The Phantom Tax That Made The Deficit Look Better

By Marilyn Geewax

Published January 3, 2013 at 3:06 PM EST

The alternative minimum tax created a "useful fiction," as one analyst says, by appearing to shrink budget deficits.

As Americans continue to sort out the contents of the fiscal cliff legislative package passed by Congress Tuesday, they are finding elements they like and some they hate.

There's one exception. Everyone is glad Congress finally found a permanent fix for the alternative minimum tax.

That one portion of the U.S. tax code — always intended to affect only very wealthy people — had turned itself into a dreaded stalker. The AMT became a constant threat to millions of middle-class taxpayers who never understood it and never knew when it might strike them.

Each year, Congress would rush to the rescue to "fix" the AMT to keep it from walloping tens of millions of filers with hefty new taxes. But until this week, lawmakers would never approve a long-term solution. Why? Largely because having the AMT on the books helped future budget deficits look smaller by making it appear that new tax revenues soon would be rolling in.

"It was a useful fiction, but it was incredibly irresponsible," said Marc Goldwein, senior policy director for the Committee for a Responsible Federal Budget, a nonpartisan research group.

Goldwein said that on paper, the AMT would generate tons of tax revenues in coming years, making the future deficits look less frightening. But no one on Capitol Hill ever believed those funds would actually show up because each year, lawmakers would apply a "patch" to keep the AMT from hauling in huge revenues.

The Tax Policy Center, another research group, estimates that in 2022, the AMT — with no patch — would generate nearly $400 billion in revenues to fund government. But if Congress were to apply the typical patch as it always does, the AMT would bring in only about $90 billion in revenues in 2022.

How did the situation get this weird? It's complicated. We'll explain:

In 1969, Congress decided it needed to ensure that everyone paid a minimum amount of taxes. But it also wanted to preserve tax breaks written into the code as economic and social incentives.

For example, Congress wanted to keep the home mortgage interest deduction to provide more incentive to buy real estate. Supporters of that deduction say homeownership has economic and social value.

But the tax code had so many various deductions that some wealthy people could take an array of them and end up paying extremely low taxes.

So Congress created a parallel tax system. The wealthy could prepare their taxes in the usual way, then recalculate their taxes under the AMT formula, and pay whichever amount was bigger.

Unfortunately, Congress failed to build in an inflation escalator. And over ensuing decades, it cut tax rates. The combined effect of higher inflation and lower rates undermined the intent of the AMT. Each year, it threatened to hit more and more middle-class families.

The result was that a tax intended to affect only the richest Americans needed to get updated again and again so that it would hit only the wealthiest 4 million taxpayers. If Congress had not patched it on Tuesday, it would have applied to nearly half of the people with incomes of $75,000 to $100,000. That would have pulled in an estimated 27 million more tax filers, who would have found themselves paying an average of $3,700 more in taxes for 2012.

The annual push to patch the AMT became chaotic because of congressional gridlock. "The biggest and thorniest problem for the IRS and next year's filing season is the AMT patch," IRS Commissioner Doug Shulman said in a September speech to the American Bar Association.

Finally, in the fiscal cliff deal, Congress agreed to permanently adjust AMT income exemption levels to inflation. It also gives lower-income families bigger tax breaks to make sure they don't face the threat of getting caught up in the AMT.

Tax experts say the changes will pretty much ensure that people making less than six-figure salaries won't have to think about the AMT rates, which range from 26 percent for singles to 28 percent for married couples. The tax collected some $102 billion in 2010, the last tax year on record.

Goldwein said the permanent fix will now provide a more realistic assessment of what revenues will be coming in the future. "One nice thing about the fiscal cliff deal — at least from a budget wonk perspective — is that what is written into law is more closely aligned with what will actually happen in the future."

And it will be better for taxpayers, who now will be able to plan better for what their taxes will be each year, according to Mark Vitner, senior economist for Wells Fargo Securities LLC.

"You shouldn't go through this patchwork year after year," Vitner said. "It's always preferable to remove uncertainty."