WASHINGTON – A potential casualty of the “fiscal cliff” standoff is the ability of Congress to adjust an outdated tax code provision that could significantly boost what millions of middle-income households owe to the government.
The provision, called the alternative minimum tax, or AMT, was enacted in 1969 to make sure that the very wealthy paid some income tax.
But the threshold for the usually higher tax was not indexed for inflation, and it threatens each year to ensnare millions of people it was never intended to catch — prompting the annual congressional fix.
This year, however, the AMT is caught up in the broader fight over extending the President George W. Bush-era tax cuts and reducing government spending.
The Internal Revenue Service warned lawmakers that if they don’t act by Dec. 31, the number of people facing the AMT in April would jump to about 33 million from about 4 million who had to pay it this year.
For those who haven’t faced it before, the effect could be a shock — an average increase of about $3,700 per household, according to the nonpartisan Tax Policy Center.
Without an AMT patch, those taxpayers would be faced “with a very large, unexpected tax liability,” acting IRS Commissioner Steven T. Miller wrote to key lawmakers this month.
Fixing the tax is a rare example of bipartisan agreement in Washington. Democrats and Republicans have joined together nine times since 2001 to make one- or two-year fixes to the annual taxable income level at which the AMT kicks in.
If no fix is made by Dec. 31, the threshold at which the AMT would kick in for the 2012 tax year will drop to $33,750 from $48,450 for individuals. The level for joint filers will drop to $45,000 from $74,450. Those are the same thresholds that existed in 1993.
“The alternative minimum tax was put in place to target a few millionaires,” Sen. Kay Bailey Hutchison, R-Texas, told her colleagues on the Senate floor this month. “Now, because of inflation and wage increases, it is targeted right at the middle class.”
This year, fixing the tax has become more complicated as Congress and the White House wrestle with the large automatic tax increases and spending cuts coming in January, a combination known as the fiscal cliff.
Normally, lawmakers would pass the AMT patch along with other noncontroversial extensions of expiring temporary tax provisions. Some on Capitol Hill would like to clear away those issues first before tackling the much more contentious fiscal cliff issues.
But other lawmakers want to keep the AMT linked to the fiscal cliff because it adds to the consequences for average Americans of not striking a deficit-reduction deal by the end of the year.
“This year, as in every year, there is a strong bipartisan desire to patch it,” said Edward D. Kleinbard, a University of Southern California law professor and former chief of staff of Congress’ Joint Committee on Taxation. “It’s just being held hostage.”
The AMT is, in effect, a second tax system, Kleinbard said.
It has a lower rate, but does not allow many important deductions, particularly the ability to deduct state and local taxes. That makes the AMT more of a threat to people in California and other high-tax states, he said.
“People think the AMT is for fat cats or for tax-shelter junkies and then they discover it, in fact, applies to regular folks,” he said.
Persons whose annual taxable income is above the threshold must figure out their tax obligation under the AMT system and under the regular tax system. A person then pays the higher amount.
“It’s insane to have two rival tax systems, side by side, that apply to millions of people,” Kleinbard said. “And it’s also absurd that every year we’re required to participate in this roller coaster of ‘Will Congress patch it or not?”‘
A permanent fix would be costly because it would eliminate future revenue from the AMT under budget rules that assume the thresholds are not adjusted.
In his proposed fiscal 2013 budget, President Barack Obama asked Congress to permanently index the AMT thresholds to inflation. The plan, which was not approved by Congress, would have reduced tax revenues by $1.9 trillion over the next decade.
Over the years, Congress has made a series of temporary fixes that are less costly to long-term budget projections. Still, a two-year patch proposed in the Senate would cost the government $132.2 billion in lost revenue.
An additional complication is that if Congress doesn’t act by Dec. 31, the AMT thresholds would be in place for people filing their 2012 income taxes next year. Congress could still fix the tax retroactively, but the uncertainty would create havoc for filers and the IRS, Miller warned lawmakers.
The IRS is assuming a fix will come, he said. If it doesn’t, the agency would have to rework its computer systems. The “magnitude and complexity of the changes” could prevent many taxpayers from filing returns until the end of March or maybe later, he said.
Kleinbard said some taxpayers would delay filing their returns, while others would have to guess whether Congress would make a retroactive change. Guessing the wrong way could lead to an overdue tax bill and potential penalties or paying too much to the government on their returns, he said.