Suppose They Took the AM Out of the AMT?

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The individual alternative minimum tax (AMT) was originally intended to assure that high-income people paid at least some tax. But the AMT was poorly designed and affects more and more middle-income people every year. Unless the tax law changes, about 30 million taxpayers will fall prey to the complicated tax by the end of the decade. Unfortunately, the AMT raises a lot of tax revenue: reforming or eliminating it could cost $500 billion or more over the next decade.

These problems have led some to suggest that the best option would be to make the AMT the regular tax system, rather than an alternative. This option would have several advantages, according to its proponents. The AMT is nearly a flat-rate tax—there are only two statutory rates, 26 and 28 percent. It eliminates various special tax breaks in the regular tax system—that is, it applies to a broader base. And, over the long run, it is a more effective revenue generator than the regular income tax. Indeed, by 2009, it would cost less to eliminate the regular tax than to eliminate the AMT.

There are some problems with this analysis. First, the AMT is not really a flat tax: it has high phantom tax rates—32.5 and 35 percent—caused by the phaseout of the exempt threshold. Second, some of the base broadeners in the AMT have questionable validity as policy. For example, deductions for certain legal expenses are not allowed under the AMT, so some people who win civil damage awards with contingent legal fees can end up worse off after tax than they would have been if they had lost the lawsuit. Parents may not claim deductions for their children against the AMT. And the AMT can impose very large marriage penalties on certain households. Finally, the AMT's power as a revenue generator stems entirely from the fact that its parameters are not indexed for inflation. In consequence, people whose incomes only just keep pace with inflation will face higher and higher average tax rates over time (a phenomenon sometimes referred to as bracket creep).

Nonetheless, the notion that taxpayers should not be subject to two tax systems has merit. This paper examines the implications of basing a reformed tax system on the AMT rules. The next section describes how the AMT works and compares the AMT's rules with those of the regular income tax system. Section II discusses various policy simulations aimed at illustrating how repealing the regular income tax, or splicing the AMT's rules onto the regular income tax structure, would affect households and revenues. Several options are designed to be approximately revenue-neutral, meaning they are admissible candidates for reform under the president's guidelines to the Tax Reform Panel.¹ Section III discusses policy implications.

Notes from this section

1. See Executive Order 13369: President's Advisory Panel on Federal Tax Reform (Bush 2005).

Note: This report is available in its entirety in the Portable Document Format (PDF).

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

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