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Slay This Tax 'Monster'

Saturday, April 2, 2011

A soak-the-rich measure is badly in need of reform.

“It's a monster,” said then-Ways and Means Chairman Charles Rangel about the Alternative Minimum Tax. Congress created the AMT in 1969 to prevent 155 wealthy taxpayers from using deductions and credits to avoid paying any federal income taxes.

Here’s how it works. Taxpayers subject to the AMT must calculate their tax liability twice: once under regular income tax rules and again under AMT rules. If liability under the AMT proves higher, taxpayers pay the difference as an add-on to the regular tax. The difference paid is their AMT.

When the regular income tax was indexed for inflation in 1981, however, Congress failed to index the AMT. So the AMT’s reach has expanded over time to hit middle-income people it was never intended to tax. As a result, the AMT affects a growing share of the population. And it could get worse.

This chart tracks the number of taxpayers subject to taxation under the AMT since it was first enacted. According to the Congressional Budget Office, last tax season 4.5 million taxpayers were affected by the alternative minimum tax, an increase of more than 4 million taxpayers since 1970.

de Rugy 4.2.11

Until 2000, less than 1 percent of taxpayers paid the AMT in any given year; by 2008, 3 percent of taxpayers were subject to the AMT. And its costs go far beyond taxpayers’ increased tax liabilities.

The AMT disallows certain tax breaks—especially state and local tax deductions and the personal exemption. As a result, the AMT hits some taxpayers harder than others. Married couples with children and taxpayers in high-tax states are disproportionately hit by the tax.

And that's why Democrats such as Rangel are so upset about the AMT. About half of the people paying the tax in recent years live in one of four states—California, Massachusetts, New Jersey, and New York—that account for almost a quarter of the nation's population. This liberal tax hits liberal states really hard.

This liberal tax hits liberal states really hard.

To add insult to injury, taxpayers also have to deal with what’s called the “real bracket creep.” Bracket creep occurs when taxpayers get an increase in wages, salary, or other income that moves them into a new tax bracket and makes them subject to the AMT. For instance, because the AMT is not indexed for inflation, income growth (which, due to inflation, is not necessarily accompanied by an increase in the standard of living) tends to raise the AMT liability more than regular income tax liability. This phenomenon is especially pernicious in places with a high cost of living—like New York City, where some employers offer generous salaries to offset sky-high rents and other city-related costs. Since the inflation index used to set the brackets does not appropriately take these localized costs into account, the more people earn to make up for the high cost of living, the more likely they are to be hit by the AMT.

Lawmakers have addressed the problems created by this “monster” through a series of short-term adjustments to income thresholds, commonly known as “patches.” The most recent of these patches came from Congress in mid-December of last year, leaving accountants and the Internal Revenue Service scrambling to adjust. Without the patch, the number of taxpayers subject to the AMT would have swelled from an estimated 4.5 million taxpayers in 2009 to 27 million taxpayers in 2010. This change would have affected one in six American taxpayers.

Repealing the AMT will require that lawmakers plan for the resulting reduction in tax revenue. Historically, lawmakers have never taken that route, instead choosing to fix the issue each year, so that it looks less expensive on paper. Ideally, the AMT problem would be addressed in the context of fundamental tax reform, such as adopting a flat tax. More likely, lawmakers will just keep patching away each year.

Veronique de Rugy is a senior research fellow at The Mercatus Center at George Mason University.

FURTHER READING: De Rugy explains how we are "Another Day Older and Deeper in Debt," gives “Two Cheers for Rivlin-Ryan,” and says President Obama pulls “A Con Job on Jobs.” Andrew Biggs considers "Impediments to Job Creation," Arthur Brooks outlines "The Unhappy Paradox of Santa-Statism," and Alan Viard writes "Responding to VAT: Concurrent Tax and Social Security Reforms."

Image by Rob Green/Bergman Group.

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