Proposed Surtax Would Be Worse than Existing Alternative Minimum Tax

Published February 1, 2008

Some Democrats are floating a proposal developed by the Tax Policy Center, a joint undertaking of the Urban Institute and Brookings Institution, to repeal the Alternative Minimum Tax (AMT) and replace it with a 4 percentage point surtax on adjusted gross incomes in excess of $100,000 for singles and $200,000 for couples.

The AMT was originally designed to tax wealthy households that paid little income tax due to deductions and credits they claimed. Today’s AMT, however, is hitting more and more middle-income households in spite of temporary fixes, such as raising the threshold of income not subject to the tax.

The last temporary patch expired at the end of 2006. If Congress does not act, it is estimated the number of AMT taxpayers will mushroom to more than 23 million for the 2007 tax year.

Would Increase Taxes

It sounds like a simple solution, but the surtax would act more like the AMT in disguise. It would be pegged to adjusted gross income (AGI)–income before subtracting personal exemptions, the standard deduction, itemized deductions, and tax credits.

The proposed surtax would go further than the AMT and disallow many legitimate deductions and credits. It would hit all tax filers with AGIs above $100,000 for singles and $200,000 for couples, regardless of how much regular income tax they pay. As a result:

  • Affected taxpayers now in the 25 percent income tax bracket would see their marginal tax rate increase to 29 percent, higher than the 28 percent rate prior to the Bush tax cuts.
  • The marginal tax rate for taxpayers in the 28 percent income tax bracket would jump to 32 percent, higher than the pre-Bush 31 percent bracket.
  • Taxpayers currently in the 33 percent bracket would pay a marginal tax of 37 percent, higher than the pre-Bush 36 percent bracket.
  • For taxpayers in the 35 percent bracket, the marginal rate would increase to 39 percent, almost as high as the pre-Bush 39.6 percent.

Would Hit More Households

The surtax would also apply to other forms of income. For instance:

  • The rate on long-term capital gains, which was reduced from 20 percent to 15 percent in 2003, would go back up to 19 percent for taxpayers subject to the surtax.
  • Only the marginal rate on qualified dividends, which would rise from 15 percent to 19 percent, would remain appreciably below what it was prior to the Bush tax cuts, when dividends were taxed at the ordinary rate.

Since the surtax would be based on adjusted gross income instead of taxable income, it would affect households surprisingly low on the income ladder.

For a single filer with itemized deductions equal to 20 percent of AGI, the 4 percentage point surtax would begin at a taxable income of $76,600, which is in the regular income tax’s 25 percent bracket. For a couple with two children who claim itemized deductions equal to 20 percent of AGI, it would begin at a taxable income of about $147,000, which is in the regular tax’s 28 percent bracket.

Harmful to Economy

Many of these taxpayers have considerable discretion in how much they work, spend, and save. A surtax would reduce work effort, reduce saving and investment, and increase tax avoidance and evasion. The economic damage would be especially serious because the millions of people the surtax would target are among the most productive and economically dynamic people in society.

For example, as high-productivity, upper-income people cut the time and intensity of their work effort in response to a higher tax rate on their labor, they employ fewer people, reducing job creation. In addition, as they save and invest less due to a higher tax rate on their capital income (at the corporate or shareholder level, or on income from non-corporate businesses), the rate of capital formation will drop, reducing plant and equipment purchases and construction of buildings and other structures.

In essence, part of the tax burden would be shifted to the rest of the population, and middle- and lower-income workers would thus indirectly bear a significant part of the burden of the surtaxes on higher-income individuals. They also would suffer if they own stock shares directly or through pension funds, as the higher tax burden on capital would reduce the value of stocks.

Middle- and lower-income households would additionally bear some of the tax as consumers, because output would be reduced, and consumers of all income levels would have to make do with fewer, higher-priced goods and services.

Would Cut Revenue

Ironically, the surtax or any other revenue-raiser Washington uses to fix the AMT would collect much less revenue than estimates predict. Official revenue scoring models assume tax increases have no ill effects on employment, investment, productivity, output, and growth.

It doesn’t work that way. The 1986 increase in the capital gains tax collected much less revenue than the government’s static revenue estimates had predicted. The stock market crashed in 1987, and capital gains realizations were depressed for years.

By contrast, U.S. Treasury studies in the mid-1980s found the 1980 cut in the capital gains tax rate to 20 percent actually increased revenues just by spurring realizations. Those studies did not consider additional revenue gains resulting from a higher stock market, additional investment, and higher productivity and wages. But such gains do occur in the real world.

Following the enactment of the 15 percent cap on tax rates for long-term capital gains and qualified dividends, many firms either increased their dividend payouts or began paying dividends for the first time. Consequently, there has been a surge in taxes from non-withheld sources, including capital gains and dividends.

Enacting a 4 percentage point surtax would at least partially undo these positive changes, would raise little revenue, or would do sufficient economic damage to result in a revenue loss.

Surtax No Solution

The best that can be said for the proposed surtax or some other large tax increase is that it does not look quite so bad if it is assumed to be the only alternative to the out-of-control AMT. Leonard Burman and Gregory Leiserson of the Tax Policy Center correctly note the surtax would be simpler than the complex AMT.

Burman and Leiserson write, “The proposed add-on tax would be extremely simple: subtract the threshold ($100,000 or $200,000) from AGI and multiply the difference (if any) by 4 percent. Add that to income tax.” The surtax attains its simplicity, however, by being even guiltier than the AMT of using an overly broad tax base that disallows many adjustments found in the normal income tax.

The history of the AMT offers the caution that a tax initially billed as applying only to the rich can quickly extend its reach far down into middle-income households. Policymakers are talking about repealing the AMT permanently, but enacting a large surtax in its place would ultimately be another massive tax hike.

Michael Schuyler ([email protected]) is a senior economist for the Institute for Research on the Economics of Taxation. A version of this article originally appeared as Brief Analysis No. 559 of the National Center for Policy Analysis, October 29, 2007. Reprinted with permission.