Muddy Waters: The AMT and the U.S. Tax Code

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MARCH 2007 - Few aspects of our nation’s muddled tax code exemplify the snowball effect of complexity better than the alternative minimum tax (AMT). The AMT—which is owed when tax computed using AMT rules exceeds the regular tax—was introduced by the Tax Reform Act of 1969 to ensure that high-income individuals could not use deductions and exemptions to completely eliminate their tax liability. Today, however, the AMT ensnares not just high-income taxpayers paying little or no tax, but many more people than its creators probably ever intended. Indeed, one of the most critical issues facing our nation today is the increasing burden being placed on the middle class by the AMT.

Consider that only 20,000 people paid the AMT in 1970, according to the IRS. That number has grown dramatically to about three million taxpayers in 2005, and if the tax code doesn’t change, as many as 33 million taxpayers may pay additional taxes under the AMT by 2010. Imagine 33 million people having to calculate their tax twice to meet their civic responsibility. Once should be enough!

Why are so many taxpayers now affected by the AMT? The two main reasons are rate creep and inflation. The AMT was created when the maximum regular tax was at 50%, two and one-half times the 20% AMT rate. Countless rate changes later, the current maximum regular rate of 35% is only a quarter higher than the 28% AMT rate, which itself is an indirect legacy of the Tax Reform Act of 1986. Furthermore, since the mid-1980s the regular income tax components have generally been indexed, or automatically adjusted, for inflation—but not the AMT. Over 20 years, these changes, largely enacted for different tax- policy reasons, have made a huge impact on how the regular tax and the AMT affect a given taxpayer. The difference between the regular tax and the AMT is further exaggerated because tax reductions, such as the child tax credit, often reduce the regular tax but do not impact the AMT. For all these reasons, each year more and more taxpayers find that their AMT computation exceeds their regular tax.

So why doesn’t Congress just eliminate the AMT? According to a Congressional Budget Office report, simply scrapping the AMT would prove extremely costly. The AMT currently rakes in about $18 billion annually; eliminating it would shrink projected government revenues by at least $600 billion over the next 10 years. Making changes on a temporary or piecemeal basis has delayed the larger political battle over how to deal with such a large projected revenue shortfall.

Achieving a Workable Solution

In May 2005, the NYSSCPA proposed the Simple Exact Transparent (SET) Tax, a greatly simplified income tax system, devoid of unnecessary complexity, including the AMT. Under the SET Tax, Congress would select a politically acceptable, economically appropriate single tax rate for both individuals and businesses, and then use only straightforward exclusions of its choosing to accomplish additional public-policy goals, such as eliminating the income tax for the poor and reducing the effective rate of tax on the middle class. An individual’s tax would be calculated using this simple, easy-to-understand formula:

(Income – Subtractions/Congressionally defined exclusions) x Rate = Tax

Because the SET Tax uses a single tax rate, it can, on the surface, be confused with so-called “flat tax” proposals. But unlike the various flat tax proposals, the SET Tax adheres to the current tax code’s tradition of tax progressivity: higher tax rates for higher incomes. Essentially, the SET Tax would continue to give Congress the flexibility to use the tax code to accomplish policy goals, but it would do so more transparently, through an easier to understand and administer code.

Under the SET Tax, income would be measured using existing, familiar principles and rules: generally the cash basis for individuals and small businesses, and the accrual method for larger businesses. Current law definitions would be very helpful in this area, and would be retained. Exclusions in the SET Tax system could include all of today’s deductions, exemptions, exclusions, credits (reengineered into exclusions), and other mechanisms that reduce an individual’s or a corporation’s gross income to determine the taxable income. Exclusions could be used not only to achieve progressivity but also to encourage economic behavior such as saving for retirement, encouraging domestic manufacturing, exploring for oil, or developing alternate energy sources. They could also accomplish social-policy goals such as encouraging homeownership and charitable giving.

In terms of progressivity, a lump-sum exclusion could eliminate or greatly reduce the income tax for people who can least afford it in a way that would be easy to find and easy to understand. More-complex exclusions for the highest-income individuals would require a little more work to calculate and understand. That’s called progressive complexity, and it addresses the needs of our complex economy and policy goals. The burden of progressive complexity falls on those who should be capable of dealing with it. The work to claim tax exclusions that would reduce someone’s tax (and their related required disclosure of complex behavior) makes the SET Tax easier to administer, and easier for the government to detect tax-evaders. In addition, a tax code based on the SET Tax system could be designed to generate a tax liability equivalent to each taxpayer’s current obligation, but the amount would be easier to understand and calculate.

A Nation Ready for Change

The midterm elections last November revealed an American public that is eager and ready for change. Tax policy would be a great place to start, and the SET Tax proposal gives the nation a viable solution that is equitable and transparent. It also obviates the need for an AMT (both corporate and individual) and provides an elegant, revenue-neutral solution to replace the lost revenues. The full version of the SET Tax proposal can be found on the NYSSCPA website at www.nysscpa.org/pdfs/set.pdf.


Louis Grumet
Publisher, The CPA Journal
Executive Director, NYSSCPA
lgrumet@nysscpa.org

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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