Components of the Fiscal Cliff

Per expectations, we have passed the election with no progress on avoiding the year-end “fiscal cliff.”  And also per expectations, several technical issues are proving important.  This note will provide some background on two of them.

 The Alternative Minimum Tax

The alternative minimum tax (AMT) under the individual income tax has been a bit player in the movie version of “The Incredible Fiscal Cliff.”  But those who read the 1,000 page novel (in the original German) know it as a powerful, threatening character.  For this reason, the AMT is beginning to get more attention in the specialist press.

One thing that many people do not understand is that the previously customary, annual inflation fix for the AMT is not one of the tax provisions that is scheduled to expire on December 31, 2012.  Rather, it already expired on December 31, 2011.  Therefore, that expiration would affect not only tax returns for income years 2012 and later; it would affect tax returns for this year, income year 2012, which all of us taxpayers are eager to file (just kidding) by April 15 of next year, just five months from now.

A second key point that has not yet fully sunk in is that the expiration of the inflation fix would take the law all the way back to its original, fully un-indexed parameters.  The jump in the number of taxpayers subject to the AMT would be enormous – more than 28 million additional returns would owe more than they had anticipated because of the AMT (estimate from the Tax Policy Center), and the amounts of money would not be trivial to the affected taxpayers.

And the reason why the money would not be trivial is that these newly minted AMT taxpayers would by no means be the “one percent” – which should be obvious by their large numbers.  In fact, most of the “one percent” outgrew the AMT long ago (because the top-bracket ordinary income tax rate is higher than the AMT rates).  But two key tax “preferences” that are not allowed by the AMT are the personal exemptions and the itemized deductions for state and local taxes.  In other words, the major victims of the impending expanded reach of the AMT are (1) large families living in (2) high-tax states.  And those families do not need enormous incomes to be caught by this monster; $75,000 per year is more than enough under the right circumstances.  Think a school teacher married to a fire fighter in New York or California.

Some folks in Washington blithely say that this AMT hit would not possibly be allowed to happen for political reasons, and promptly forget about it (or fuhgetaboudit, as the case might be).  But timing matters – a lot.  Marginal delay in fixing the AMT is a problem.  Going all of the way over the fiscal cliff is a crisis.  This is not a question of policy, although policy is important; it is an administrative issue.

First, consider marginal delay:  The Internal Revenue Service wants to finalize its tax forms this month.  The old liberating event that set the printing presses humming was even earlier: the publication of the September Consumer Price Index in mid-October, which allowed the computation of inflation indexing.  The popularity of electronic filing and computer tax software makes printing the forms less urgent, but only slightly.  There are still millions of people who file on paper.  There are people – taxpayers and paid preparers – making preliminary calculations, who need to know what the parameters are.  Holding up the filing process postpones the receipt of returns from the early birds until closer to those of the procrastinators, and makes the ultimate IRS processing crunch worse than it would be.  It takes some of the “service” out of the Service, and that is in no one’s interest.

But take that delay to the extreme, and assume that we “go over the cliff” without enacting the AMT patch.  That takes us to disaster.

There would be tens of millions of tax returns – not just those that would pay the AMT, but also others whose disposition would be uncertain – that would be put in limbo.  Those taxpayers could not file.  The IRS could process their returns only on the assumption that the AMT would be imposed, and if it ultimately would be lifted, the additional complexity of amending those returns would cause an enormous increase in workload.  Returns filed on paper would likely have to be returned; the IRS is engineered for throughput, not storage.  Innocent taxpayers, bewildered that their expected refunds had turned into payments due – assuming that they had tax forms at all – would deluge the IRS with phone calls and office visits.  And remember that we are talking about millions upon millions of everyday households – not the financial elite who typically have advisers and accountants.

The term “failed filing season” has been bandied about among the cognoscenti in Washington in contemplating this prospect.  In sum, sending the AMT over the cliff is simply not an option, and it is uncertain that enough people understand that.

So if you are looking for deadline flexibility, forget about the AMT.  But look instead to federal income tax withholding on wage and salary income in 2013.

Wage Withholding

The Treasury Secretary is required by law to establish the terms of wage withholding, “in such form, and… such amounts to be deducted and withheld, as the Secretary determines to be most appropriate… to reflect the provisions of chapter 1 [that is, tax rates and other tax-law parameters] applicable to such periods.”  In other words, the Secretary has the authority to determine how much withholding is “appropriate” for different wage levels.  Taxpayers, of course, have the right to adjust their own withholding up or down, subject to rules requiring timely payment.

If we reach the end of the year with no resolution of the fiscal cliff, the Secretary therefore has the authority to judge that it is “appropriate” to hold the withholding rates unchanged – perhaps because he believes that a resolution of the dispute is likely, that tax rates for most wage earners will soon be restored, and he does not want to subject those wage earners to the dislocation of a sudden increase in the amount withheld from their wages.

In the coming continued divided government, leaving withholding unchanged could be a dangerous game.  There is nothing that taxpayers like less than discovering at tax filing time that they have a balance due instead of a refund.  (See “Minimum Tax, Alternative.”)  If the Secretary took that gamble and found partway through the year that he or she had been wrong, the additional withholding needed for the remainder of the year to get back up to the annual target could be painfully high.  But as one hand of high-stakes poker to get the advantage against the other party in the Congress, manipulating withholding might be a tempting option.

Some might question whether the Secretary truly has this measure of authority, or would ever exercise it.  However, there is a precedent.  In the weak economy of 1992, in the fiscal year 1993 budget, President George H.W. Bush proposed, as part of his “short-term agenda for growth… [e]xecutive [a]ction… to strengthen economic activity in areas where the executive branch can proceed without depending upon Congressional action…a reduction of excessive personal income tax withholding by an average of $345 per year (joint return) for those taxpayers who wish to have this burden reduced.”  So as discussed above, the taxpayer always has the option to increase withholding, but pending such taxpayer action, President Bush used his (that is, the Secretary’s) authority to reduce withholding by a substantial amount – with no proposed or impending change in the underlying income tax rates.  The hope was that taxpayers would spend the additional cash, even though there was no reduction in tax liability at the end of the year, and therefore no change in the federal government’s ultimate revenues.

In sum, driving the bus off the fiscal cliff is a bad idea.  The economy is shaky, and does not need such a violent shock.  Allowing inflation indexing of the AMT to expire would be particularly painful for many taxpayers, and at the same time would disrupt tax administration to a degree unheard of within memory.  However, the President and his Treasury Secretary could manipulate income tax withholding to cushion the blow of tax-rate changes at the bottom of the cliff.

Today’s bizarre experiment in tax policymaking through the fiscal cliff raises all sorts of issues – which would be interesting if they were not so destructive.  There have been some hopeful stories about tentative offers of cooperation this week; but such stories have come and gone many times over the last two years.  We can only hope that this fascinating experimentation will stop soon.

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