Download Special Report No. 155
AMT Reform Requires Changes to Regular 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. Code
Special Report No. 155
Introduction
In the tax returns Americans finished filing a month ago, the federal government collected tax on less than 40 percent of personal income. The rest went untaxed, and only a small fraction of that was due to illegal tax evasion. Most income that escaped taxation did so in perfectly legal ways, through exclusions, deductions, exemptions and credits that Congress has written into our income tax code over many years.
The three main effects of all these special tax breaks are higher tax rates, economic inefficiency and unfairness. The rates have to be higher on taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. to make up for all the untaxed income. To minimize taxes, people put their money to comparatively unproductive use, making the economy less efficient and the people less prosperous. And because some people, by accident and design, are earning a lot more untaxed income than others, unfair taxation is a systemic problem.
Of course, there are people who think this uneven application of high tax rates is fair: the very beneficiaries of those tax breaks. They believe their income is special, more important or more virtuous. Once they secure a special tax break through political action, these beneficiaries have a perverse incentive to favor higher tax rates on everyone else because that makes their special provision more valuable.
Economists have always considered these unjustified tax breaks to be an offense to efficient, fair taxation and an impediment to economic growth. But was there ever a point when the American political system considered the growing accumulation of tax preferences “excessive”? The answer is yes, in 1969 when Secretary of the Treasury Joseph Barr testified before Congress that 155 individuals had incomes above $200,000 (about $1.2 million in 2007 dollars) but owed no income tax. The resulting uproar led Congress to enact the so-called “add-on” minimum tax, a precursor to today’s Alternative Minimum Tax (AMT).
The AMT identifies taxpayers who have taken “excessive” advantage of legal tax breaks and forces them to re-calculate their income tax. They must add back in some of the previously untaxed income, then take a special AMT exemption (yes, even the AMT has one), and finally pay tax on this new definition of taxable income at different rates. Therefore, in theory at least, the AMT serves as a tax backstop, taxing income that would have escaped taxation.
The logical, preferable alternative to such an administratively redundant tax system would be to repeal all or some of the offending tax breaks from the regular income tax. But each of those special tax breaks has a committed group of champions who fight like dogs to preserve and expand it. In effect, by enacting the AMT and keeping it in law for decades, Congress has recognized that it simply will not repeal tax preferences that benefit politically powerful groups no matter how unjustified those tax breaks are in principle. In fact, it regularly enacts new tax breaks in the regular income tax and expands old ones, so the AMT backstop is the way Congress has settled on to limit their impact on the treasury.
This report gives an overview of our income tax system, both the regular tax and the AMT, identifying major flaws and suggesting remedies. We describe the AMT’s role and answer several important questions that the Congress is contemplating right now: Where does the AMT improve the system, and what harm does it do? Who has to file the AMT return and why? When people have to pay the AMT, does it actually bring their taxes up to the level that people with similar incomes pay? Section II gives the big picture of America’s income and taxation, identifying the vast swaths of income that go untaxed by the regular income tax. Understanding this problem is key to a rational reform of the AMT.
Section III explains the mechanics of the AMT. Section IV presents the tax returns of two families as they work through these two tax systems. Section V explains why more AMT returns have been filed in recent years and explains how we can reform the regular income tax and the AMT.
Key Findings
• The overriding flaw of our income tax system is the vast flow of funds that escapes taxation through the use of various loopholes in the tax code. The AMT corrects a small portion of this problem, albeit imperfectly.
• The AMT is often redundant and complex, but the basic idea behind it—taxing a broader base at lower rates—is a sound one that should serve as a guide to tax policy.
• Unfortunately most of the AMT “fixes” currently under consideration would move us in the wrong direction—shrinking the 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. and taxing what is left at even higher rates.
• The key to fixing the AMT lies in the regular tax code. By curtailing the myriad exclusions, deductions, exemptions, and credits in the code we could expand the tax base. This would allow us to raise the same revenue with lower tax rates, reduce the number of filers affected by the AMT, improve the overall quality of the tax system, boost the nation’s economic well-being, and improve tax equity.
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