JGTRRA accelerated the gradual income rate reductions and the tax credit increases passed in EGTRRA so that instead of taking full effect in 2006, they took full effect immediately and were made retroactive to January 2003. In addition, the threshold at which the AMT applied was also increased. Finally, to reduce the double-taxation of corporate equity income, the tax treatment of capital gains and dividends was changed. Corporate income is taxed twice under current law, once because of the corporate income tax, and the second time because dividends and capital gains are taxed through the personal income tax. By contrast, the interest on corporate bonds is not doubly taxed because although it is taxed at the personal level, it is not taxed at the corporate level because interest paid is deducted in the calculation of corporate income. Many economists believe the double-taxation of corporate equity income has deleterious economic effects, including encouraging excessive corporate leverage, discouraging corporate investment, discouraging the payment of dividends, and inhibiting the efficient use of the corporate form of organization. The maximum tax on long-term capital gains was cut from 20% to 15%. "Qualified dividends"1 were no longer taxed as ordinary income; their maximum tax rate was also cut to 15%. The provisions of JGTRRA were scheduled to expire at the end of 2010 along with the provisions of EGTRRA.
Whether the Bush tax cuts were good or bad is a matter of opinion, but in the current election season, each political party's stance concerning their future is clear. For the most part, the Republicans believe they all should be extended, while President Obama campaigned in 2008 for repealing some, but not all, of the cuts-a view he still supports.
The AMT was created by the Tax Reform Act of 1969 in response to a discovery that 155 high-income households had paid no income tax through the aggressive use of tax benefits. The AMT was designed to require that everyone with a high income pay some income tax by capping the use of tax benefits. The AMT has been modified numerous times since 1969, but one important feature remains: the exemption amounts are not indexed for inflation. The result is that the AMT captures an increasing share of American households, many of whom are not high income. Moreover, the interaction of the AMT and the regular income tax is such that the AMT, if unmodified, would have offset some of the Bush tax cuts. Rather than make a permanent reform of the AMT, in recent years Congress has made a series of short-term "patches" to the AMT to limit its reach, patches that reduced federal revenue. The most recent AMT patch expired at the end of 2011, but Congress is considering renewing the patch for 2012. If it does, the new patch would expire at the end of 2012. In recent years, slightly over 4 million tax returns were subject to the AMT. If Congress does not continue its patches for the AMT, the Congressional Budget Office estimates that in fewer than 10 years, over 40 million tax returns would be subject to the AMT.
The U.S. faced an early version of fiscal cliff at the end of 2010, when all of the Bush tax cuts and the AMT patch were scheduled to expire. Many thought the economic recovery was weak and feared that the end of the Bush tax cuts would impose more fiscal austerity than the fragile recovery could withstand. After the elections of November 2010, President Obama asked Congress to extend the Bush tax cuts for the middle- and lower-income tax brackets but to allow the tax cuts on the high-income tax brackets to expire as scheduled, a policy he advocated during his campaign. Congress declined to implement President Obama's proposals.
Subsequently, the administration and Congress worked out a compromise. In December 2010, Congress passed and President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. That law extended all of the Bush tax cuts (including various tax credits, deductions and exemptions) through the end of 2012, renewed the AMT patch and extended emergency unemployment benefits through 2011. To boost household incomes further, the law also delivered for 2011 a two-percentage point reduction in the employee portion of the Social Security payroll tax (from 6.2% to 4.2% for paycheck employees and from 12.4% to 10.4% for the self-employed). To boost investment, qualified business capital spending was given more generous tax depreciation allowances; in particular, such spending was 100% tax deductible through the end of 2011 and 50% tax deductible through the end of 2012. Finally, the federal estate tax, which was eliminated for 2010, was due to return to its Clinton-era levels in 2011. The law allowed the estate tax to return but established a $5 million exemption and a maximum tax rate of 35% through the end of 2012.
What Is The Fiscal Cliff?
The vast array of tax features scheduled to expire at the end of 2012 would generate the fiscal cliff. Below, I outline the various elements of the fiscal cliff and how much money they would cost. These estimates are derived from analysis by the Congressional Budget Office (CBO).2 I warn that these estimates are imprecise, but I think they give the right flavor to the issue.
Income Taxes and AMT
While President Obama has been highly critical of the Bush income tax cuts, he has nonetheless asked repeatedly that Congress renew most of them. In particular, he has asked that the Bush tax cuts for higher income taxpayers expire at the end of 2012 but that cuts for everyone else be renewed indefinitely. The Republican opposition prefers to renew all of the Bush tax cuts. As they position their parties for the November elections, Congressional leaders in both parties have stated that they will not yield on their respective positions. If nothing is done, all of the Bush income tax cuts will expire at the end of 2012, even though that is not the preferred policy of either party.
The latest patch for the AMT expired at the end of 2011. It is widely expected that Congress will renew the patch for 2012, but nothing has been done so far concerning 2013. So we consider the expiration of the AMT patch in January 2013 part of the fiscal cliff.
If all of the Bush income tax cuts and the AMT patch expire at the end of 2012 as scheduled, income taxes would rise by $265 billion in 2013.
It could get worse. If Congress fails to renew the AMT patch for 2012 or 2013, not only will millions of taxpayers be liable for higher taxes for the 2013 tax year, but come April 2013, millions will have to pay higher taxes for their 2012 income. It would be a double-hit of higher tax withholdings for 2013 and higher tax payments in April 2013 for 2012 income.