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March 7, 2007
hp-299
Testimony of Treasury Assistant Secretary for Tax Policy Eric Solomon before the Subcommittee on Select Revenue Measures of the House Committee on Ways and Means
Washington, D.C.--Mr. Chairman, Ranking Member English, and distinguished Members of the Committee, thank you for the opportunity to discuss the issue of the individual alternative minimum tax.
The individual alternative minimum tax, or AMT, was intended to deal with a relatively small but important issue. Unfortunately, the AMT has created a far larger issue than the one it was intended to address.
The Administration is very concerned about the adverse effects of the AMT. It is complex and frustrates the millions of taxpayers who have to calculate their taxes twice – once under the regular tax system and a second time under the AMT tax system. Taxpayers find that benefits otherwise provided under the regular tax system are taken away by the AMT, or they do the double calculations only to find that they are not subject to the AMT.
History of the AMT
The predecessor of the AMT – the minimum tax – was first enacted in 1969 to ensure that a small group of high-income individuals who had managed to avoid paying federal income tax would pay at least a minimum amount of tax. In 1969, Treasury Secretary Barr noted in his testimony before the Joint Economic Committee of Congress that 155 taxpayers with incomes over $200,000 paid no tax in 1966. Even though the minimum tax reduced the number of high-income taxpayers who otherwise would have paid no income tax, it has never been completely successful in attaining the original goal of ensuring that all high-income taxpayers pay at least some tax. More than 37 years of legislative changes to the tax code have transformed the original minimum tax into the current AMT.
Structure of the AMT
The AMT is a second income tax that operates parallel to the regular income tax. The AMT has its own tax base, exemption amounts, tax rates, and usable tax credits. A taxpayer's AMT liability is essentially the excess of the liability calculated under the AMT tax system over the liability calculated under the regular income tax.
The AMT tax base starts from taxable income as defined under the regular income tax, but the base is broadened by adding back certain tax preferences. Preferences include, for example:
• the itemized deduction for State and local taxes,
• the itemized deduction for certain miscellaneous expenses exceeding two percent of adjusted gross income (AGI),
• the itemized deduction for medical expenses to the extent it represents medical expenses of less than 10 percent of AGI,
• the standard deduction, and
• personal exemptions.
A number of other items are treated as AMT preferences totally, or to the extent they are AMT preferences, must be calculated differently for AMT purposes. These include items such as incentive stock options, the net operating loss deduction, and investment interest expenses. The largest AMT preference items are the regular tax State and local tax deduction and personal exemptions.
The AMT tax base is reduced by an AMT exemption which varies by filing status but not by family size. From 1984 through 1992, the AMT exemption was $40,000 for married taxpayers and $30,000 for unmarried taxpayers. In 1993, it was increased to $45,000 for married taxpayers and $33,750 for unmarried taxpayers. Beginning with the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), Congress has included provisions in each of the major tax relief bills to increase the AMT exemption temporarily, thus preventing a large increase in the number of AMT taxpayers. For 2006, the AMT exemption levels were $62,550 for married taxpayers filing joint returns and $42,500 for unmarried individuals.
The AMT exemption begins to be phased out at $150,000 of AMT income for married taxpayers filing joint returns, at $112,500 for unmarried individuals, and at $75,000 for married filing separately returns. The exemption is reduced by 25 percent of AMT income above those thresholds until they are completely phased out.
Since 1993, the first $175,000 of taxable income for AMT purposes is taxed at a 26 percent rate, and amounts above $175,000 are taxed at a 28 percent rate. However, capital gains and qualified dividends are taxed under the AMT at the lower tax rates that apply under the regular income tax. Because the AMT exemption is phased out, it results in four effective AMT marginal tax rates of 26 percent, 32.5 percent (for taxpayers phased out of the 26-percent AMT tax bracket), 28 percent, and 35 percent (for those phased out of the 28-percent AMT tax bracket). Consequently, because of the phase-out of the exemption, some taxpayers face a marginal effective AMT tax rate of 35 percent.
Generally, the AMT can prevent some tax credits from being claimed against the regular tax because credits are disallowed if they reduce regular tax below the tentative amount of the AMT tax. Since 1998, Congress has repeatedly extended temporary legislation that has permitted most personal tax credits to reduce the otherwise applicable AMT. However, general business credits (most importantly the low-income housing credit) can be limited by the AMT.
The temporary extensions of the higher AMT exemptions and allowance of the full use of most personal tax credits (which have come to be known as the "AMT patch") expired at the end of 2006. The President's fiscal year 2008 Budget includes a proposal to extend the AMT patch through 2007, with the AMT exemptions increased for 2007 to $65,350 for married taxpayers filing joint returns and $43,900 for unmarried individuals. The Budget proposal is designed to hold the number of taxpayers affected by the AMT constant at approximately 4 million.
Does AMT Eliminate Nontaxable High Income Returns?
In spite of the AMT, each year a very small percentage of high-income tax returns are filed reporting no income tax liability. The reasons for high-income returns reporting no income tax liability are varied. Certain itemized deductions and exclusions from income could cause this result. High-income returns with no income tax liability often result from a combination of factors, none of which, by itself, would completely eliminate income tax liability. Some items that singly or in combination may eliminate regular income tax liability cannot eliminate AMT liability because these items give rise to adjustments or preferences for AMT purposes. However, due to the AMT exemption and the fact that the starting point for alternative minimum taxable income is taxable income for regular tax purposes, which could be negative, a return could report no regular income tax and no AMT even though it included some items that produced AMT adjustments or preferences.
Tax-exempt bond interest, itemized deductions for interest expense, miscellaneous itemized deductions not subject to the two-percent-of-AGI floor, casualty or theft losses, and medical expenses (exceeding 10 percent of AGI) could, by themselves, completely eliminate income tax liability because they do not generate AMT adjustments or preferences. More typically, combinations of these items together with deductions for charitable contributions completely eliminate tax liability without generating AMT liability.
Complexity of the AMT
The complexity and burden of the AMT result from the necessity that taxpayers understand and comply with two parallel tax systems. Moreover, because many taxpayers become subject to the AMT for reasons that are not the result of tax-motivated planning, many taxpayers are not aware that they will be affected by the AMT until they complete their tax returns. Even then, some taxpayers who complete their returns manually may not be aware that they are required to do the calculations for the AMT, creating a compliance problem.
The Growing Ranks of AMT Payers
Unlike the regular tax, the AMT tax system is not indexed for inflation. The AMT exemption, the exemption phase-out, and the boundary between the two AMT tax rates are all fixed in nominal terms. Consequently, with the passage of time, the effects of inflation will steadily increase the number of taxpayers subject to AMT and the amount of revenue from the AMT. When relatively few taxpayers were affected, the AMT arguably was achieving its policy objective. However, serious tax policy issues arise when the AMT affects millions of taxpayers who were never intended to be the target of this separate tax.
The AMT exemption in effect through 2006 has generally kept the vast majority of taxpayers from being subject to the AMT. If the AMT exemption had been indexed to inflation beginning in 1984 when the regular income tax brackets were indexed, the exemption in 2007 would be about $81,000 for married taxpayers filing jointly and $61,000 for unmarried individuals. With these indexed exemption amounts, only about 2 million taxpayers would be affected by the AMT in 2007.
Growth of the AMT
If the AMT patch is not extended or the AMT is not otherwise addressed, the number of taxpayers projected to be affected by the AMT will rise sharply, from 4 million in 2006 to 25 million in 2007 (Chart 1). If no further changes are made to the AMT, the number of taxpayers affected by the AMT is expected to grow to over 56 million by 2017. By 2017, almost one-half of all taxpayers with income tax are projected to be affected by the AMT.
The AMT will increasingly affect middle-income taxpayers unless action is taken. If the Administration's proposed extension and expansion of the AMT patch is enacted for 2007, about 7 percent of taxpayers with incomes between $100,000 and $200,000 will be subject to the AMT for 2007. However, if the AMT patch is not extended beyond its current expiration in 2006, when taxpayers file their tax returns in the spring of 2008 for tax year 2007, over 80 percent of taxpayers with income between $100,000 and $200,000 will be subject to the AMT.
To put this into perspective, consider how the AMT would affect a hypothetical joint filer with two children in tax year 2007 if the Congress does not extend the AMT patch as proposed in the Administration's 2008 Budget (see Chart 2). The taxpayer calculates tax liability under both the regular tax and the AMT and pays whichever is larger. The illustration shows that in 2007 the hypothetical taxpayer becomes subject to the AMT when his income exceeds $66,114. The AMT is no longer a tax that applies only or predominantly to high-income taxpayers.
The AMT also increasingly affects families with children because it does not allow deductions for personal exemptions. Moreover, the AMT exemption includes a marriage penalty, which can worsen the effect of the AMT on married couples.
Assuming no AMT patch extension for 2007 or other action with respect to AMT, the increase in the number of AMT taxpayers over the next decade will be accompanied by a dramatic increase in tax revenues from the AMT. AMT revenue will increase from $22 billion in fiscal year 2006 to $67 billion in fiscal year 2007 and to $250 billion in 2017 (roughly 12 percent of total individual income tax revenue). AMT revenue will become so large that by 2013 the cost of repealing the AMT would exceed the cost of repealing the regular tax (Chart 3).
Addressing the AMT Issue
In many respects, the AMT illustrates how a good-faith attempt to address an issue in the income tax system can have enormous unintended and undesirable consequences. Today the AMT is imposing burdens on millions of taxpayers who were not its intended targets. Because the AMT parameters are not indexed, whereas the main parameters of the regular income tax are indexed annually for the effects of inflation, over time the AMT itself has become a significant issue.
The Administration shares the concerns of taxpayers and Congress about the increasing scope of the AMT. A permanent solution is essential for the continued functioning of our individual income tax system.
We look forward to working with this Committee and others in the Congress on a permanent solution to this difficult and important issue. However, until a long-term solution has been enacted, it is essential to prevent an ever-larger share of taxpayers from being affected by the AMT. We are committed to helping ensure that middle-income taxpayers are not affected by the AMT this year or in the future. In the past, generally the AMT has been dealt with on a year-by-year basis, and the Administration's proposal in the President's fiscal year 2008 Budget for a one-year AMT patch reflects that experience.
Thank you again, Mr. Chairman, Ranking Member English, and Members of the Committee for the opportunity to appear before you today. I would be pleased to answer any questions you might have.
REPORTS