Modifying the Alternative Minimum Tax (AMT): Revenue Costs and Potential Revenue Offsets
Modifying the Alternative Minimum Tax (AMT):
Revenue Costs and Potential Revenue Offsets
March 18, 2008
Jane G. Gravelle
Senior Specialist in Economic Policy
Government and Finance Division
Modifying the Alternative Minimum Tax (AMT):
Revenue Costs and Potential Revenue Offsets
Congress enacted the precursor to the current individual alternative minimum
tax (AMT) in the Tax Reform Act of 1969 to ensure that all taxpayers, especially
high-income taxpayers, paid a minimum of federal taxes. Initially, the minimum tax
applied to fewer than 20,000 taxpayers; in 2007 it applied to 4.2 million. Moreover,
absent legislative action, the AMT will affect significantly more middle- to upper-
middle-income taxpayers: by 2008, up to 26 million taxpayers are projected to be
subject to the AMT.
The AMT’s expanded coverage will occur because temporary increases in the
basic AMT exemptions and provisions allowing taxpayers to apply certain tax credits
against the AMT have expired. To keep the AMT from affecting more taxpayers in
the future would, at a minimum, require (1) that the higher AMT exemption levels
be maintained and that they be indexed for inflation, and (2) that all personal tax
credits be allowed against the AMT. This “patch” is estimated to cost about $75
billion in its first full year.
If the recent reductions in the regular income tax expire at the end of 2010, then
the patch would cost $313 billion over the FY2009 through FY2013 period and $724
billion over FY2009 through FY2018. If the reductions in the regular income tax are
extended past 2010, then the cost of the AMT patch would have increased to $1.3
trillion dollars over the same 10-year period. Repealing the AMT would be even
While offsetting the costs of AMT relief may prove difficult, several approaches
are being discussed. One approach would shift AMT taxes from middle-income to
high-income taxpayers by some combination of higher AMT rates and taxing capital
gains and dividends at the AMT rates. Proponents argue that including capital gains
preferences in the AMT would be consistent with the original purpose of the
In other proposals, AMT relief would be financed by raising regular income tax
rates; for example, raising the top three rates by 24%. Another approach might be
to repeal or restrict some of the preference items under the regular income tax.
However, income tax base broadening may be difficult because many of these
provisions are both longstanding and popular.
Another approach to financing AMT relief might be to focus on reducing the tax
gap. Although the tax gap is estimated to be in the neighborhood of $300 billion, the
revenue yield from proposals to reduce the gap appears to fall far short of the amount
needed to address the AMT.
This report will be updated to reflect legislative developments.
Structure of the AMT...............................................2
Revenue Effects of Modifying the AMT................................3
Potential Cost Offsets for AMT Modification............................7
Offsetting AMT Revisions with Changes to the Structure of the AMT....7
Offsetting AMT Revisions with Individual Income Tax Rate Increases....9
Offsetting AMT Revisions with Income Tax Base Broadening..........9
Offsetting AMT Revisions by Reducingthe Tax Gap and Greater
Increased Withholding or Third Party Reporting.................13
Economic Substance Doctrine...............................15
International Tax Shelters..................................16
Summing Up: Tax Gap Issues...............................17
Appendix. Capital Gains Realization Response.........................18
List of Tables
Table 1. Revenue Costs of Modifying the AMT
Table 2. Percentage of Taxfilers with AMT Liability by Cash Income in
2006 Dollars, Selected Calendar Years 2006-2017....................5
Table 3. Interest, Dividends, and Capital Gains by Adjusted Gross Income
Class, as a Percentage of Total Income, 2003........................6
Table 4. Largest Tax Expenditures for Individuals, FY2006................11
Modifying the Alternative Minimum Tax
(AMT): Revenue Costs and Potential
Congress enacted the precursor to the current alternative minimum tax (AMT)
for individuals in the Tax Reform Act of 1969 to ensure that all taxpayers, especially
high-income taxpayers, paid at least a minimum amount of federal taxes.1 Initially,
the minimum tax applied to fewer than 20,000 taxpayers. However, absent
legislative action, the AMT will affect significantly more middle- to upper-middle-
income taxpayers in the near future. In 2007, about 4.2 million taxpayers were
subject to the AMT, but by 2008, up to 26 million taxpayers would be subject to the
AMT without legislative action commonly referred to as the AMT “patch.” (In
December, 2007 the latest one year extension of the patch was adopted without
Two main factors have caused the increase in the number of taxpayers affected
by the AMT. First, the regular income tax is indexed for inflation, but the AMT is
not. Over time, this failure to index has reduced the differences between regular
income tax liabilities and AMT liabilities at any given nominal income level,
differences that will continue to shrink in the absence of AMT indexation. Second,
the 2001 and 2003 reductions in the regular income tax have further narrowed the2
differences between regular and AMT tax liabilities. Because of these two factors,
many taxpayers will find that their regular income tax liability has been so reduced
relative to their AMT liability that, even though they have few (if any) tax
preferences, they may still be subject to the AMT.
An increase in the basic exemption for the AMT and provisions allowing certain
personal tax credits to offset AMT liability have temporarily mitigated the increase
in the coverage of the AMT. For 2007, the AMT exemption was $66,250 for joint
returns and $44,250 for unmarried taxpayers. Under current law the basic AMT
exemption is scheduled to revert to $45,000 for joint returns and $35,750 for
unmarried taxpayers in 2008. In addition, starting in 2008, several personal tax
credits will not be allowed against the AMT.3
1 The original minimum tax was an add-on minimum tax. It was paid in addition to the
regular income tax. For a more detailed discussion of the history of the minimum tax and
information on how it is calculated, see CRS Report RL30149, The Alternative Minimum
Tax for Individuals, by Steven Maguire.
2 The Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16) and the
Jobs and Growth Tax Relief Reconciliation Act of 2003 (P.L. 108-27).
3 Starting in 2008, the dependent care credit, the credit for the elderly and disabled, the
This report first reviews the cost of modifying the AMT to reduce its coverage.
It then discusses a range of potential revenue offsets for these modifications,
including alterations to the AMT and to the regular income tax. These measures
include higher rates under both the AMT and the regular income tax, a reduction of
preferentially treated items under the regular income tax, and measures to reduce the
tax gap. Many of the revenue offsets examined are designed so that the burden of
paying for AMT modifications is borne by those taxpayers for whom the AMT was
originally intended (i.e., taxpayers at the highest income levels).
Structure of the AMT
The AMT operates as a parallel tax system to the regular income tax. Under
current law, calculating AMT tax liability requires taxpayers to first add back various
tax items (called adjustments and preferences) to their regular taxable income. The
three major preference items added back to the AMT tax base are personal
exemptions, state and local tax deductions, and miscellaneous itemized deductions.
These three items account for over 90% of the total AMT preference items and
adjustments added back to regular taxable income for AMT purposes. Other items
subject to tax under the AMT include net operating losses, passive activity losses,
incentive stock options, and private activity bond interest.
This grossed-up income becomes the tax base for the AMT. For tax year 2007,
a basic exemption of $66,250 for joint returns, or $44,350 for single and head of
household returns, is subtracted to obtain AMT taxable income. These exemption
levels are temporary and are scheduled to revert, in 2008, to their prior law levels of
$45,000 for joint returns and $35,750 for unmarried taxpayers. The basic AMT
exemption is phased out for taxpayers with high levels of AMT income. A two-
tiered rate structure of 26% and 28% is assessed against AMT taxable income. The
tax is 26% of AMT taxable income up to $175,000 and 28% of AMT taxable income
in excess of $175,000. The taxpayer compares his AMT tax liability to his regular
tax liability and pays the greater of the two.
It is important to note that even though a taxpayer may not be subject to the
AMT, it can still affect his regular income tax liability. The reason is that, after
amount by which regular income tax liability exceeds AMT liability. Thus, a
taxpayer who has a regular income tax liability of $5,000 and $1,000 of these
affected personal tax credits will effectively see these regular income tax credits
reduced in value by $300 if his AMT liability is $4,300.
credit for interest on certain home mortgages, the HOPE Scholarship and Lifetime Learning
credits, the credit for certain nonbusiness energy property, the credit for residential energy
efficient property, and the D.C. first-time home buyer credit will not be allowed against the
AMT. The child tax credit, the adoption tax credit, and the savers credit will continue to be
allowed against the AMT in full.
4 See previous footnote.
Revenue Effects of Modifying the AMT
The fact that the AMT is poised to affect so many taxpayers in the near future
has prompted calls for change. Absent legislative action, the AMT will “take back”
much of the recently enacted reductions in the regular income tax for millions of
taxpayers. Because personal exemptions are not allowed against the AMT, large
families will be particularly susceptible to the AMT. In addition, because deductions
for state/local taxes are not allowed against the AMT, taxpayers who itemize and
deduct these taxes on their regular income tax returns are also more likely to be
adversely affected by the AMT. However, modifications to reduce AMT coverage
would prove costly in terms of forgone revenue.
When discussing the long-run (beyond 2010) revenue implications of modifying
the AMT, it is critical to specify whether it is assumed that the 2001/2003 tax cuts
are allowed to expire after 2010 as scheduled, or whether it is assumed that the tax
cuts will be extended beyond 2010. Allowing the 2001 tax cuts to expire as
scheduled will reduce the costs of modifying the AMT. Extending the tax cuts
beyond 2010 substantially increases the costs of modifying the AMT. If the
2001/2003 tax cuts are extended then, as a rough estimate, the cost of most options
for modifying the AMT would almost double. The revenue effects of several
modifications to the AMT are shown in Table 1.
To keep the AMT from affecting more taxpayers in the out years than it did in
2007 would, at the least, require maintaining higher exemption levels and indexing
the AMT for inflation. According to the Congressional Budget Office (CBO), this
option (which is often referred to as a “patch” and assumes allowing personal tax
credits against the AMT, and indexing the basic exemption levels of
$66,250/$44,350 along with the AMT tax brackets for inflation after 2007) would
reduce revenues by $75 billion in its first full year.
If the recent reductions in the regular income tax expire as scheduled at the end
of 2010, then the patch will cost $313 billion over the period FY2009 through
FY2013 (five-year cost) and $724 billion over the FY2009 through FY2018 period
(10-year cost). However, if the reductions in the regular income tax are extended
past 2010, then the cost of the AMT patch as outlined by CBO rises to $1.3 trillion
dollars over the same 10-year period. If these changes are debt financed (not paid for
by either raising other taxes or reducing expenditures), then the cost of the patch rises
significantly because of the higher net interest outlays.
Repealing the AMT is even more expensive (although the data here are not for
exactly the same years). The five-year cost of repeal could be around $408 billion.
The 10-year cost of repeal could range from around $851 billion to $1.7 trillion,
depending on whether the reductions in the regular income tax are extended past their
2010 expiration. Again, if the repeal was debt financed, the cost of debt servicing
would engender considerably more cost.
The additional policy options outlined in Table 1 would be less expensive than
the patch or outright repeal of the AMT, but these options would mean more
taxpayers would fall under the AMT in the future than in 2007. These estimates
predated the enactment of the patch for 2007, but the magnitudes are roughly
appropriate to capture the relative size of the cost.
Table 1. Revenue Costs of Modifying the AMT
(billions of dollars)
First F Y 09-18 F Y 09-18
Policy OptionfullyearFY08-12(2001 taxcuts(2001 taxcuts
cost expire) ext e nded)
Basic AMT exemption levels of
$62,550/$42,500, index exemption
and bracket amounts for inflation$75$313$724$1,322
after 2006, allow personal taxa
credits against the AMT
Additional debt service$2$39$189$294
First Cal e nder Cal e ndarY e ars Cal e nde rYears
cost (tax cutsexpire)(tax cutsextended)
Repeal the AMTc$86$408$851$1,659
First F Y 08-17 F Y 08-17
Additional Policy Options (PriorfullFY08-12(2001 tax(2001 tax
to 2007 Patch)yearcutscuts
cost expire) ext e nded)
Allow AMT taxpayers to take
personal exemptions, the standard
deduction, misc. itemized$73$390$757N/A
deductions and deductions forc
Allow personal exemptions underc$43$236$494N/A
Allow state/local tax deductionsc$55$281$556N/A
a. Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2009 to 2018, Jan. 2008.
b. Urban-Brookings Tax Policy Center, Aggregate AMT Projections and Recent History: 1970-2017, Jan. 2006.
c. Joint Committee on Taxation, Present Law and Background Relating to the Individual Alternative Minimum
Tax, March 5, 2007.
Although the AMT originally targeted the wealthy, the highest income taxpayers
are currently not as affected by the AMT as the income classes below them, and this
dichotomy will grow over time. As shown in Table 2, only 31% of taxpayers in the
highest income class were subject to the AMT in 2006 or 2007.
Table 2. Percentage of Taxfilers with AMT Liability by Cash
Income in 2006 Dollars, Selected Calendar Years 2006-2017
Cash 2017(With Tax
Income 2006 2007 2010 2017 Cut s
Less than $300.0%0.0%0.0%0.1%0.1%
$30-$50 0.0% 0.0% 3.0% 12.2% 13.0%
$50-$75 0.2% 0.2% 17.1% 30.1% 38.8%
$75 - $1000.7%0.5%49.9%53.7%67.2%
$100 - $2004.8%4.1%80.4%61.7%92.3%
$200 - $50050.9%50.2%94.3%77.7%96.8%
$500 - $1,00049.5%50.5%72.2%27.0%73.8%
Source: Urban-Brookings Tax Policy Center, AMT Participation Rate by Individual Characteristics,
Jan. 29, 2008.
Even if the basic AMT exemption reverts to its lower prior-law levels and
certain credits are no longer allowed against the AMT, coverage in the highest
income class will only be 39% 2010.
On the other hand, there will be a significant expansion of AMT coverage for
taxpayers with cash income in the $50,000 to $1,000,000 range if the basic AMT
exemption reverts to its lower prior-law levels and certain credits are not allowed
against the AMT. For example, in 2006 4.8% of taxpayers with income in the
$100,000 to $200,000 range were subject to the AMT. By 2010, over 80% of
taxpayers in that income range will be subject to the AMT.
There are several reasons why a high-income taxpayers will be less affected by
the AMT in the future than their lower-income counterparts.
First, the marginal tax rates high-income taxpayers face under the regular
income tax tend to be higher than the marginal tax rates they face under the AMT.
Under the regular income tax, the top two marginal income tax rates are 33% and
Second, under the regular income tax, personal exemptions are phased out for
high-income taxpayers. So the fact that personal exemptions are not allowed under
the AMT does not have a significant effect on high-income taxpayers who do not get
personal exemptions under the regular income tax.
Third, under current law, the basic AMT exemption is phased out for taxpayers
filing joint returns when AMT taxable income exceeds $150,000. For joint returns
in 2008, the basic AMT exemption is fully phased out at AMT taxable income levels
in excess of $330,000. Hence, many high-income taxpayers do not get a basic
exemption under the AMT. Therefore, the scheduled reduction in the basic AMT
exemption will have little or no effect on their AMT liabilities.
Finally, high-income taxpayers, unlike their lower-income counterparts,
generally derive a significant percentage of their total income from capital gains and
dividend income. These items receive preferential tax treatment under the AMT as
well as the regular income tax. Under both, the tax rate on long-term capital gains
and dividend income is limited to a maximum rate of 15%.
Income from dividends and capital gains is an important source of income at
high income levels. Table 3 below shows the share of income in interest, dividends,
and capital gains by income class. For example, in the highest adjusted gross income
class (over $1 million), on average 30.3% of income is from capital gains and 4% is
from dividends currently taxed at 15%. In contrast, taxpayers in the $75,000 to
$100,000 AGI range derive 1.1% and 0.8% of their income from capital gains and
Table 3. Interest, Dividends, and Capital Gains by Adjusted
Gross Income Class, as a Percentage of Total Income, 2003
Income ClassInterestDividendsCapital GainsFinancial
$15-$30 2.6 0.6 0.2 3.4
$30-$50 1.8 0.5 0.3 2.6
$50-$75 1.8 0.6 0.6 3.0
$75-$100 1.7 0.8 1.1 3.5
$100-$200 2.0 1.2 2.7 5.9
$200-$500 2.9 2.1 8.2 13.2
$500-$1,000 3.5 3.0 13.4 19.9
Overall 2.5 1.3 4.7 8.6
Source: CRS calculations based on the Internal Revenue Service 2003 Individual Statistics of
Income. Excludes returns with negative adjusted gross income. Reproduced from CRS Report
RL33285, Tax Reform and Redistributional Issues, by Jane G. Gravelle.
Potential Cost Offsets for AMT Modification
There are many ways that the AMT could be changed to mitigate its impact in
future years. This report concentrates on the two most widely discussed alternatives:
a short-term patch to the AMT or outright repeal of the AMT. This section discusses
what revenue offsets would be needed to pay for these two solutions to the AMT
The revenue offsets are grouped into four main categories: offsets derived from
(1) changes to the structure of the AMT, (2) changes to the individual income tax rate
structure, (3) income tax base broadening, and (4) reducing the tax gap.
Offsetting AMT Revisions with Changes
to the Structure of the AMT
One approach to dealing with the expanding scope of the AMT would shift the
AMT tax burden away from taxpayers with AGIs in the $50,000 to $500,000 range
and towards higher-income taxpayers. This approach appeals to some because it
helps restore the AMT to its original purpose — ensuring that high-income taxpayers
pay what many argue is their fair share of the federal tax burden.
Revisions within the AMT could take many forms but three revisions are of
special interest. AMT tax rates could be increased or dividends and capital gains
income could be included in the AMT tax base at regular AMT tax rates, or both.
Either increases in the AMT tax rates or a combination of increases in AMT tax rates
and subjecting capital gains and dividend income to full AMT tax rates could raise
enough revenue to offset the costs of an AMT patch.
Increasing the top rate of the AMT is one option for shifting the burden of the
AMT to higher-income taxpayers. For example, in a paper written in 2002,
researchers at the Urban/Brookings Tax Policy Center (TPC) proposed a revenue-
neutral AMT revision that included increasing the basic AMT exemption, lowering
the income level at which the AMT rate increases, eliminating the phaseout of the
AMT exemption, and raising the top AMT tax rate to 35%.5
The Citizens for Tax Justice (CTJ) recently presented a proposal to tax capital
gains and dividend income at ordinary AMT tax rates rather than the lower dividend
and capital gains rates applicable under the regular income tax.6 According to the
CTJ analysis, such a change would pay for 87% of the cost of the AMT exemption
increase (making the higher exemption levels permanent and indexing them) for the
next four years. They also calculate that including capital gains and dividends in the
5 Leonard E. Burman, William Gale, Jeffrey Rohaly, and Benjamin H. Harris, The Individual
AMT: Problems and Potential Solutions, at [http://taxpolicycenter.org/publications/
6 See Citizen’s for Tax Justice, “A Progressive Solution to the AMT Problem,” December
AMT combined with an increase in the top AMT tax rate to 29% would make the
proposal revenue neutral.
CTJ argues that this change would restore the AMT to its original purpose. The
principal target and most critical preference in the initial minimum tax was the
capital gains preference.
A more recent study by researchers at the TPC discusses a variety of revenue
neutral revisions over the ten-year budget horizon (FY2007-FY2016) that would shift
the burden of the AMT to higher-income taxpayers.7 These revisions were made
prior to the enactment of the AMT patch and were for earlier years. The cost of
patching the AMT tends to rise as we move through time because each year is closer
to the expiration of the 2001 tax rates. These options are still relevant as ways of
addressing the AMT problem. One proposal for an AMT patch, which is very similar
to the CTJ approach, would be paid for by including capital gains and dividend
income under the AMT and subjecting them to AMT tax rates. Combined with a 3%
increase in the AMT tax rates (to 26.8% and 28.9%) this option would more than pay
for itself over the next four years, according to TPC projections.
However, the CTJ and TPC estimates assume capital gains realizations are
fixed. If realizations decline in response to these tax increases, then other measures
would be needed to make up the revenue loss. Both studies acknowledge this issue,
although CTJ argues that capital gains realization responses are small. With a
realization response, including capital gains as a preference item in the AMT will not
raise as much revenue as these two estimates indicate. The Joint Committee on
Taxation (JCT) takes an expected decline in realizations into account in its estimates
of the revenue effects of changing tax rates on capital income. Based on the JCT
estimate of the effect of the tax rate changes on realizations in the late 1980s, only
about 43% of the static gain from increasing the tax rate on capital gains and
dividend income would actually be realized. Recent evidence suggests the
realization response would be such that up to 80% of the static change in revenue
would be realized. (This issue is discussed in more detail in the appendix.)
It is worth reiterating that, in large part, Congress enacted the first minimum tax
largely to recapture the capital gains income that was excluded under the regular
income tax. In 1969, 50% of a long-term capital gain was exempt from tax under the
regular income tax. The long-term capital gain income that escaped tax under the
regular income tax was included as a preference item under the original minimum tax
and subjected to minimum tax rates. Prior to 1969, many high-income taxpayers
used the preferential tax rates on capital gains income to reduce their federal income
7 Leonard E. Burman, William G. Gale, Gregory Leiserson, and Jeffrey Rohaly, Options to
Fix the AMT, Tax Policy Center, January 19, 2007, available at
[http://www.taxpolicycenter.org/home/]. This study examines a variety of revisions to the
AMT that would be revenue neutral over a ten-year budget horizon. However, the baseline
for their estimates is current law, which assumes that the reductions in the regular income
tax expire after 2010. If the tax cuts are extended, either in part or in total, then these
options to reform the AMT would not be revenue neutral.
tax liabilities to levels that Congress deemed inappropriate for their levels of
Offsetting AMT Revisions with Individual
Income Tax Rate Increases
Another option to pay for AMT revisions is raising the individual income tax
rates. In a tax reform proposal introduced by Ways and Means Committee Chairman
Rangel , H.R. 3970, prior to enactment of the 2007 patch, the AMT was repealed and
the revenue offset by a 4% surtax on adjusted gross income over $200,000 (and a9
4.6% surtax on adjusted gross income over $500,000. This additional tax would be
applied not to taxable income, but to adjusted gross income, a larger base.
The TPC study discussed above contains a variety of scenarios where rates are
increased to pay for the AMT revisions. For instance, increasing the top three
individual income tax rates by 24% over the next four years would offset the cost of
repealing the AMT. This would require raising the top three rates from 28%, 33%
and 35% to 34.8%, 41%, and 43.5% respectively.
To pay for the AMT patch, the TPC estimates that the top income tax rates
would have to be increased by 2% from 28%, 33%, and 35% to 28.6%, 33.7%, and
35.8%. In addition, this option would require taxing dividends and capital gains
income at regular AMT tax rates. Over the first few years, this option actually
increases total revenues by about $28 billion, according to TPC projections. (Note
that these options do not account for any capital gains realization responses and these
projections were made prior to the enactment of the AMT patch for 2007 and relate
to earlier years.)
Offsetting AMT Revisions with Income Tax Base Broadening
It is possible to pay for repeal or a patch to the AMT through income tax base
broadening. There are many provisions in the income tax law that narrow the tax
base compared to a tax base that approximates economic income, but many of these
tax benefits are both popular and long established.
The AMT patch for 2007 was not paid for by revenue offsets. However, there
were bills (passed in the House) that would have paid for the patch. H.R. 3996,
which also included provisions that might be considered base broadening to pay for
the one-year 2007 AMT patch and extending some other expiring provisions. The
revenue raising provisions included two individual tax provisions relating to
8 U.S. Congress. Joint Committee on Internal Revenue Taxation. General Explanation of
the Tax Reform Act of 1969, December 3, 1970, p. 105. It is worth noting that after 1986,
when the preferential tax treatment of capital gains income was repealed under the regular
income tax, the number of taxpayers subject to the AMT fell from around 60,000 in 1986
to around 11,000 by 1989.
9 This proposal is reviewed in CRS Report RL34249, The Tax Reform and Reduction Act
of 2007: An Overview, by Jane G. Gravelle.
individuals managing hedge funds: one would tax income deferred in overseas
entities on a current basis and one that would treat earnings now taxed as capital
gains as ordinary income (this income is referred to as carried interest).10 Another
revision would delay application of a provision adopted in 2004 to include interest
on debt acquired abroad in the total to be allocated between foreign and domestic
income for purposes of the foreign tax credit. Each of these three provisions raised
around $25 billion over ten years. Since these provisions’ revenue gain over ten
years would only offset the AMT patch for about a year, they would not be adequate
to finance permanent changes.
There are several legislative proposals that would use more general base
broadening to offset AMT reforms. Senator Ron Wyden and Representative Rahm
Emmanuel introduced legislation (S. 1927 and H.R. 5176) in the 109th Congress that
would have repealed the AMT and provided for overall tax reform, and Senator
Wyden introduced a similar bill (S. 1111) in the 110th Congress. The cost of this
legislation would have been offset through income tax base broadening and increases
in the individual income tax rates.
In the 110th Congress, Senator John Kerry has introduced legislation (S. 102)
that would partially offset the cost of a one-year AMT patch by rolling back the lower
rates for dividends and capital gains for 2009 and 2010. Under this legislation, the
maximum tax rate on capital gains income would increase from 15% to 20% and
dividend income would be taxed at regular income tax rates. The lower rates on
capital gains and dividends are set to expire after 2010, and so increasing these rates
for 2009 and 2010 would only have a short-run revenue effect for scoring purposes.
Based on revenue estimates done by the JCT in 2003, changing the tax rates on
capital gains and dividends appears to increase revenues in the neighborhood of $20
billion per year for dividends and $4 billion for capital gains. These capital gains
estimates involve some timing effects, and were estimated at a time when gains were
smaller. (Capital gains realizations are very volatile.) Based on the most recent
estimate of capital gains liabilities, $75 billion for 2005,11 a static gain from
increasing the rate by a third (from 15% to 20%) would be $25 billion. The actual
revenue gain would be about 40% of the static cost, or $10 billion if the realization
response is around 0.7 (a 10% reduction in tax leads to a 7% increase in realizations);
60% or about $15 billion for a realization response of 0.46 range, 78% or about $20
billion if the realization response of 0.25 range, and 90% or about $23 billion for
responses of 0.11. These effects would not cover the full cost of the patch, but could
provide some revenue.
There are several sources of information on possible tax base broadeners.
Discussions of base-broadening provisions, along with their revenue effects, are
10 For a discussion ,see CRS Report RS22717, Taxation of Private Equity and Hedge Fund
Partnerships: Characterization of Carried Interest, by Donald J. Marples, and CRS Report
RS22689 Taxation of Hedge Fund and Private Equity Managers, by Mark Jickling and
Donald J. Marples.
11 Congressional Budget Office, letter to Chairman Charles E. Grassley, February 23, 2006.
found in various tax expenditure documents.12 Table 4 reports the largest tax
expenditures for individuals in the tax expenditure list, and while many of them
would provide sufficient revenue to pay for the AMT patch, most of them are
longstanding provisions that are quite popular. There are many other smaller tax
expenditures as well as significant tax expenditures in the corporate income tax
which could also be considered. Because there are more than 160 separate tax
expenditures, a discussion of them is beyond the scope of this report.
Table 4. Largest Tax Expenditures for Individuals, FY2006
Dollars P e rcentage
Net Exclusion of pension contributions and earnings124.70.95
Reduced tax rates on dividends and long-term capital92.20.70
Exclusion of employer contributions for health care90.60.69
Deduction for mortgage interest69.40.53
Exclusion of capital gains at death50.90.39
Tax credit for children under age 1746.00.35
Earned income credit (EIC)42.70.33
Deduction of state and local taxes36.80.28
Exclusion of Medicare benefits35.10.27
Exclusion of investment income in life insurance, annuity28.00.21
Exclusion of benefits provided under cafeteria plans27.90.21
Exclusion of interest on public purpose state and local26.00.20
Exclusion of capital gains on sales of principal residences24.10.18
Exclusion of untaxed Social Security benefits23.10.18
Deduction for property taxes on owner-occupied19.90.15
Source: Reproduced from CRS Report RL33641, Tax Expenditures: Trends and Critiques, by
12 Both the Administration and the Joint Committee on Taxation provide annual lists which
can be found respectively in the budget documents and on the Joint Tax Committee’s
website. For a more detailed discussion of these provisions, see Senate Budget Committee,
Tax Expenditures: Compendium of Background Material on Individual Provisions, prepared
by the Congressional Research Service, S. Prnt. 109-072, December 2006.
The President’s Advisory Panel on Tax Reform proposed a variety of base
broadeners, including disallowing the itemized deduction for state and local taxes,
in their tax reform plans.13 Some of these revisions did not involve total elimination
of the tax benefits, but placed limits on them, such as a cap on deductions for health
insurance or a floor on deductions for charitable contributions. It might be more
feasible to restrict rather than eliminate major tax expenditures.
CBO has also provided a list of possible base broadeners that in many cases
would modify rather than eliminate tax provisions.14 For example, they discuss
proposals for a 2% floor for state and local tax deductions and for charitable
contributions, which would respectively raise $26.6 billion and $19.9 billion in
FY2009. Floors already exist for some itemized deductions (casualty losses and
medical expenses) and they tend to simplify tax compliance, especially in the case
of charitable contributions. The CBO study from 2005 also discussed a proposal to
limit health benefit deductions which would raise $30.3 billion in FY2007, and lower
the ceiling on mortgage interest deduction from $1 million to $400,000, which would
raise $4.9 billion in FY2009. A proposal to allow the benefits of itemized deductions
at a 15% rate is estimated to yield $53.5 billion in FY2009. CBO also discussed
proposals that primarily affect corporations, such as eliminating graduated tax rates
($3 billion in FY2009) and lengthening depreciable lives ($12.9 billion in FY2009).
Offsetting AMT Revisions by Reducing
the Tax Gap and Greater Tax Compliance
The tax gap is the difference between the taxes legally owed and the taxes
actually collected. The latest estimate of the tax gap (for 2001) indicated a gross tax15
gap of $345 billion. If a significant fraction of that gap could be collected, then it
would be possible to finance the AMT revisions with tax compliance measures. (The
net gap, after collections IRS expects to make with audits and other measures, is
estimated to be $290 billion).
The discussion below summarizes some legislative options aimed at closing the16
tax gap. It is not comprehensive, as there are numerous small changes in rules and
13 Simple, Fair, and Pro-Growth: Proposals to Fix America’s Tax System, November 2005,
which can be found at [http://www.taxreformpanel.gov/]. For a review see CRS Report
RL33545, The Advisory Panel’s Tax Reform Proposals, by Jane G. Gravelle.
14 Congressional Budget Office, Budget Options, February 2007.
15 U.S. Treasury Office of Tax Policy, A Comprehensive Strategy for Reducing the Tax
Gap, September 26, 2006.
16 These proposals come from a variety of sources, including the Treasury study cited above,
past administration budget proposals, and prior congressional proposals. They also include
statements made at a hearing of the Senate Finance Committee on the tax gap, on July 26,
Treasury Inspector General for Tax Administration; and Nina Olsen, Taxpayer Advocate,
posted at [http://finance.senate.gov/sitepages/hearing072606.htm]. They also include
reports by the Joint Committee on Taxation, including JCS-2-05, Options to Improve
Compliance and Reform Tax Policy, January 27, 2005, and an unnumbered report,
requirements that could alter tax compliance; these changes are discussed in some of
the sources cited in this section. Unfortunately, there are no estimates for the revenue
gains for many of the measures and those that are available indicate that the revenue
gains are small.
Increased Withholding or Third Party Reporting. Tax gap estimates
indicate that compliance is greatest with direct withholding, rather then with third
party reporting. Wages, which are subject to withholding, have a 1% non-reporting
rate. Interest, dividends, social security payments, pensions, and unemployment
payments, which are generally subject to third party reporting, have a 4.5% non-
reporting rate. For income that has some (but not substantial) reporting — such as
partnership/S corporation income, alimony, reportable exemptions, deductions, and
capital gains — the rate is 8.5%. Income not subject to reporting (which includes17
proprietorship income, rents, and royalties) has a non-compliance rate of 54%.
Businesses with cash transactions are estimated to have a non-compliance rate of18
A number of possible revisions to increase third party reporting include the
following: (requiring broker reporting of basis was included in H.R. 3996):
!Withholding of non-employee compensation for independent
contractors (a rule recently imposed on governments), or
withholding if no taxpayer identification number is provided.
!Requiring credit card companies to report payments made to
!Requiring information reporting on services provided by
corporations (presently corporations, including small corporations,
!Requiring brokers to report basis on capital gains.19
!Requiring the reporting of proceeds of auction sales.
!Requiring reporting of real estate taxes by state and local
!Requiring more detailed reporting of mortgage interest, including
information on whether the loan is refinanced or exceeds the
Additional Options to Improve Tax Compliance, August 3, 2006. Finally, many of these
proposals are included in the Administration’s FY2008 revenue proposals. Their revenue
estimates can be found in General Explanations of the Administration’s Fiscal Year 2008
Revenue Proposals, Department of the Treasury, February 2007.
17 U.S. Treasury Office of Tax Policy, A Comprehensive Strategy for Reducing the Tax
Gap, September 26, 2006.
18 Statement of J. Russell George, Treasury Inspector General for Tax Administration,
before the Senate Finance Committee, July 26, 2006.
19 Currently gross proceeds are reported, but not basis. To institute this rule would require
some type of rule about how basis is established when some but not all of a type of assets
(for example, shares of particular stock) are sold. Currently, a variety of rules are available.
!Adopting a due diligence rule for preparers relating to offshore
banks and similar operations.
!Reporting distributions to partners and S corporation shareholders
in personal service businesses.
!Requiring corporations to report interest deductions limited by
Some of these information reporting provisions are aimed at the part of the
taxpaying population that tends to have the lowest compliance rates, small
businesses. Proposals to withhold taxes on independent contractors, require credit
card reporting of payments, and require information reporting on corporate services
purchased are all aimed at this particular sector.
It appears that these changes have a limited ability to close the tax gap. For
example, the gap arising from the failure to report basis (generally, the acquisition
cost of the asset) on capital gains is estimated at $11 billion, and misreporting of gain
is estimated at 36% for assets where basis is not reported, as compared to 13% for
mutual funds where net capital gains are reported.20 These differences seem to imply
a potential gain of several billion dollars. The Administration estimates in their
FY2009 budget, however, that a basis reporting requirement after 2008 would yield
a revenue gain that is less than $628 million per year by FY2013, and would provide
only $1,203 million in cumulative revenue through FY2013.
For the first three items in the list above, withholding on independent
contractors without a taxpayer identification number, reporting credit card sales, and
information reporting on payments to corporations, the revisions would yield
respectively $70 million, $2,027 million, and $886 million for FY2013. They would
yield respectively $248 million, $5,735 million, and $2,849 million cumulatively
through FY2013. (Note that full withholding on payments to independent contractors
would yield more revenue, perhaps considerably more).
Information reporting on sales of tangible personal property (reporting proceeds
of auctions), included in the FY2008 budget, would raise $220 million in 2012, and
$233 million through 2010. The Administration also proposed in the 2009 budget
increased reporting on non-wage payments by governments, yielding $27 million by
2013 and $248 million through FY2013. All of the Administration’s FY2009
compliance provisions, which include most of the significant items on the list above,
would yield slightly $10.5 billion through 2010.
The provision enacted in the Tax Increase Prevention and Reconciliation Act
of 2006, which required withholding on independent contractor payments by
governments, had a one-time increase of $6 billion (reflecting timing effects), but
afterwards raised about $200 million a year. It is possible that expansion to
withholding on all independent contractors would yield more revenue, but it would
likely be a controversial proposal since it would affect many taxpayers (both payers
20 Government Accountability Office, Capital Gains Tax Gap: Requiring Brokers to Report
Securities Cost Basis would Improve Compliance if Related Challenges Are Addressed,
GAO-06-603, June 2006.
For most of the proposals that have been considered to improve compliance and
reduce the tax gap through third party reporting, the revenue raised is a small fraction
of the revenue needed to pay for the AMT patch or other AMT reforms.
Tax Shelters. Many proposals to restrict tax shelters would have relatively
small revenue effects, but there are some provisions that could help offset the cost
of an AMT patch. Some of these provisions have been contained in prior legislative
proposals and some in general tax reform proposals.
Economic Substance Doctrine. Even when transactions meet the letter of
the tax law, tax benefits may be disallowed by the courts if the activity is found to be
a type of sham transaction; in the particular case of tax shelters the related issues of
economic substance or business purpose are often used.21 That is, if an activity does
not have economic substance or there is no business purpose, the tax benefits are
Several bills that were introduced in the 109th Congress would have codified the
economic substance doctrine. For instance, a provision in S. 2020 was projected to
eventually gain about $2.5 billion in revenue annually. H.R. 3970, Chairman
Rangel’s tax reform proposal, introduced in the 110th Congress would also have
included the economic substance doctrine, with a 10-year gain in revenue of $3.9
These changes would have recognized these doctrines in the tax law itself and
provided several specific guidelines. For example, if a court found the economic
substance doctrine to be relevant, the bill provided that the taxpayer must meet both
the objective test of economic substance and the subjective test of having a non-tax
business purpose to keep the tax benefit. Requiring both is referred to as a
conjunctive rule, while requiring either is referred to as a disjunctive rule.
This legislation sought to strengthen the rule and to bring more uniformity to
court decisions. Some court cases have required both aspects to be met and others
only one. The bill also set out specific rules for determining when the taxpayer meets
the economic substance test of demonstrating profit potential, by requiring that the
return outside the tax benefits exceeds the riskless rate of return. The bill would also
require that the transactions must be a reasonable means of achieving the business
21 For a general background on the economic substance doctrine see Joseph Bankman, “The
Economic Substance Doctrine,” Southern California Law Review, vol. 74, November 2000,
pp. 5-30; Gerald R. Miller, “Corporate Tax Shelters and Economic Substance: An Analysis
of the Problem and Its Common Law Solution,” Texas Tech Law Review, vol. 34, 2003, pp.
1015-1069; and Martin J. McMahon, Jr., “Economic Substance, Purposive Activity, and
Corporate Tax Shelters,” Tax Notes, February 25, 2002, pp. 1017-1026. See also CRS
Report RL32193, Anti-Tax Shelter and Other Revenue-Raising Provisions Considered inth
the 108 Congress, by Jane G. Gravelle; and CRS Report RS22586, The Economic
Substance Doctrine: Recent Significant Legal Decisions, by Erica Lunder.
There has been controversy about how much revenue codifying the economic
substance doctrine would actually raise and the revenue estimates have varied over
Earnings Stripping. Reducing U.S. tax with debt or other deductible
payments to related firms is referred to as “earnings stripping.” Because of the
potential for abuse, the current tax code has a restriction on deductibility of interest
for thinly capitalized U.S. firms (with more than 60% of assets held in debt and with
more than 50% of earnings paid in interest).
H.R. 2896 in the 108th Congress would have tightened the general earnings
stripping rules by eliminating the asset share test (i.e., disallowing interest based only
on the interest as a share of income) and lowering the interest share (to 25% for
ordinary debt and 50% for guaranteed, or 30% overall). This provision would have
raised about $2.7 billion over 2004-2013 and would have brought in almost $400
million annually by 2013.
Some interest in earnings stripping developed from concerns about corporate
inversions. A corporate inversion occurs when a U.S. company sets up a foreign
incorporated firm to become the parent corporation, making the current U.S. firm the
subsidiary corporation. Proposals to penalize corporate inversions have been
considered in a number of previous Congresses, but some have not been enacted. A
provision considered but not adopted in 2005 would have raised revenues by about
$50 million annually.
International Tax Shelters. Earnings stripping and corporate inversions can
be used as tax shelters by shifting income to low tax countries. There are numerous
ways to accomplish this income shifting: by shifting debt to high tax countries, by
shifting intangible income (such as that related to innovations and marketing), and
through inter-company pricing. There are many possible legislative responses to
these tax sheltering activities, although the revenue consequence of each is likely
Robert McIntyre,23 testifying before the Senate Budget Committee, summarized
the recommendations that came out of that committee, along with some additional
revisions that he suggested. Among them is a proposal to tax currently the income
of foreign subsidiaries of U.S. companies. This proposal would have policy
implications beyond reducing tax shelter opportunities. Under current income tax
law, this income is not taxed until repatriated. Estimates suggest that taxing this
income now rather than waiting until it is repatriated could result in a revenue gain
of around $6 billion per year. Another proposal to curtail this form of tax sheltering
activity is to provide an apportionment formula for allocating profits (allocate profits
based on physical assets, employment, sales, or some combination).
22 See, for example, the report released by the Permanent Subcommittee on Investigations
of the Committee on Homeland Security and Government Affairs, U.S. Senate, Tax Haven
Abuses, The Enablers, the Tools and Secrecy, August 1, 2006.
23 Proposals made by the chairman and ranking member of that committee are summarized
in testimony of Robert McIntyre before the Senate Budget Committee, January 23, 2007.
Summing Up: Tax Gap Issues. The IRS estimates that there is a
significant tax gap but the legislative measures that could be undertaken to close that
gap appear limited. For many measures, there are no estimates of the revenue that
could be generated. The revenue estimates that have been done tend to suggest only
small revenue gains.
When assessing provisions aimed at reducing the tax gap it is critical to
differentiate between potential collections (as measured by the tax gap estimates) and
the amount of revenue that might realistically be collected through provisions aimed
at increasing tax compliance.
Addressing the growing reach of the AMT through repeal or through some form
of a temporary patch is a major fiscal challenge. The cost of addressing the AMT is
large. There is no shortage of potential ways to pay for these revisions, whether it be
through revisions to the AMT itself, raising income tax rates, broadening the income
tax base, or some combination of all of these options. Although there is much
discussion of the tax gap and the potential revenue associated with closing that gap,
revenue estimates of gains from legislative proposals, where they do exist, suggest
attempts to close the tax gap are unlikely, by themselves, to raise adequate revenues
to address the AMT problem.
Appendix. Capital Gains Realization Response
In the late 1980s, there was a debate about the magnitude of the capital gains
realizations response. This response is usually characterized as an elasticity, the
percentage change in realizations divided by the percentage change in tax rates.
Empirical studies had produced widely ranging estimates. There were two types
of empirical studies: times series studies that examined aggregate changes in capital
gains realizations over time as tax rates changed, and cross-section or panel studies
that compared many individuals’ realizations within a time period. The time series
studies yielded a much smaller and less variable estimate of the realizations response
than did cross sections studies.24
There were difficulties with both types of studies. For example, time series
studies confronted difficulties in controlling for other factors, such as falling stock
transaction costs and changes in potential realizations. The cross section and panel
studies also had some significant limitations. Perhaps the most serious of these
potential problems was the likelihood that much of the response might reflect a
transitory effect. High income taxpayers, who tended to have variable income, would
time their realizations to coincide with periods when tax rates were low, so that the
relationship between high realizations and low tax rates may have merely been a
timing response, and did not reflect a response to a permanent change. The
seriousness of this problem and the variable, and in some cases, extremely large,
elasticities in these studies led the Joint Committee on Taxation (JCT) and
Congressional Budget Office (CBO) to rely on their own time series estimates for
their revenue estimating and forecasting purposes.25
Most estimates of capital gains realizations responses were made using non-
linear forms. A popular one, and one used by JCT and CBO, was a semi-log
function, where the elasticity (percentage change in realizations divided by26
percentage change in tax rate) rose proportionally with the tax rate. At a tax rate
of 0.22 (which is roughly the midpoint between the 15% capital gains tax rate and the
top AMT rates), at the time, the JCT estimate of elasticity was 0.76, but after
accounting for a portfolio response was 0.70. The first-year response was 70% larger
at 1.20, so that, at least for a cut in the capital gains tax, realizations would be
expected to rise so much the first year that projected revenue would increase.
24 The issues surrounding the debate at that time are discussed in CRS Report 90-16, Can
A Capital Gains Tax Cut Pay for Itself?, by Jane G. Gravelle. This archived report can be
requested from the Congressional Research Service. It is also reprinted in Tax Notes, vol.
25 The Administration also had an estimate that was somewhat higher than that of the JCT
and CBO but did not come from a explicit estimating equation. It is not clear how the value
26 Holding all other variables constant, under this formula, G = Ae-bt, where G is gains, A is
a constant reflecting other variables and fixed amounts, b is the coefficient of the
realizations response, and the elasticity is bt.
Subsequent to the adoption of this elasticity, a number of studies and events
suggested that the elasticity estimates should be lowered. First, the importance of
transitory responses was highlighted by the huge surge of realizations that were
eventually documented following the proposed capital gains rate increases in the
1986 Tax Reform Act. This observation increased concerns about transitory effects
in cross section and panel studies. Second, a study that used the limits to the
behavioral response (since realizations can never exceed accruals), suggested
elasticities that were likely to be under 0.5.27 Third, Burman and Randolph published
a major new study using cross section data that controlled for transitory effects by
using the variation in state tax rates to measure the permanent response to differential
tax rates.28 They found a very low permanent elasticity of 0.18 at a 16 % average tax
rate, a number that was not statistically significant. This measure implied an
elasticity of 0.25 at a 22% rate, using the semi-log estimating function. When
weighted by population, they found a smaller elasticity, 0.06, with a 12% average
marginal tax rate, implying a 0.11 elasticity at 22% rate. They found a transitory
elasticity of 6.4. Finally, as data were added to the aggregate time series in CBO’s
continuing studies, the elasticities fell, and are currently at 0.46 at a 22% rate.
A subsequent study by Auerbach and Siegel confirmed the relatively low
elasticities in the Burman and Randolph study (finding an elasticity of 0.33, and also
finding elasticities at virtually zero for very wealthy and very sophisticated
t ax p ayers). 29
The elasticity makes a great deal of difference for the share of the static revenue
gain from capital gains that is estimated to be collected. Measuring all elasticities at
a 22 percent rate, with the JCT’s 0.70 elasticity, only 27% of the static revenue gain
from moving the tax rate from 15% to the top rate of 28% would be collected. With
CBO’s 0.46 elasticity, 49% would be collected. Burman and Randolph found that
71% would be collected with the 0.25 elasticity and 86% would be collected with the
In the aggregate, 22% of the total of capital gains and dividends reflects dividend
payments. Thus, if this share also applies to the AMT, the total shares collected
would begin at 43% for the 0.70 JCT elasticity (0.22 plus 0.78 times 0.27), by 60%
if one assumes the CBO elasticity, and 77% and 89% for the two Burman and
27 CRS Report 91-250, Limits to Capital Gains Feedback Effects, by Jane G. Gravelle. This
archived report is available from the Congressional Research Service. It is also reprinted
in Tax Notes, vol. 51, April 22, 1991, pp. 363-371
28 Leonard E. Burman and William C. Randolph, “Measuring Permanent Responses to
Capital-Gains Tax Changes in Panel Data,” The American Economic Review, vol. 84,
September 1994, pp. 794-809.
29 Alan J. Auerbach and Jonathan M. Siegel, “Capital Gains Realizations of the Rich and
Sophisticated,” The American Economic Review, Papers and Proceedings, vol. 90, May
2000, pp. 276-282. This study also reported a very large 1.7 elasticity; however, discussions
with researchers at the Congressional Budget Office (where this research was performed)
indicate subsequent concerns that this measure is reflecting transitory effects.
These calculations apply only before 2011, or assume that the dividend and
capital gains tax benefits adopted in 2003 will be made permanent. If one assumes
that the dividend and capital gains relief enacted in 2003 will expire, then there will
be no revenue gain from dividends at all and the capital gains tax rate will begin at
a higher level of 20%. In that case, the share of static revenue collected will be
smaller for example, 22% at the original JCT elasticity and 46% at the CBO
elasticity, but about the same for the Burman and Randolph measures. The absolute
value of the static gain would also be smaller than under the assumption that these
provisions are made permanent, but total federal revenues would be larger.