CRS Updates Report on State and Local Taxes, Federal AMT

The alternative minimum tax (AMT) is a parallel tax to the regular individual income tax and is intended to help ensure that high-income individuals bear at least some tax liability. The recent major tax cuts, however, lowered the average tax liability under the regular income tax such that many taxpayers could have been captured by the AMT, which is not indexed for inflation. The AMT for individuals will capture significantly more taxpayers beginning in the 2007 tax year if Congress does not act to modify or repeal the tax. This report describes the potential impact on taxpayers and state and local governments if the AMT reverts to pre-2001 rules or is repealed. Both taxpayers and state and local governments are potentially affected because state and local taxes are deducted for purposes of the regular income tax, but are not deducted when calculating AMT liability.

The impact on state and local governments arises because the tax price of public goods is reduced through federal deductibility. Each tax dollar a taxpayer (who itemizes) pays to a state or local government reduces the taxpayer's federal tax liability by an amount equal to his marginal tax rate multiplied by the taxes paid. Theoretically, state and local governments can levy higher taxes and provide more public goods than they would be able to absent federal deductibility. Through deductibility, state and local governments are also able to "export" part of their tax burden to all federal taxpayers, high-tax states more than others. Repeal of the AMT would expand the tax benefit generating more tax exportation. AMT reversion to pre-2001 rules would reduce the tax benefit and reduce tax exportation.

The variation of tax structures among states will lead to a significant differential impact by state and by individual. Generally, repeal of the AMT would reduce taxes for high-income taxpayers and reversion would increase taxes for high-income taxpayers. Most of the highest-income taxpayers (adjusted gross income over $500,000), however, would not be affected because their regular income tax liability exceeds AMT liability.

Generally, high-tax, high-income states would fare relatively better under AMT repeal and relatively worse under reversion to pre-2001 AMT rules. This report includes a state-by-state breakdown of the average taxes-paid deduction and the percentage of AMT filers and itemizers. This information is provided to help policymakers evaluate the effect of possible reforms of the AMT on constituent governments.

This report analyzes the broad impact of the AMT and options for its modification. For information on congressional action with respect to the AMT, see CRS Report RS22100, The Alternative Minimum Tax for Individuals: Legislative Initiatives and Their Revenue Effects, by Gregg A. Esenwein.

 Contents

Congress temporarily adjusted the AMT exemption amounts in 2001 (through the Economic Growth and Tax Relief Reconciliation Act, EGTRRA) and 2003 (through the Jobs and Growth Tax Relief Reconciliation Act, JGTRRA). Congress extended the temporary exemption amount increases in 2004 (through the Working Families Tax Relief Act, WFTRA) and again in 2006 (the Tax Increase Prevention and Reconciliation Act of 2005, TIPRA).² By increasing the AMT exemption amount, the threshold where regular income tax liability falls below AMT liability is relatively higher, temporarily reducing the number of taxpayers subject to the AMT. In addition, some personal credits that were previously not allowed to offset AMT liability can now be used to offset the AMT.

Potential changes to the AMT would have a significant effect on the taxes levied on individuals and on the tax structure of state and local governments. Specifically, the distribution of the federal tax burden on individuals would change if either extreme, reversion to pre-2001 rules or repeal of the AMT, is implemented. State and local governments would either see the tax price for public goods increase (reversion) or decrease (repeal).

The report includes a state-by-state breakdown of the average "taxes paid deduction" and the percentage of AMT filers and itemizers. This information is provided to help policymakers evaluate the effect of possible reforms on constituent governments. The report concludes with a discussion of how congressional action on the AMT could affect state and local governments and taxpayers if Congress takes action dealing with the AMT before 2007.

          Table 1. Returns by Income Class, Selected Characteristics,

Income Distribution of the State and Local Taxes Paid Deduction

Under the regular income tax, individuals who itemize deductions may deduct state and local taxes paid. Taxpayers must choose to deduct either income or sales taxes, not both.³ In the 2003 tax year, before the sales tax deduction option was available, 43.1 million returns deducted $310.9 billion in taxes paid.⁴ In the 2004 tax year, the first year for the sales tax deduction option, 46.0 million returns deducted $362.6 billion.⁵ The increase in number of returns claiming the taxes paid deduction, 6.8%, and in the amount deducted, 16.6%, is likely due in large part to the sales tax deduction option. In contrast to the regular income tax treatment, under the alternative minimum tax (AMT) state and local taxes paid are considered a preference item and are included in the base of the tax. According to one estimate, approximately 2 million taxpayers "added back" approximately $42 billion in state and local taxes paid for purposes of calculating AMT tax liability.⁶

The taxes paid deduction is most common for returns in the higher income brackets. Out of the 22.9 million total returns with reported AGI of over $75,000, 19.5 million itemized deductions (see Table 1). The over $75,000 cohort of itemizing taxpayers represented 42.2% of itemized returns yet claimed 71.1% of the total taxes paid deduction (see Table 2). Those with AGI greater than $100,000 represented 9.6% of all returns yet accounted for 56.3% of the state and local taxes paid deduction.

As is often the case with federal tax policy, different parts of the tax code contradict one another. The treatment of state and local taxes is one example. The policy objective behind the tax preference for state and local taxes paid under the regular income tax has been supported with the claim that to disallow the deduction would amount to a "tax on a tax."⁷ Proponents of the deduction suggest that taxes paid to state and local governments are not available to pay federal income taxes and thus should not be included in taxable income. In short, proponents of deductibility claim that "taxing a tax" is inequitable. If the AMT were to revert to the pre-2001 rules, this tax preference would be reduced, contravening the original intent of the tax deduction under the regular income tax.

          Table 2. Taxes Paid Deduction by Income Class, 2004 Tax Year

The previous discussion touches on another justification for the deduction for state and local taxes: the indirect subsidy to state and local governments. The lower "tax price," theoretically, allows the local government to impose a tax rate that is higher than would be the case without deductibility.⁸ For example, if a taxpayer is allowed to deduct property taxes, it is likely the case that these taxpayers would be more willing to accept a marginally higher property tax rate. For each dollar of property tax paid, the federal tax burden is reduced by the taxpayers marginal tax rate. A taxpayer in the 28% tax bracket would have federal tax liability reduced by 28 cents for each dollar paid in property taxes.

Economic theory predicts that more public services would be provided than would otherwise be the case without deductibility. The taxpayer has more disposable income (lower federal taxes), and thus would demand more public services. And, the relative price of government provided goods would decline, increasing the quantity of public goods demanded.⁹

From a state distributional perspective, high-tax, high-income states would benefit the most under expanded deductibility of state and local taxes (e.g., AMT repeal). This report provides a more detailed discussion of the effect on state and local governments of the taxes paid deduction under AMT reform (and repeal) proposals in a later section.

Income Distribution of AMT Liability

The AMT affects considerably fewer taxpayers than the itemized deduction for taxes paid; 3.1 million and 46.3 million in 2004). The distribution of those affected by the AMT, however, is more concentrated than is the taxes paid deduction. The aggregated data produced by the Internal Revenue Service (IRS) and summarized in Table 3 clearly exhibit the concentrated (and progressive) nature of AMT liability; 84.8% of AMT returns reported AGI between $100,000 and $500,000.

CBO testimony from May 2005 indicates that the share of taxpayers with AGI greater than $500,000 subject to the AMT would not change significantly if the AMT reverts to pre-2001 rules (see Table 3). In contrast, the share of taxpayers subject to the AMT in the $50,000 to $100,000 cohort and the $100,000 to $200,000 cohort would rise dramatically.¹⁰ For these cohorts, the AMT rates are higher than the regular income tax rates. Taxpayers in the over $500,000 cohort encounter higher tax rates under the regular income tax than under the AMT and thus would not be affected by AMT reversion to pre-2001 rules.

          Table 3. Income Distribution of Returns with AMT Liability,

State and local government representatives generally support the deductibility of state and local taxes under the regular income tax because of the indirect subsidy to sub-national governments delivered through a lower federal tax burden. Generally, state and local governments are able to "export" part of their tax burden to all federal taxpayers -- some states more than others. Exporting the state and local tax burden can be measured by the amount of tax revenue that is deductible. The greater the amount of deductible taxes, the greater the exportation.

Recent tax cut legislation, the American Jobs Creation Act of 2004 (AJCA 2004), expanded the deductibility of the state and local taxes to include an option to deduct sales taxes in lieu of income taxes for taxpayers that itemize.¹³ Taxpayers choose the greater of sales taxes or income taxes when itemizing deductions. The new provision primarily benefits taxpayers in states that do not levy an income tax. The provision expires after 2007.

A variety of methods can be used to compare the relative tax burden of state and local taxes. For this report, state and local taxes that could have been deductible under AJCA 2004 rules were chosen as the instrument of comparison. The greater of sales taxes or income taxes was added to property taxes for each state. This amount was then divided by the number of 2004 tax returns filed in each state to produce an average amount for each state. The third column of Table 4 presents these estimates of the average "deductible" taxes per return, by state. Note that because businesses pay a large portion of sales and property taxes, the averages overstate the burden on individual returns, yet the estimates are useful for comparative purposes.

Potentially deductible taxes (under the AJCA rules) would have been $7,313, on average, for returns filed in New York state; $2,551 in Alabama (see Table 4). The U.S. average was $4,588 per return.¹⁴ Recall that state and local governments that rely more on deductible taxes pay a relatively lower "tax price" for public goods. Jurisdictions in New York state, for example, pay a lower tax price and export more of their tax burden to federal taxpayers than do jurisdictions in Alabama.

Table 4 also presents data on the percentage of AMT filers by state and the average state and local taxes paid deduction by state in FY2002. Note that taxpayers in states that do not levy an income tax will have a greater incentive to itemize and claim the deduction for taxes paid.¹⁵ The average taxes paid deduction will almost certainly rise in these states as existing itemizers simply add the sales tax paid to other itemized deductions. The IRS reported that in 2004 "[A]n estimated 11.1 million taxpayers took advantage of this [sales tax deduction], deducting $17.3 billion."¹⁶ There are likely many taxpayers in these states who did not itemize before AJCA was enacted, but were relatively close to the threshold where itemized deductions could exceed the standard deduction.

According to the tables in IRS Publication 600, the state sales tax deduction for a family of four in Knoxville, Tennessee, with income between $100,000 and $120,000, would have been $1,496 in 2004 ($1,682 in 2006).¹⁷ In addition, this family could deduct another $481 ($541 in 2006) for local sales taxes paid. Further, if this family had purchased a $20,000 car (or boat), they could deduct another $1,850. In sum, this Tennessee family could have deducted an additional $3,827 under the sales tax deduction option. With the standard deduction for joint filers at $9,700 in 2004, it seems reasonable to assume that the additional sales tax deduction would have induced itemizing for many taxpayers in a similar situation.

The data from the U.S. Census Bureau in the third column of Table 4 include the property tax and either the sales tax or income tax. The tax which generates the most revenue, either income or sales, was added to the property tax to simulate a state's reliance on deductible taxes. Comparing states based on what current law would allow seems to be a reasonable proposition.

States without a broad based state income tax are indicated by an asterisk. Note that unlike other states, almost all these states have an average amount of potentially deductible taxes that is greater than the average actual taxes paid deduction.

          Table 4. AMT Filers and the Average Taxes Paid Deduction on

If the AMT is repealed, federal revenue will decline considerably as current budget forecasts predict repeal would generate a $611 billion revenue loss over the 2006-2015 budget window, assuming the EGTRRA and JGTRRA tax cuts are not extended.¹⁸ If the other regular income tax cuts are extended and the AMT is repealed, the federal revenue loss over the same budget window would be approximately $1.16 trillion.¹⁹

The second option, extension of the highest AMT exemption and indexation, would essentially maintain the status quo and would not significantly shift the burden of federal taxation among the states. But, because current law does not index the AMT, the cost of indexation under this option (beginning with the higher AMT exemption amounts) would be $385 billion over the 2006-2015 budget window assuming the regular income tax cuts are not extended.²⁰ If the tax cuts are extended, the cost of this proposal would rise to $642 billion.²¹ In contrast to indexation, the two extremes, reversion and repeal, would likely have significant impact on state and local governments and would significantly alter the burden of federal taxation. For a discussion of the revenue cost of various reform options for the AMT, see CRS Report RS22100, The Alternative Minimum Tax: Legislative Initiatives and Their Revenue Effects, by Gregg A. Esenwein.

AMT Reversion to Pre-2001 Rules

If the AMT is allowed to revert to the structure in place before 2001, and the regular income tax cuts (EGTRRA and JGTRRA) are made permanent, then the role of state and local taxes in determining federal tax liability will change significantly. Under this scenario, the AMT would capture many more taxpayers as regular income tax liability falls below the floor established by the AMT. State and local taxes paid, as noted earlier, would become taxable, reducing the implicit federal transfer to state and local governments. Because the deduction for state and local taxes paid varies by state, so too will the impact of AMT adjustments.

For example, the average taxes paid itemized deduction for filers residing in New York was $13,316 in 2004 whereas in Tennessee, the average taxes paid itemized deduction was $3,895 (see Table 4). The reason for the disparity arises from the following two factors: the level of state and local taxes and the average income in the state. Generally, higher state and local taxes and higher income would both contribute to a higher likelihood of itemizing and claiming a deduction for state and local taxes paid.

States with the highest average amount of state and local taxes deducted (New York, Connecticut, New Jersey, California, District of Columbia, Massachusetts, and Rhode Island are the top seven) would be the most negatively affected if the AMT is allowed to revert to pre-2001 rules. In contrast, states with relatively low taxes paid deductions, (Alaska, South Dakota, Tennessee, Wyoming, Alabama, Nevada, and Florida) would be the least negatively affected. Note that six of the seven states with the relatively small taxes paid deduction are states without broad-based income taxes. If the AJCA 2004 sales tax deduction option were extended beyond 2007, reversion to pre-2001 AMT rules would have a greater negative impact on these states. The burden of federal taxes would shift from the low tax states to the high tax states if the AMT reverts unchanged to pre-2001 rules. Note that reversion to pre-2001 rules would result in a significant increase in the number of AMT filers in all states, regardless of state and local taxes.

Repeal of the AMT

In contrast to allowing the AMT to revert to pre-2001 rules, Congress could repeal the AMT and state and local governments would continue to receive an indirect benefit through deductibility of state and local taxes. The elimination of the phase-out of itemized deductions under the regular income tax in 2009 would also enhance the taxpayer benefit derived from deducting state and local taxes.

If the AMT is repealed, the loss in revenue would necessarily result in one or more of the following: greater federal debt, an increase in other federal taxes, and/or reduced federal spending. If federal debt is increased, the cost of borrowing for both the government and the private sector, will also increase. State and local governments, which typically rely on debt to fund public infrastructure, such as schools, roads, and bridges, would likely face higher interest costs as the supply of all types of government bonds expands. The long-run drag on the economy generated by government dissaving, however, could be partially offset by the short-term stimulative effect of lower taxes.

The impact of increasing other federal taxes to replace the lost AMT revenue depends on the tax raised and how the tax is increased. If the base of the regular federal income tax (personal or corporate) is expanded (e.g., the elimination of special deductions or exclusions), many states could receive a slight windfall. A windfall arises because most states use the base of the federal income tax (both individual and corporate) as the starting point for state income taxes. For this reason, if state and local tax rates remain constant, the expanded federal base would increase state and local tax revenue. Alternatively, an increase in federal rates or the elimination of lower tax brackets would have little effect on most state income tax revenue. Other federal tax changes, such as changes in excise taxes, would likely have little direct effect on the state and local government finances.

Spending cuts would likely include some reduction in grants-in-aid to state and local governments. These grants comprised approximately 14% ($357.8 billion) of total federal government current expenditures in 2005.²² In addition, cuts in federal spending, other than direct grants, may also adversely affect states if states must increase spending to provide what was once provided by the federal government.

Many observers agree that the AMT issue will need to be addressed again in the next Congress. In addition, proposals addressing fundamental tax reform could include reform of the AMT. The direction of any congressional choice would have a significant and varied impact on taxpayers and on state and local governments.

² The WFTRA AMT extension is through the 2005 tax year. The TIPRA extension is through the 2006 tax year.

³ Under current law, the option to deduct sales taxes in lieu of income tax expires at the end of 2007.

⁴ IRS, Statistics of Income, Individual Complete Report 2003, Publication 1304, Oct. 2005. The sales tax deduction option was not available in 2003; it became available for the 2004 tax year.

⁵ IRS, Statistics of Income, Individual Complete Report 2004, Publication 1304, Sept. 2006.

⁶ U.S. Department of Treasury, Office of Tax Analysis, unpublished data as cited by: Len Berman and David Weiner, "Suppose We Took the AM Out of the Alternative Minimum Tax," paper presented at the National Tax Association, 97th Annual Conference on Taxation, Nov. 11-13, 2004.

⁷ See CRS Report RL32781, Federal Deductibility of State and Local Taxes, by Steven Maguire.

⁸ Douglas Holtz-Eakin and Harvey Rosen, "Federal Deductibility and Local Property Tax Rates," Journal of Urban Economics, vol. 27, 1990, pp. 269-284.

⁹ Economists refer to these effects as the income and substitution effects, respectively.

¹⁰ Douglas Holtz-Eakin, Congressional Budget Office Testimony, "The Individual Alternative Minimum Tax," before the Subcommittee on Taxation and IRS Oversight, Committee on Finance, U.S. Senate, May 23, 2005, figure 4, p. 6.

¹¹ Urban-Brookings Tax Policy Center, Table T06-0270, Washington D.C., Nov. 10, 2006.

¹² Under current law, through 2009, certain high-income taxpayers are required to reduce itemized deductions (limited to up to 80% of allowable deductions). This itemized deduction reduction is phased out beginning in the 2006 tax year until completely repealed beginning in 2009.

¹³ For more, see CRS Report RL32781, Federal Deductibility of State and Local Taxes, by Steven Maguire.

¹⁴ Note that these estimates are considerably less than the standard deduction in 2002, $7,850 for married taxpayers and $4,700 for single taxpayers. This explains in part the relatively small number of taxpayers that itemize.

¹⁵ See CRS Report RL32781, Federal Deductibility of State and Local Taxes, by Steven Maguire.

¹⁶ Balkovic, 2006, p. 10.

¹⁷ The state sales tax rate in Tennessee is 7%, and the local rate for Knoxville is an additional 2.25% for a combined sales tax rate of 9.25%.

¹⁸ Holtz-Eakin, Douglas, Congressional Budget Office Testimony, "The Individual Alternative Minimum Tax," before the Subcommittee on Taxation and IRS Oversight, Committee on Finance, U.S. Senate, May 23, 2005, p. 8.

¹⁹ U.S. Department of Treasury, Fact Sheet: A Tale of Two Taxes, Regular Income Tax and the AMT, March 2, 2005.

²⁰ Holtz-Eakin, Douglas, Congressional Budget Office Testimony, "The Individual Alternative Minimum Tax," before the Subcommittee on Taxation and IRS Oversight, Committee on Finance, U.S. Senate, May 23, 2005, Table 1, p. 8.

²¹ Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2006 to 2015, January 2005, p. 8.

²²Economic Report of the President, Feb. 2006, Table B-82, p. 379.