A Broken Tax Code

Jun 4, 2012 | Taxes

The IRS's Spring 2012 Bulletin has a report, as required by law, by Justin Bryan reporting that 20,752 tax returns for people with adjusted gross incomes of $200,000 or greater, or 0.5 percent of total returns for people making more than $200,000, were able to avoid paying any U.S. taxes in 2009. If you exclude people who paid taxes in foreign countries, that number is about half as much at 10,080 or less than 0.3 percent of total returns.

Some of these zero-tax returns for U.S. income appear to be due to the effects of the recession, considering that the number of tax returns with no tax liability has jumped by about fourfold since 2007. Indeed, small business losses that wipe out income tax liability are a primary factor in about ten percent of those returns. However, many of the reasons are structural in nature, highlighting flaws in the income tax system and the Alternative Minimum Tax, which was designed to limit upper-income taxpayers' ability to erase their tax liability.

For background, the AMT is triggered by a taxpayer being able to lower their tax liability to a very low level. However, only certain tax preferences are actually counted for AMT purposes; others can be used to an unlimited extent without triggering the alternative tax. Because Congress was only concerned about high-income earners avoiding taxes, they also created an exemption amount so middle- and low-income earners would not be affected.

Bryan notes that certain high-income taxpayers could avoid paying taxes under the AMT by relying entirely on tax preferences that would not count for the AMT. These preferences include various exemptions for interest income on certain bonds, the medical expenses deduction above a certain amount, the interest expense deduction, and certain "miscellaneous" itemized deductions above a certain amount.

In addition, Bryan points out that tax preferences can bring a taxpayer's taxable income low enough -- even negative -- that the presence of tax preferences that would trigger AMT liability would still not result in an AMT hit, because they would still have income below the AMT exemption amount.  

There are a few other factors in high-income taxpayers being able to avoid tax liability. In the case of those who did not pay only U.S. income taxes, liability can be avoided by having income overseas that is subject to foreign taxes. Individuals living abroad can take advantage of a very generous income exclusion and can use credits for foreign taxes paid to offset U.S. income tax liability. For individuals living in the U.S., the charitable deduction and the credit for past AMT taxes paid also play a significant role.

The chart below, reproduced from the report, shows the tax preferences that were the main reasons for high-income taxpayers being able to wipe out their liability.

[chart:6221]

Source: IRS

Beyond those who paid no taxes, a few tables towards the end of the bulletin show how the "headline" income tax rates can be deceiving. Someone making $200,000 or more would for the most part end up in the 33 or 35 percent brackets. Yet a distribution table of effective tax rates show that about half of those people end up paying an effective rate of 20 percent or less and 80 percent pay 25 percent or less. This is due not only to the preferences we have just mentioned, but other things like the mortgage interest deduction and preferential rates for capital gains and dividends. Having an income tax full of holes makes it much less transparent and leads to vastly different tax burdens for people with similar incomes (what is referred to as "horizontal inequity").

Distribution of Effective Tax Rates for People with AGI Greater than $200,000
Effective RateNumber of ReturnsPercent of Returns
Under 5 Percent47,0521.2%
5 to 10 Percent82,9922.1%
10 to 15 Percent393,79110.0%
15 to 20 Percent1,459,35937.2%
20 to 25 Percent1,192,73030.4%
25 to 30 Percent654,00416.7%
30 to 35 Percent72,3491.8%
Over 35 Percent1,461***

Source: IRS
***Less than 0.1%

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Tax reform can address the issue of people being able to reduce their tax burdens well below the intended rate. The AMT was enacted as a band-aid to the 1969 code to address that issue, but even that is proving to be ineffective. Tax reform can limit the ability of taxpayers to get rid of tax liability by limiting the size of tax expenditures, making the code more fair and transparent.