Implement a New Minimum Tax on Adjusted Gross Income

CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.

Billions of Dollars 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2017-2021 2017-2026
Change in Revenues 18.1 -11.6 6.2 6.5 6.8 7.3 7.6 8.0 8.4 8.9 26.0 66.2

Source: Staff of the Joint Committee on Taxation.

This option would take effect in January 2017.

Under current law, individual taxpayers are subject to statutory tax rates on ordinary income (all income subject to the individual income tax other than most long-term capital gains and dividends) of up to 39.6 percent. Higher-income taxpayers are also subject to an additional tax of 3.8 percent on investment earnings. However, people in the highest tax brackets generally may pay a smaller share of their income in income taxes than those brackets might suggest, for at least two reasons. First, income realized from capital gains and received in dividends—which represents a substantial share of income for many people in the highest brackets—is generally subject to income tax rates of 20 percent or less (before the application of the 3.8 percent additional tax). Second, taxpayers can claim exemptions and deductions (both subject to limits) to reduce their taxable income, and they can further lower their tax liability by using credits.

Taxpayers may also be liable for an alternative minimum tax (AMT), which was intended to impose taxes on higher-income individuals who use tax preferences to greatly reduce or even eliminate their liability under the regular income tax. The AMT allows fewer exemptions, deductions, and tax credits than are allowed under the regular income tax, and taxpayers are required to pay the higher of their regular tax liability or their AMT liability. However, the AMT does not affect most of the highest-income taxpayers because the highest statutory rate under the AMT is only 28 percent, and many deductions allowed under the regular income tax are still allowed under the AMT.

In addition to the individual income tax, taxpayers are subject to payroll tax rates of up to 7.65 percent on their earnings: 6.2 percent for Social Security (Old-Age, Survivors and Disability Insurance) and 1.45 percent for Medicare Part A (Hospital Insurance). Employers also pay 7.65 percent of their employees’ earnings to help finance those benefits. Higher-earning taxpayers are also subject to an additional tax of 0.9 percent on all earnings above $200,000 for single taxpayers and $250,000 for joint filers. However, the majority of those payroll taxes—specifically, those that fund Social Security benefits—are levied only on the first $118,500 of a worker’s earned income. Therefore, as a share of income, payroll taxes have a smaller effect on higher-income taxpayers than on many lower-income taxpayers.

This option would impose a new minimum tax equal to 30 percent of a taxpayer’s adjusted gross income, or AGI. (AGI includes income from all sources not specifically excluded by the tax code, minus certain deductions.) The new minimum tax would take effect beginning in 2017. It would not apply to taxpayers with AGI of less than $1 million and would fully apply to taxpayers with AGI of more than $2 million. Between those thresholds, the tax would gradually increase. The thresholds for its application would be adjusted, or indexed, to include the effects of inflation thereafter.

To reduce the liability associated with the new minimum tax, taxpayers could use just one credit equal to 28 percent of their charitable contributions. Taxpayers would pay whichever was higher: the new minimum tax or the sum of individual income taxes owed by the taxpayer and the portion of payroll taxes he or she paid as an employee. (When calculating individual income taxes, the taxpayer would include the 3.8 percent surtax on investment income and any liability under the current AMT.) If implemented, the option would raise $66 billion from 2017 through 2026, according to estimates by the staff of the Joint Committee on Taxation.

One argument in favor of this option is that it would enhance the progressivity of the tax system. The various exclusions, deductions, credits, and preferential tax rates on certain investment income under the individual income tax—combined with the cap on earnings that are taxed for Social Security—allow some higher-income taxpayers, especially those whose income is primarily in the form of capital gains and dividends, to pay a smaller share of their income in taxes than many lower-income tax-payers, especially those whose income is primarily in the form of wages or salaries. By creating a new minimum tax with no deductions and just one tax credit, the option would increase the share of income paid in taxes by some higher-income taxpayers.

One argument against this option is that, by effectively imposing a second AMT, it would increase the complexity of the tax code—reducing the transparency of the tax system and making tax planning more difficult. Raising taxes on higher-income people through the existing tax system (for example, by increasing the top statutory rates or by limiting or eliminating certain tax deductions or exclusions) would be simpler to implement.

Furthermore, the option would alter the affected taxpayers’ incentives to undertake certain activities. Under current law, for example, the tax subsidy rate for charitable contributions can be as high as 39.6 percent. For taxpayers subject to the minimum tax, this option would cap the subsidy rate at 28 percent of contributions. That reduction in the tax subsidy for charitable contributions would reduce donations to charities.

The option would also raise the marginal tax rates that some taxpayers face. (The marginal tax rate is the percentage of an additional dollar of income from labor or capital that is paid in taxes.) For example, the option would impose a minimum tax rate of 30 percent on most income realized from capital gains or received in dividends. In contrast, the highest tax rate on most capital gains and dividends is 23.8 percent under current law. Raising the marginal tax rate on capital gains and dividends would reduce taxpayers’ incentives to save. In addition, the higher marginal tax rates on earnings that some higher-income taxpayers face would lessen their incentive to work.