AMT: Keep it or kill it, you'll pay for it

Everyone with a pulse in D.C. says they want to fix the alternative minimum tax. But there will be a price to pay whether the fix is temporary or permanent.

By Jeanne Sahadi, CNNMoney.com senior writer

NEW YORK (CNNMoney.com) -- If lawmakers repeal or fix the alternative minimum tax (AMT), taxpayers are likely to foot the bill, even if tax rates aren't raised explicitly.

Taxpayers with high incomes and taxpayers who live in high-tax states may be among those who bear the biggest burden, depending on which "fixes" are chosen. And if none are chosen, middle-income taxpayers will take a hit.

Take away AMT or just reduce its impact, and suddenly the U.S. deficit looks a whole lot worse. That's because federal budget projections are based on current law, under which the AMT is scheduled to bring in an estimated $1 trillion during the next 10 years.

"That's even real money in Washington," said Clint Stretch, managing principal of tax policy at Deloitte Tax LLP.

The AMT is easy to hate. First imposed in 1969 on the wealthy few to ensure they pay tax, it now threatens to catch tens of millions of taxpayers who are not wealthy. That's because the AMT disallows key breaks such as the state and local income tax deduction and child tax credits, and its exemption levels were never indexed for inflation.

If nothing is done, 23 million taxpayers will be hit with AMT in 2007, and 39 million by 2017, according to the Tax Policy Center. That assumes President Bush's tax cuts expire as scheduled in 2010. If they're made permanent, 53 million taxpayers will be hit up by 2017.

But the AMT is a lot harder to fix than it is to hate. Lawmakers on both sides of the aisle know there's no pretty way to resolve the issue. "It's clear that a political set of judgments has to be made," Stretch said.

Options for change

If repeal is seen as insurmountable, reform may be a runner-up. "There are a lot of knobs and dials to change in the AMT just short of repeal," Stretch said.

For instance, lawmakers could permanently index the adjusted gross income exemption levels to inflation or they could allow for personal exemptions currently disallowed, like the state and local tax deduction. Or they could do both.

The estimated decline in revenue from doing both over 10 years: Between $520 billion (if tax cuts are allowed to expire) and $940 billion (if tax cuts are extended), according to the Tax Policy Center.

The current thinking, however, is that lawmakers won't do much more than continue to "patch" the AMT for tax year 2007. That is, they would temporarily extend the higher income exemption levels put into place a year earlier, and allow for some personal credits to be used.

Even the patch, however, isn't exactly deficit-friendly at an estimated cost of nearly $50 billion a year.

Options to deal with the revenue decline

There are those who don't wish to raise taxes to compensate for the loss of AMT revenue. In co-sponsoring a bill for repeal, Senator Charles Grassley (R-Iowa) said in a statement, "It's unfair to raise taxes to repeal something with serious unintended consequences like the AMT."

But others, like House Speaker Nancy Pelosi (D-Calif.), have said they'd consider repealing President Bush's tax cuts on the highest income taxpayers.

Whatever lawmakers' publicly stated positions, it's just as likely that a combination of spending and tax measures may be considered:

Here are just a few of the tax options that may be discussed:

Narrow the tax gap: Roughly $350 billion a year in taxes is owed but not paid, due largely to an underreporting of income. There are efforts under way to ensure better compliance. But those efforts are not likely to close the gap entirely, said Eric Toder, senior fellow at the Urban Institute.

Let tax cuts expire for all or just some: Lawmakers may choose not to extend the tax cuts scheduled to expire in 2010, allowing income tax rates to return to their higher, pre-2001 levels and reimposing a 20 percent rate on long-term capital gains while taxing dividends at your top income tax rate. Currently both are taxed at 15 percent.

More likely, however, they may roll the tax cuts back for only high-income taxpayers. Pelosi has said she'd consider the latter for taxpayers with incomes over $500,000. That might mean letting the top income tax rate revert to 39.6 percent, up from 35 percent.

Another option is to continue taxing capital gains and dividends at 15 percent under the regular code, but taxing them at the higher rates under AMT. That would change the make up of who is subject to AMT, Toder said. Currently, a high-income taxpayer who gets most of his income from capital gains and dividends might not be subject to AMT because investment income is taxed the same under both codes.

Change tax preferences, thereby increasing many's tax liability: If AMT is repealed, one option might be to repeal the state and local income tax deduction under the regular tax code as well. That alone could more than make up for the decline in AMT revenue, assuming the tax cuts are allowed to expire, said Len Burman, director of the Tax Policy Center.

The cost would be borne most heavily by those who live in high-tax states -- they also are the ones hardest hit by the AMT.

Reform the tax code: Some believe that to successfully deal with the AMT, the entire tax code needs to be overhauled and simplified. The President's Tax Reform Panel in 2005 proposed a tax code that would eliminate AMT and and reduce or eliminate various tax preferences. Among the revenue raisers they recommended:

  • Convert the mortgage interest deduction to a 15 percent credit and lower the amount of interest on which that credit may be taken;
  • Cap the amount of tax-free contributions an employer may make to help pay for a worker's health insurance premiums; and
  • Repeal the federal deduction for state and local income taxes.

The chances for serious overhaul of the tax code, however, are not high before the 2008 presidential elections.

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Correction: An earlier version of this story incorrectly identified Nancy Pelosi as House Majority Leader. Steny Hoyer (D-Md.) holds that title. Top of page

 
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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.