI by 20 percent, and that would have been the lowest amount he could owe – an idea that the President’s modern “Buffett Rule” proposal echoes. The version that ultimately passed a year later was quite different and far more complex. More on the AMT.