A Simple, Progressive Replacement for the AMT

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Abstract

The individual alternative minimum tax (AMT) was originally an add-on tax intended to assure that high income people paid at least some tax. It has morphed and mutated over time, and now is on track to hit 23 million households in 2007. This note describes an option that would return the AMT by repealing the AMT and replacing it with an add-on tax of four percent of adjusted gross income (AGI) above $100,000 for singles and $200,000 for couples. It is a simple, approximately revenue neutral over the ten-year budget window and highly progressive.

Introduction

The precursor to the individual alternative minimum tax was originally an add-on tax intended to ensure that high-income people paid at least some tax. It has morphed and mutated over time, and now is on track to hit 23 million households in 2007, many of them middle- and upper-middle-income families with children. This article describes an option that would return the AMT to its original purpose.

In short, the option would repeal the AMT and replace it with an add-on tax of 4 percent of adjusted gross income above $100,000 for singles and $200,000 for couples. The thresholds would be indexed for inflation after 2007. The option restores the AMT to its original purpose. The proposed add-on tax would be simple: Subtract the threshold ($100,000 or $200,000) from AGI and multiply the difference (if any) by 4 percent. Add that to income tax.

The option is approximately revenue neutral over the 10-year budget window. It would reduce revenue by about $92 billion between fiscal 2007 and fiscal 2011, but would gain roughly the same amount from 2012 through 2017.

This option is highly progressive. Most taxpayers with incomes less than $500,000 affected by the proposal would pay lower taxes through 2010. Most taxpayers with higher incomes would pay more. After 2010, when the Bush tax cuts expire and AMT liabilities decline under current law, the break-even point shifts down somewhat, but by 2017 the distribution is very similar to that in 2007.

The option would replace a tax that is increasingly encroaching on the middle class with one that would be targeted at those most able to pay. Under current law, more than 40 percent of the AMT will be paid by households with incomes less than $200,000 in 2010. Taxpayers with similar incomes would bear less than 4 percent of the proposed AGI surtax, in contrast. Almost 58 percent of the surtax would be borne by taxpayers with incomes exceeding $1 million. Under current law, that group will pay only about 8 percent of the AMT in 2010.

It should be noted that the proposal would not negate all of the benefits of the Bush tax cuts through 2010. Almost nobody (0.2 percent of taxpayers) would owe higher taxes in 2010 under the proposal than they would under pre-2001 law — the same share that would owe higher taxes without the AMT reform (tables 2 and 8). Even those with incomes exceeding $1 million would receive a net tax cut equal to more than 4 percent of income, or almost $86,000 in 2010. That is substantially smaller than the tax cut originally conferred by the tax cuts, but still larger than most middle-income taxpayers’ tax cuts. And, by repealing the AMT, middle-income taxpayers would receive the full benefit of the Bush tax cuts. In a previous analysis, we have shown that theAMT takes back almost 30 percent of the tax cuts in 2010.

Taxpayers with incomes below $500,000 would, on average, receive a tax cut from the proposal, averaging 0.5 percent of income in 2007 for those with income between $75,000 and $100,000 and more than 1 percent for those with income between $100,000 and $500,000. Higher-income people would pay more tax, on average, especially those with incomes exceeding $1 million, who are relatively unlikely to be subject to AMT under current law.

Among taxpayers affected by the proposal, most would face lower effective tax rates on ordinary income than under current law, and many would also face lower effective rates on capital gains. The marginal effective tax rate is the additional tax paid on an additional dollar of income. It is a measure of how the tax system affects incentives to work, save, and engage in tax sheltering. It can differ from statutory tax rates because of income phase-ins and phaseouts. The AMT creates an implicit income tax surcharge because the exemption phases out over a range of income at a 25 percent rate. The surtax is thus equivalent to 25 percent of the AMT rate — either 6.5 percent (25 percent of 26 percent) or 7 percent (25 percent of 28 percent) — for AMT taxpayers in the phaseout range. The surtax applies to both ordinary income and capital gains. Thus, the effective capital gains rate under the AMT can be as high as 22 percent (the 15 percent statutory rate plus the 7 percent AMT surtax). Repealing the AMT will therefore reduce rates by more than 4 percentage points for many taxpayers affected by the exemption phaseout. As a result, they will pay at lower marginal rates even with the new add-on tax. In addition, middle-income taxpayers are removed from the AMT and are unaffected by the new tax. Most very-high-income taxpayers would pay tax at higher rates, however.

After 2010 the sum of the top statutory rates in the regular income tax and the add-on tax rate would be higher than the top statutory rates under pre-2001 law — 43.6 percent on ordinary income and 24 percent on capital gains. However, the tax system would be much simpler and more transparent, and nearly all AMT taxpayers would pay lower taxes.

A tax based on AGI may seem like a new departure for the tax system, but it is not. There are countless implicit taxes on AGI. For example, the child tax credit phases out at a 5 percent rate on AGI exceeding $110,000 for couples, creating a 5 percent AGI surtax over a range of income. Itemized deductions and personal exemptions similarly phase out with AGI (although the 2001 tax cuts have partially repealed those provisions in 2007 and will fully repeal them by 2010). A more sweeping reform might subsume all or almost all of the AGI phaseouts into the new AGI surtax, although that would require a higher rate or a lower threshold to be revenue neutral.

For more information on the AMT, see the Tax Policy Center’s collection of AMT resources at: www.taxpolicycenter.org/newsevents/amt.cfm.

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