Alternatives to the Alternative Minimum Tax

It's May and you're eagerly awaiting your tax refund.  But wait a minute.  The mail arrives with a notice that says you actually owe several thousand dollars of alternative minimum tax (AMT).  How can this be?  Isn't the AMT for rich people who make liberal use of big tax breaks?  You had no tax shelters, stock options, medical expenses, or other such complicating factors. 

Unfortunately, however, you really do owe AMT.  And you are not alone.  Increasing numbers of ordinary Americans are getting nailed by this punitive tax originally intended to snare only the very wealthy.  It doesn't take lots of special tax breaks to get hit; pretty ordinary circumstances are enough.  The AMT hit 1 percent of taxpayers in 1998, 3 percent in 2000, and will hit 10 percent in 2010 if it is not reformed. 

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The AMT was enacted in 1969 amidst charges that a group of 155 wealthy Americans was allegedly paying no income tax.  Initiated with a relatively low 20 percent rate, the AMT at first affected few taxpayers.  By 1992, however, the rate had been raised to 28 percent and a phase-out of the AMT's single $45,000 exemption had begun, ensuring that larger numbers of taxpayers with more modest incomes would be caught.

But this information is probably news to most Americans because the AMT is a complex, parallel tax calculation that is too much trouble to study.  Like much of the tax code, the AMT is a pile of Byzantine details begging for clarification.  Congress has never adequately debated its quirky effects, and it is highly unlikely that the average taxpayer can properly understand and react to those effects.

So how does a taxpayer figure his AMT?  First, he calculates his tax according to the regular income tax rate, then he uses an alternative rate and method to determine a "tentative AMT" figure.  This figure is "tentative" because if it's smaller than his regular tax, then he pays the regular tax.  But if the tentative AMT figure exceeds the regular tax figure, he has to send that much extra to Washington.

Tentative AMT can exceed regular tax, even with a moderately lower rate, because taxable income under the AMT is enlarged by so-called "preferences" and because the exemption is phased out according to how high the taxpayer's income is.  The IRS considers preferences to be certain regular tax deductions (and excluded income items) that it deems to be "tax benefits."  These "benefit" items are recaptured (not allowed) for AMT purposes on the rationale that no taxpayer should take excessive advantage of them.  But, the way the numbers turn out, excessive seems to mean anything over average.

A core problem with the AMT is its lack of a conceptual thrust; it is just a set of numbers generating tax.  For example, the federal tax deduction for state and local taxes is by far the largest "preference" item, without which few taxpayers would be liable for AMT.  A deduction for mandatory tax payments hardly has the character of a true preference, and without it, the same income is taxed twice.  Miscellaneous deductions supporting the generation of income are also phony preferences.  Furthermore, there is no clear rationale for phasing out the exemption under the AMT. 

For a typical home-owning family of four, the treatment of state and local taxes and miscellaneous expenses as preferences raises the AMT base, before an allowable exemption, to 117 percent of the regular tax base.  This alone brings tentative AMT quite close to regular tax.  In addition, the phase-out of the current $45,000 AMT exemption effectively adds 7 percent to the AMT rate over the phase-out interval.

Besides tax and miscellaneous preferences, other items are treated as preferences including catastrophe and theft losses, medical expenses, tax-exempt interest, and incentive stock options.  Moderate inclusions of these can result in net AMT.  In spite of the absence of multiyear averaging provisions, extraordinary single-year AMT payments are not recoverable unless caused by timing preferences.

Long-term capital gains can produce AMT even though they are now taxed at a 20 percent rate for both regular tax and AMT.  Capital gains add to the phase-out of the AMT exemption and also to the amount of state income tax (the deduction of which is treated as a preference). 

Some claim that the AMT is a proxy for a flat tax. This is populist nonsense. A flat tax should not only be simple, it should also affect all taxpayers similarly and have a uniform, moderate rate. The AMT fails on all three counts: It's complicated, has differing impacts depending on different taxpayers' circumstances, and has an effective rate that is neither moderate nor flat. (Its effective rate for typical families is zero for incomes below the exemption, 30 percent for the next increment, 41 percent during the exemption phase-out, and 32 percent thereafter.)

This year, Congress faces pressure to provide relief to the growing number of middle-class taxpayers getting hit by the AMT.  The best solution would be to do away with the AMT altogether.  Failing that, however, other steps can be taken.  Congress could index the tax to the rate of inflation, add more personal exemptions to the single existing AMT exemption, and allow for certain low-income credits.  Beyond this, the AMT should be simplified, and the practice of treating state taxes and certain other items as preferences should be ended. 

Until Congress acts, however, more and more of us may be nervously watching our mail during tax season.

Increasing numbers of ordinary Americans are getting nailed by this punitive tax originally intended to snare only the very wealthy. The best solution would be to do away with it altogether.