The Case For The Tax Cut

Studies | Taxes

No. 226
Sunday, August 01, 1999
by Bruce Bartlett

Alternative Minimum Tax

The alternative minimum tax is like a completely separate tax system, with its own rate structure and rules about deductions, exclusions and credits. Basically, taxpayers take taxable income from their 1040 form and add back a long list of so-called tax preferences, including deductions for state and local taxes, charitable contributions and the standard deduction. There is an exemption of $33,750 for singles and $45,000 for couples. The tax rate is 26 percent up to $175,000 and 28 percent above that. In essence, taxpayers calculate their taxes under the regular system and the AMT, paying whichever yields the higher tax.

The problem is that the personal exemption, standard deduction and individual income tax brackets are indexed to inflation, whereas the AMT exemption is not. Thus over time it becomes more and more likely that a taxpayer with a given income will owe more under the AMT than under the regular income tax. In effect, inflation is pushing the middle class up into the AMT.

It is estimated that unless action is taken, the number of individual tax returns required to pay the AMT will rise from about 800,000 this year to over 9 million by 2009. The government's tax take will rise from $3.6 billion to $19.8 billion.49 The main impact will be on taxpayers with incomes between $50,000 and $100,000. Of all taxpayers owing AMT, 40 percent will be in this income class by 2007, up from 26 percent today. Their share of AMT tax revenue will rise from 7 percent to 17 percent.50

"As the alternative minimum tax is now structured, many taxpayers with modest incomes end up paying it."

Ironically, the 1997 tax cut actually increased the number of taxpayers affected by the AMT. That is because the child credit and the education incentives will cause more taxpayers to have an AMT liability greater than their regular income tax, forcing them to pay the difference. As a consequence, many taxpayers with modest incomes will end up paying a tax that was originally enacted to ensure that the wealthy could not avoid taxes through excessive use of tax preferences.51

The congressional tax bill deals with this problem in a straightforward manner by phasing out the AMT and abolishing it for individuals in 2008.

The bill also reforms the AMT for corporations. The corporate AMT was enacted as part of the Tax Reform Act of 1986. Its purpose was to ensure that profitable corporations could not discharge their entire tax liability through the use of tax deductions. The AMT set up an alternative tax system in which many tax deductions are disallowed. Corporations calculate their tax liability under the regular corporate income tax and under the AMT. Under the former the tax rate is 35 percent, under the latter 20 percent. Companies pay whichever system yields the higher tax. In 1994, the Treasury collected $4.5 billion from the AMT.

According to the U.S. General Accounting Office, only about 28,000 firms - about 1.3 percent of all corporations - paid any AMT in 1992, although 400,000 were required to file AMT returns. However, just 2,000 large corporations paid 85 percent of all AMT collected. Public utilities paid the greatest amount, followed by chemicals, paper, transportation, mining and autos.52

One of the problems with the AMT is that liabilities can vary greatly from year to year. For example, in 1990 the auto industry paid almost $1 billion in AMT, but only $31 million the following year.53 The reason is that depreciation, the write-off firms get for the wearing out of their plant and equipment, is the single biggest business deduction covered by the AMT. In a recession year like 1990, when profits fall, capital-intensive firms like auto companies still have a lot of depreciation. That is what triggers a large AMT payment. Then in future years, when a company may not be covered by the AMT, it gets a credit for the AMT it paid in previous years. In 1994, corporations received a credit of $3.3 billion for AMT they had paid earlier, reducing the net yield of the tax to just $1.1 billion.

What all this means is that the AMT increases corporate taxes during recessions and reduces them during expansions - the opposite of what the tax system ought to do. It also is notoriously complex, makes corporate planning more difficult and discourages capital investment. Thus a study from DRI/McGraw-Hill predicts that repeal of the AMT would increase capital investment by 7.9 percent over the next 10 years. More investment translates into higher productivity, higher wages and more jobs.54

"The problems are now leading even many liberals to question the wisdom of having the AMT."

These problems with the AMT are now leading even many liberals to question the wisdom of this tax. For example, a new book from the Brookings Institution makes a strong case for repeal. In Cracking the Code, University of Maryland economics professor Andrew Lyon says that the AMT fails to achieve any notable equity objective. "There is little reason to believe that the distribution of taxes among corporations corresponds to a meaningful concept of equity among individuals," he writes.55

Economist Martin Sullivan of Tax Analysts is even more critical. He says the AMT "makes an economically unjustified corporate income tax even more cumbersome and inefficient." Moreover, it is all done for the sake of appearance. "There is no policy justification for the AMT," Sullivan writes. "It exists so there will be no bad press about large corporations not paying any tax."56

While the tax bill does not repeal the corporate AMT, as it does the AMT for individuals, it does reduce the burden of this tax significantly.

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