Statement of Alan Viard, Ph.D, Resident Scholar, American Enterprise Institute

Testimony Before the Subcommittee on Select Revenue Measures
of the House Committee on Ways and Means

March 07, 2007

Chairman Neal, Ranking Member English, Members of the Committee; it is an honor to appear before you today to discuss the alternative minimum tax (AMT).

I would like to make four main points:

• The fundamental reason for the spread of the AMT is that the exemption amount has never been indexed to inflation. As a result, the AMT spread rapidly before the 2001 and 2003 tax laws were adopted, it would have continued spreading without those laws, and it is projected to spread further after 2010 even if those laws sunset.
• The 2001 and 2003 tax laws, in combination with other tax legislation adopted in 2001 through 2006, slowed the AMT spread in those years, but will accelerate the spread in 2007 through 2010.
• Taxpayers who move onto the AMT in 2007 through 2010 due to the 2001 and 2003 tax laws still enjoy a net tax cut from those laws.
• The spread of the AMT exposes more taxpayers to an ill-designed tax system.

AMT Exemption Amount Has Never Been Indexed for Inflation

The basic design of the AMT has remained largely unchanged since 1987, when the provisions of the Tax Reform Act of 1986 (enacted October 22, 1986) took effect. At that time, the exemption amount was $40,000 ($30,000 for unmarried taxpayers). No automatic inflation adjustment was provided for the AMT exemption, even though the regular tax brackets and exemption amounts were and are adjusted for inflation.

Since that time, there has been only one permanent increase in the exemption amount. The Omnibus Budget Reconciliation Act of 1993 (OBRA93) (enacted August 10, 1993) increased the exemption amount to $45,000 ($33,750 for unmarried taxpayers), effective in 1993. As can be seen in Figure 1, the increase fell far short of the amount needed to offset the cumulative effects of inflation since 1987.

Moreover, OBRA93 also failed to provide for inflation indexation. By 2000, therefore, the exemption amount had fallen further behind what was needed to keep up with inflation.

Inflation Caused AMT to Spread Before 2001

When the regular tax system is indexed for inflation and the AMT is not, the effects of inflation are straightforward. Tax liability computed under AMT rules rises more rapidly than tax liability computed under regular tax rules. A larger number of people therefore find that their AMT-computed tax liability is the larger of the two and they then move onto the AMT.

As one would expect, the AMT spread relentlessly during the 13 years after 1987, as shown by the Brookings-Urban Tax Policy Center data displayed in Figure 2. The AMT rolls surged from a mere 140,000 in 1987 to 1.6 million in 2000. Throughout this period, the number of AMT taxpayers typically doubled every three or four years.

Inflation Caused Further AMT Spread in 2001-2006; Tax Legislation Slowed the Spread

The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) (enacted June 7, 2001) provided sweeping reductions in regular income tax rates in 2001 through 2010. The Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) (enacted May 28, 2003) provided further reductions in regular tax liability.

A common criticism asserts that these laws accelerated the spread of the AMT by lowering regular tax rates without providing AMT relief. As taxpayers’ regular tax liabilities declined with no change in their AMT liabilities, the story goes, taxpayers moved onto the AMT.

That story does not accurately describe what happened in 2001 through 2006. EGTRRA and JGTRRA actually provided some AMT relief and other laws signed by President Bush during this period provided additional relief. The net consequence of these laws was to slow the spread of the AMT in 2001 through 2006, relative to what would have happened under pre-2001 law.

EGTRRA increased the AMT exemption amount to $49,000 ($35,750 for unmarried taxpayers) for 2001 through 2004.[1] The higher exemption amounts duly took effect for 2001 and 2002. Subsequently, JGTRRA increased the exemption amount still further to $58,000 ($40,250 for unmarried taxpayers) for 2003 and 2004.

Three other laws also provided AMT relief during this time period:

• The Job Creation and Worker Assistance Act (enacted March 9, 2002) allowed personal nonrefundable credits to be claimed against the AMT in 2002 and 2003 (prior law allowed such credits only through 2001).
• The Working Families Tax Relief Act (enacted October 4, 2004) extended the $58,000 exemption amount for 2005. It also allowed personal nonrefundable credits to be claimed against the AMT in 2004 and 2005.
• The Tax Increase Prevention and Reconciliation Act (enacted May 17, 2006) raised the exemption amount to $62,550 ($42,500 for unmarried taxpayers) for 2006 and also allowed personal nonrefundable credits to be claimed against the AMT in that year.

According to Brookings-Urban Tax Policy Center data, the net effect of the legislation adopted in 2001 through 2006 was to reduce AMT coverage in those years. This reduction can be seen in the first part of Figure 3, the portion to the left of the first dashed horizontal line.

If the tax code had simply been left alone after 2000, the AMT rolls would have surged from 1.6 million in 2000 to 8.1 million in 2006. The surge would have occurred for the same reasons as the growth in the previous 13 years; inflation would have increased AMT liabilities relative to regular tax liabilities. The legislation adopted during this period slowed the spread of the AMT; the actual AMT rolls were smaller in each year than they would have been under prior law. Due to this legislation, there were 3.5 million taxpayers on the AMT in 2006, rather than 8.1 million.

The AMT relief adopted during this period, some of it provided in EGTRRA and JGTRRA and some added by the other three laws, was sufficiently generous that it had the net effect of moving taxpayers off of the AMT. (Because the legislation increased AMT revenue per AMT taxpayer, AMT revenue was roughly unchanged from the level that would have resulted from prior law.) These laws slowed the AMT spread that would otherwise have resulted from inflation.

Inflation is causing a Further Spread in 2007-2010, Reinforced by the Effects of the Tax Cuts

The story in which EGTRRA and JGTRRA move taxpayers onto the AMT does have some validity for 2007 through 2010. This can be seen from the middle part of Figure 3, the portion between the two dashed horizontal lines. With the recent tax legislation in place, the AMT rolls number 23.4 million in 2007, rising to 32.4 million in 2010. The spread would have been slower without the legislation; under pre-2001 law, the AMT rolls would have been 10.2 million in 2007, rising to 16.5 million in 2010.

The numbers also reveal, though, that a rapid inflation-driven spread was already programmed into the AMT, again due to its lack of indexation. Even if EGTRRA and JGTRRA had never been adopted, we would still be confronting an unacceptable spread of the AMT. We would be discussing a tax system that reached over 10 million people today, up from less than 1 million a decade earlier. The problem clearly involves more than the effects of those laws.

Still, it is true that the AMT spread is more rapid with EGTRRA and JGTRRA than it otherwise would have been. These laws provide substantial regular tax relief for 2007 through 2010, without providing accompanying AMT relief.

Taxpayers Who Move onto the AMT, Taxpayer Still has a Net Tax Cut

As discussed above, some taxpayers who would otherwise be on the regular tax are on the AMT in 2007 through 2010 due to EGTRRA and JGTRRA. It is important to understand how these taxpayers’ tax liabilities are affected. Some observers claim that EGTRRA and JGTRRA constitute a “tax increase” for these taxpayers. In reality, however, these taxpayers still enjoy net tax cuts from those laws.

Consider an example. Suppose that, without EGTRRA and JGTRRA, a hypothetical taxpayer would have a $100 tax liability under regular tax rules and a $90 tax liability under AMT rules. The taxpayer would then be on the regular income tax and would have a $100 tax liability. Suppose that those laws reduce the taxpayer’s liability under regular tax rules to $85 while leaving his or her liability under AMT rules unchanged at $90. Because liability under the AMT rules is now higher than the liability under the regular tax rules, the taxpayer moves onto the AMT and has a $90 tax liability.

Although these laws cause the taxpayer to move onto the AMT, they do not raise his or her tax liability, relative to prior law. On the contrary, the laws reduce the taxpayer’s liability from $100 to $90. Moving onto the AMT merely reduces the size of the tax cut, which would have been $15 without the AMT, to $10. In colloquial terms, the AMT “takes back” one-third of this taxpayer’s tax cut.

It is correct, therefore, to speak of the AMT taking back part of the tax cuts, but it is not correct to speak of the AMT turning the tax cuts into tax increases. The only taxpayers who do not receive any tax savings from the regular-tax-rate reductions in EGTRRA and JGTRRA are those who would already have been on the AMT, even without these laws.[2]

Inflation Will Cause AMT to Spread Still Further after 2010, Even if the Tax Cuts Sunset

Due to inflation, the AMT is projected to continue spreading after 2010. The AMT rolls during this period are shown in the third part of Figure 3, the portion to the right of the second dashed horizontal line. The rolls grow from 32.4 million in 2010 to 39.1 million in 2017.

As noted above, EGTRRA and JGTRRA expand the AMT rolls to some extent in 2007 through 2010 and their sunset therefore provides a respite from the spread of the AMT. But, the respite is short-lived, as inflation resumes its steady toll. The AMT spreads to absolutely unacceptable levels, even without EGTRRA and JGTRRA. Because those laws are scheduled to sunset, the AMT rolls under current law are essentially identical to those under pre-2001 law after 2010.

Of course, the AMT spread would be even more rapid if EGTRRA and JGTRA were extended without any long-term AMT relief or solution. An extension of these laws would need to include AMT relief, if no fundamental AMT solution had yet been adopted.

The Spread of the AMT Puts More Taxpayers on an Ill-Designed Tax System

Without relief, the AMT will spread to a wide range of taxpayers. Those most likely to be hit by the AMT include the following:

• Taxpayers with large families are more likely to owe AMT, because the AMT disallows the personal exemption ($3,400 per person in 2007) that the regular income tax allows for the taxpayer, spouse, and dependents. Under current law, in 2007, almost 40 percent of taxpayers with three or more children will owe AMT, compared to 11 percent of taxpayers without children.[3]
• Taxpayers who live in high-tax states are more likely to owe AMT, because the AMT disallows the regular tax system’s itemized deduction for state and local income (or sales) and property taxes. Under current law, in 2007, 22 percent of taxpayers in high-tax states are on the AMT, compared to 15 percent in low-tax states.
• Taxpayers with incomes in the ranges in which the AMT rate schedule is closest to the regular tax schedule are most likely to be on the AMT. Under current law, in 2007, 90 percent of taxpayers with cash incomes between $200,000 and $500,000 (in 2006 prices) are on the AMT, compared to 34 percent of those with incomes above $1,000,000 and 36 percent of those with incomes of $75,000 to $100,000.

As these taxpayers move onto the AMT, they will experience a significant increase in complexity. It should be recognized, however, that they will also be moving onto an ill-designed tax system.

Some have argued that the AMT is a low-rate flat-rate broad-based income tax that would actually be a good replacement for the income tax. As I argued in the November 2006 AEI Tax Policy Outlook, that view is unconvincing.[4]

The AMT’s base-broadening provisions are limited and highly selective, hampering any gains in economic efficiency. In some cases, the AMT is likely to induce taxpayers to shift from one tax-preferred activity to another tax-preferred activity (that the AMT does not address), with little or no gain in economic efficiency. Also, some of the base-broadening provisions are misdirected, because they deny people the ability to deduct costs of earning income. The AMT also features harsh treatment of some workers who exercise incentive stock options and some winners of taxable damage awards.

The redeeming feature of the AMT is supposed to be its low marginal rates, but that, too, do not stand up under scrutiny. Effective marginal tax rates under the AMT are not systematically lower than those under the regular income tax. A common misconception holds that the AMT has two brackets, 26 percent and 28 percent. In reality, however, the AMT features two other, higher-rate, brackets. The marginal rates are 32.5 and 35 percent in the interval in which the exemption amount is being phased out. Also, the effective tax rate on an additional dollar of wages is enhanced under the AMT because a smaller portion of that dollar is deductible from taxable income, since the AMT allows a narrower range of itemized deductions.

Figure 4 provides illustrative calculations of the difference in effective marginal tax rates between the two systems, for different types of returns and at different income levels, under a specific set of simplifying assumptions. It can be seen that the AMT rate is sometimes higher and sometimes lower than the regular tax rate. Although this calculation is only for a stylized example, it indicates that there is no inherent tendency for the AMT to have lower marginal tax rates.

Summary

The fundamental reason for the spread of the AMT is that the exemption amount has never been indexed to inflation. As a result, the AMT spread rapidly before the 2001 and 2003 tax laws were adopted, it would have continued spreading without those laws, and it is projected to spread further after 2010 even if those laws sunset.

The 2001 and 2003 tax laws, in combination with other tax legislation, slowed the AMT spread in 2001 through 2006, but will accelerate the spread in 2007 through 2010. It should be recognized that taxpayers who move onto the AMT due to the 2001 and 2003 tax laws still enjoy a net tax cut from those laws.

The spread of the AMT not only causes complexity, but also exposes more taxpayers to an ill-designed tax system.

[1] EGTRRA also made the child credit and the earned income tax credit allowable under the AMT through 2010.

[2] Even those taxpayers may enjoy tax savings from other provisions of EGTRRA and JGTRRA. To begin, EGTRRA provides some AMT relief that applies in 2007-2010, as mentioned in footnote 1, above. Also, many of the tax-reduction provisions in EGTRRA and JGTRRA apply under both the AMT and the regular tax, including the rate reductions for dividends and long-term capital gains and the expansion of tax-free savings accounts.

[3] All of the data on 2007 AMT coverage are Urban-Brookings Tax Policy Center data, taken from Greg Leiserson and Jeffrey Rohaly, “The Individual AMT: Historical Data and Updated Projections,” Tax Notes, December 25, 2006.

[4] Alan D. Viard, “The Alternative Minimum Tax: A Better System?” AEI Tax Policy Outlook, November 2006, www.aei.org/publication25110.