The Heritage Foundation

WebMemo #1888 on Taxes

April 14, 2008

April 14, 2008 | WebMemo on Taxes

Coming Together on Tax Simplification: AMT and Extending the TaxCuts

Several proponents of small government oppose repeal of the individual alternative minimum tax (AMT) despite that tax's confusing strictures, bureaucratic nature, and excessive demands on the American taxpayer. This is due to an unfortunate misunderstanding of repeal's effects.

It is suggested that repeal of the AMT would actually raise marginal tax rates for most individuals and therefore not create positive growth effects. A closer look at AMT repeal's actual effects on tax rates, particularly in combination with extension of the 2001 and 2003 Bush tax cuts, reveals that this objection is misguided. When the Bush tax cuts are extended in conjunction with AMT repeal, marginal rates do not increase for any income class compared to current law, and the overall average marginal rate falls. In addition, average effective tax rates fall significantly more than with the Bush tax cuts alone. Legislators should consider the total effect of a combination policy if they want to pursue a pro-growth agenda.

A Pro-Growth Agenda

Repeal of the AMT together with extension of the Bush tax cuts would reduce average effective tax rates and marginal tax rates for all income groups compared to current law.Senator John Ensign (R-NV) proposed exactly this policy as the AMT Repeal and Tax Freedom Act (S. 2318) in November 2007.

However, concern over the AMT's impact on marginal tax rates has made coming together to support such a tax policy plan difficult. For this reason, it is critical that those who favor economic growth consider carefully the true economic impact of both policies, both together and separately. It quickly becomes clear that cutting taxes is pro-growth tax policy.

Average Effective Tax Rates

Marginal tax rates are only half of the story. Average effective tax rates are also important. While marginal rates often drive labor and investment behavior, total effective tax rates tell us the amount of spending power in the hands of the private citizen and the amount left in the hands of wasteful government. As the world learned from the experiment with socialism, private control of wealth is necessary for efficient use. Lower effective tax rates spur economic growth. AMT repeal reduces effective tax rates for all persons affected by the AMT and raises them for no one.

It is also critical in this regard to remember that if the Bush tax cuts are extended but the AMT is not repealed, the AMT eliminates much of the potential reduction in rates from the Bush tax cuts. Hence, though it may at first appear that the total rate reduction is not very large from repeal of the AMT, in fact the combination policy reduces rates by much more than the tax cuts alone: It actually doubles the percentage-point drop in average effective rates. (See Table 1.)

Marginal Tax Rates

The effect on marginal rates is not as simple as opponents of the tax policy claim. AMT repeal alone-if the Bush tax cuts are not extended-has different effects on marginal rates for different income classes, some positive and some negative. Those not reporting positive adjusted gross income (AGI) will see a fall in marginal tax rate. This is because the AMT was put in place to try to ensure that "the rich" always pay something.

Marginal tax rates are indeed higher with a repeal of the AMT alone, compared to current law, for three higher income classes: those between $100,000 and $1 million in AGI. (See Table 2.) However, the combination policy produces a different result. The $100,000-$500,000 AGI groups see a greater reduction in marginal tax rates compared to the Bush tax cuts alone. While the reduction in marginal rates from extension of the tax cuts alone is tempered by AMT repeal for those above $500,000, it is magnified for three lower income classes, and no income class sees a rise of marginal rates compared to current law.

Compared to current law, the overall average impact of AMT repeal alone on marginal tax rates is neutral: The overall average marginal tax rate is the same. The combination policy, however, produces a significant drop of 4 percentage points. The repeal of AMT is responsible for one-quarter of that drop. (See Table 2.)

The AMT Patch

What about an indefinite extension of the AMT patch? One problem with this approach is that the same political battle must be fought every year. Another problem is that the taxpayer will not know that the patch will be extended with certainty, so reduction in marginal rates may not actually affect incentives as expected.

Still, it is useful to compare the marginal and average effective rates of extension of the tax cuts with the extension of the patch to extension of the tax cuts with complete repeal of the AMT. As seen in Table 3, the overall average marginal rate is unaffected, though different groups benefit, and average effective tax rates are lower with the repeal. It is significant to note that the income groups that are hurt by an increase in marginal rates with a complete repeal are actually also helped by a decrease in the average effective tax rate.

Conclusion

The purpose of the AMT was to ensure that people who take deductions pay a minimum tax; a repeal clearly will lower their effective tax rate. Furthermore, AMT repeal will not increase marginal tax rates so long as the repeal is in conjunction with an extension of the Bush tax cuts. Such a combination policy would reduce average effective tax rates significantly for all groups, fostering economic growth by leaving spending power in private hands. The effective rate reduction would be much greater than an extension of the tax cuts alone, and the overall average marginal rate would be lower as well.

Those who favor a simpler and fairer system recognize the need to repeal the convoluted individual AMT. Pro-growth legislators are in favor of lower taxes. Conservatives of both stripes should come together to back any bill that, without raising other taxes, proposes repeal of the AMT and extension of the tax cuts. Such a combination policy would reduce tax rates for all citizens and ensure economic growth.

Guinevere Nell is Research Programmer in the Center for Data Analysis at The Heritage Foundation


[1] "Current law" means that the Bush tax cuts expire and the AMT continues, not indexed by inflation (without a patch). Comparison with the patched AMT is discussed below.

About the Author

Guinevere Nell Research Programmer
Center for Data Analysis