Americans want a fair tax system. This means a system that is both progressive—where we require greater responsibility from those with higher incomes—as well as one in which people in the same general situation are treated equally. Our current tax system, however, allows thousands of high-income tax filers to avoid paying any tax at all.
The IRS recently released data on high-income tax returns which show an estimated 5,650 tax filers with incomes over $200,000 paid no U.S. federal taxes in 2002.[1] This was a substantial 15 percent increase over the previous year. In 1977, there were just 85 of these high-income tax filers with no income tax liability (see figure 1).
While on average high-income tax filers had higher effective tax rates than the overall population, a total of 88,586 of these high-income filers paid less than 10 percent of their income in taxes, and 618,203 paid less than 20 percent—which is less than the average for all filers.[2]
Figure 1. Number and Percent of Tax Returns with Incomes over $200,000 and without Tax Liability
This increase in the number of zero-tax returns is not entirely due to inflation or a growing number of upper-income filers. Another way to track this data is to look at high-income tax filers as defined by an inflation-adjusted measure. If the threshold for high-income is set to be $200,000 in 1976 dollars—which is equivalent to $632,337 in inflation-adjusted 2002 dollars—we still find a significant increase with 616 tax filers owing no tax. In fact, a greater percentage of these high-income tax filers owed no tax than in any year since the IRS began computing these numbers in 1977 (see figure 2.)
Figure 2. Number and Percent of Tax Returns with Incomes over $200,000 (inflation-adjusted 1976 dollars) and without Tax Liability
Unfortunately, it could get worse. Congress is entertaining proposals to simply eliminate the alternative minimum tax (AMT) without making other changes to the tax code, and also proposals to eliminate or drastically reduce the estate tax. Both of these changes would allow more high-income, high-wealth people to avoid taxation, thus leaving the rest of taxpaying America with higher bills.
Alternative Minimum Tax
The AMT was initially introduced to address the problem of high-income tax avoidance. It seems only fair that the very richest should have to pay at least some minimum amount in taxes and should not escape their tax responsibility altogether.
Over the years since it was enacted, and especially over the last four years, the AMT has begun to impact a greater number of people. This is primarily due to two reasons: the AMT is not indexed to inflation, and tax changes made from 2001 through 2003 lowered taxes for upper-income people, but did not make adequate changes to the AMT. As such, unless changes are made, the AMT will reach an estimated 31 million tax filers in 2010.[3] The AMT is drifting away from its original purpose as a greater number of increasingly middle-class taxpayers will owe more due to the AMT.
Also, there is no question that the alternative minimum tax adds an additional layer of complexity onto the tax code. Those who are potentially impacted by the AMT must, in essence, do their taxes twice—once under the standard income tax code, and a second time under AMT rules. This process leaves those who owe extra due to the AMT feeling like they have been singled out to pay more through no fault of their own.
These considerations have led many to call for the elimination of the AMT. However, simply repealing the tax without making other changes would mean that the ranks of those with high incomes who pay no tax would likely explode. The change would be exceptionally costly as well, reducing revenue by at least an estimated $582.5 billion over the next 10 years.[4]
A more responsible approach would be to examine the reasons why so many high-income individuals are able to avoid taxes.[5] An AMT repeal should be coupled with a revamped income tax code that addresses the problem of avoidance directly rather than relying on a second layer of taxation. This may mean limiting various deductions, credits, and tax-preferred treatment for those with high incomes. For example, it appears as though high-income non-taxpayers are much more likely to report tax-exempt bond interest, and have relatively large deductions for investment interest expenses. With the elimination of the AMT, other factors that cause low- or no-tax filings will certainly arise, and we should do as much as possible to seriously limit, in advance, those preferences that lead to avoidance.
Estate Tax
No matter how carefully tax writers craft reforms, there will always be people (and their tax lawyers) looking for ways to avoid paying. If history is any guide, there will always be some loophole or some avoidance scheme that will allow people to avoid their responsibility.
In this context, the estate tax can be seen as an important backstop to the income tax code. As a general rule, to minimize overall economic distortions, an efficient tax code will strive to keep tax rates generally low and will tax a broad base of economic activities. When people, especially those who are very wealthy, are able to shelter significant amounts of money from taxation, this forces tax rates to be generally higher than otherwise necessary.
The estate tax, by catching revenue that would otherwise slip through the cracks, allows us to have lower rates throughout the rest of the code, and thus contributes to the overall efficiency of the tax code.[6] With the cost of eliminating the estate tax at around $1 trillion over the first 10 years, this would be a significant revenue loss that would have to be made up elsewhere in the tax code or in the budget.[7]
When designing a tax system, we cannot look at individual parts of the code in isolation. With an imperfect and leaky revenue system, the estate tax cannot be abandoned.
A repeal of the estate tax and the AMT without other fixes would increase the number of high-income tax filers who pay no tax, and would further shift the tax share onto middle-income taxpayers. Neither is a direction in which the tax code should be moving.
John S. Irons is the director of tax and budget policy at the Center for American Progress.