Federal Income Tax Hike Looms for Millions of Middle-Income Americans

Published June 1, 2005

The Alternative Minimum Tax, signed into law in 1978, is about to hit tens of millions of middle-income households with a tax originally meant to touch only a handful of wealthy Americans. A temporary exemption from the AMT enacted by Congress for the years 2004 and 2005 is about to expire, which will throw several million taxpayers into the AMT system.

The AMT tax rate is 26 percent on the first $175,000 for couples, and 28 percent on anything over that.

The tax wipes out personal and dependent exemptions, state and local tax exemptions, home equity loan interest deductions, some medical and dental deductions, and other common deductions. This makes it resemble a flat tax, “but with rates that are much too high,” said Leonard Burman, co-director of the Urban-Brookings Tax Policy Center in Washington, DC and U.S. Treasury deputy assistant secretary for tax analysis during the Clinton administration.

“Every year your alternative minimum tax increases relative to your regular tax,” Burman said.

Increasing Numbers Affected

About 3.8 million taxpayers will be hit by the AMT this year, 18 million next year, and more than 30 million by 2010, according to Internal Revenue Service estimates.

“By 2010, 94 percent of households with two or more kids and incomes between $75,000 and $100,000 will be on the AMT. There are horrible marriage penalties built into the AMT,” Burman said.

“It’s a tax on families, on people who live in high-tax states, on middle-income people,” said Burman, who worked on proposals to reform the AMT during the Clinton administration. He said the proposals went nowhere because of political stalemates between Democrats and Republicans in Congress.

“Blue” States Hit Hardest

The 10 states with the most taxpayers nailed by the AMT voted for John Kerry for president in 2004: California, Connecticut, Massachusetts, New York, and other states with high property taxes, high state and local income taxes, high property values, and generally high costs of living.

Ten

“[Tax Foundation President] Scott Hodge has been quoted as saying that since most of the AMT returns are being filed in so-called blue states, maybe the rush to fix the AMT isn’t as urgent from a Republican perspective as some people think it should be,” said William Ahern, the Tax Foundation’s director of communications.

“The fact is that what triggers the AMT is a high deduction for state and local taxes,” Ahern said, “so high-tax states naturally are pushing more of their residents into the AMT.”

Looming Over “Red” States

Burman warns that so-called red states are about to get hit.

“They call it a blue state tax. By next year it’s going to be an every state tax,” Burman said.

Here’s why, according to Burman:

  • The Bush tax cuts. Those cuts lowered income tax rates. Because taxpayers must pay the higher of the regular tax bill or the AMT bill, when tax rates are lowered more people are thrown into the AMT.
  • Failure to index for inflation. Regular tax brackets and personal exemptions are indexed for inflation each year to prevent automatically shifting people into higher tax brackets because of cost-of-living adjustments in wages. Because the AMT exemption amounts have not been indexed for inflation, people are being pushed into the AMT even though their wages may be unchanged in real terms.
  • Expiration of temporary AMT breaks Congress enacted for 2004 and 2005. Millions more taxpayers would already be paying the AMT if not for those temporary breaks.

Tax Called Outmoded, Ineffective

“The genesis of the alternative minimum tax shows how the country has changed over the last 30 years,” said Burman. “The Treasury Secretary in 1969 testified there were 155 people with incomes over $200,000 who paid no federal income tax. There were more letters to Congress about that in 1969 than about the Vietnam War.”

Congress responded with a variety of measures to get high-income households to pay federal income tax, but each year some managed to avoid taxes. So in 1978 Congress created the AMT, a confusing “parallel” income tax system that effectively wipes out most exemptions and deductions in the regular tax system. Even with the AMT, some high-income earners still manage to avoid paying federal income tax.


Steve Stanek ([email protected]) is managing editor of Budget and Tax News.