The Alternative Minimum Tax

"Milken Institute Review" column reprinted with permission.

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Abstract

In a tax code with no shortage of ironies, the alternative minimum tax (AMT) stands out. Created by Congress in 1969, it was aimed at millionaires, but relatively few millionaires pay it. It is billed as a low-rate levy, but most of its victims face higher taxes because of it. It undermines two widely lauded reforms of the income tax—restoring both bracket creep and the marriage penalty. And though nobody favors keeping this Frankenstein alive, it will be very difficult to kill. Welcome to the tax policy twilight zone.

Introduction

In a tax code with no shortage of ironies, the alternative minimum tax (AMT) stands out. Created by Congress in 1969, it was aimed at millionaires, but relatively few millionaires pay it. It is billed as a low-rate levy, but most of its victims face higher taxes because of it. It undermines two widely lauded reforms of the income tax—restoring both bracket creep and the marriage penalty. And though nobody favors keeping this Frankenstein alive, it will be very difficult to kill.

Welcome to tax policy in the Twilight Zone.

At first glance, the AMT may seem simple and fair. But for reasons nobody imagined when it was created, the AMT bull's-eye hangs not on folks with Cayman Islands bank accounts, but on upper-middle-income families with lots of kids who happen to live in high-tax states. And it doesn’t just raise their taxes. It plagues them with mind-numbing complexity.

Tax analysts have proposed a dozen ways to wring the perversities out of the present AMT law. All, however, present political challenges, and some would sharply cut revenue even as federal spending obligations begins to swell with the retirement of the baby boomers. But I get ahead of myself.

Alternative Minimum Tax

HOW IT WORKS

The AMT is conceptually straightforward. First, you compute your regular income tax. Next, you add back some of the deductions that reduce taxable income, deduct a flat $45,000 ($33,750 for singles) and calculate the tax on the balance at rates of 26 or 28 percent. Then you compare the two figures and pay whichever is higher.

But there's a big catch: the bulk of the AMT's taxable income adjustments have nothing to do with anybody's notion of loopholes, which is what the AMT was supposed to plug. The largest is the deduction for state and local income and property taxes, which accounted for 63 percent of all AMT adjustments in 2006 tax returns. Personal exemptions—the $3,300 deduction (in 2006) for each family member and dependent—accounted for another 22 percent of AMT addbacks, while miscellaneous itemized deductions like employee business expenses make up 11 percent of the total.

"Milken Institute Review" column reprinted with permission.

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