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Republicans see some leverage in "fiscal cliff" talks

By Kim Dixon and Patrick Temple-West

WASHINGTON (Reuters) - U.S. Republicans may have some leverage in their fiscal cliffhanger with President Barack Obama: the threat of forcing a disproportionate number of Democrats to pay the so-called alternative minimum tax.

Under U.S. law, taxpayers each year must pay the greater of regular federal income tax, or the AMT. The latter requires taxpayers to give up certain tax breaks, typically exemptions and deductions for state and local taxes and medical costs.

Only about 4 million taxpayers pay the AMT because Congress routinely passes a law to adjust for inflation, to spare middle-income and upper-middle income taxpayers. Without this legislative fix, called a "patch" by lawmakers, up to 33 million taxpayers will have to pay an AMT liability for 2012, according to the Internal Revenue Service.

That is one in five taxpayers.

The number of taxpayers affected by the AMT would jump because the AMT exemption amounts and income brackets do not automatically rise with inflation and also because across-the-board individual tax cuts a decade ago did not cut AMT rates.

States with the wealthiest taxpayers and the steepest state taxes, which typically cannot be deducted under the AMT, include New York, California and Illinois - Democratic strongholds.

That may make the threat of a lapse one of the Republicans' strongest cards after Obama's re-election last month on a theme of tax fairness.

"The AMT is one of the more significant pieces of leverage that the Republicans have," said Evan Liddiard, a former tax adviser to Orrin Hatch, the top Republican on the Senate Finance Committee. "It will pinch harder in the blue states."

That may make Republicans less likely to agree to a bill that addresses only the AMT.

Obama's Democrats and Republicans, led by House of Representatives Speaker John Boehner, have been battling while trying to keep from falling over a $600 billion "fiscal cliff" - a combination of tax increases and spending cuts due to be implemented early next year.

Now at a standstill, talks on how to avert the fiscal cliff have been largely focused on whether to renew low tax rates for the wealthiest taxpayers along with everyone else.

In a brief interview in the Capitol, Hatch said voters in the Democratic-leaning states will not be amused if their taxes go up unexpectedly.

"When they find out they are going to get hammered because of the AMT and the lack of plan by this administration to resolve that problem, yes, I think that will cost them (the Democrats) a few votes," Hatch said.

Because the latest AMT patch expired in 2011, it is in some ways more urgent to address the AMT than the Bush-era tax cuts expiring at the end of December.

Congress last patched the AMT in the lame-duck session in 2010. A bipartisan bill passed by the Senate finance committee to patch AMT for 2012 and 2013 was estimated to cost $132.2 billion.

The cost is one reason the AMT never gets patched permanently. Republicans generally want to scrap the AMT altogether; Obama's latest budget calls for adjusting it for inflation.

IRS WARNINGS

Further complicating the AMT picture is the chaos predicted for the tax-filing season due to begin on January 22, the first working day after Obama's inauguration ceremony in Washington.

A letter from the tax-collecting IRS Commissioner Steve Miller on potential agency problems related to the fiscal cliff focuses almost exclusively on the AMT.

Failure to "patch" the AMT could lead to 60 million taxpayers not being able to file tax returns or get a refund, in addition to a software nightmare for the IRS computer systems.

Miller wrote lawmakers on November 13 warning them of serious repercussions for taxpayers, including 28 million with a "very large unexpected tax liability," and delays in refunds for millions.

"Consistent with past practice, I have instructed IRS staff again this year to leave our core systems "as-is" with respect to the AMT, and hold off on the substantial design and engineering work" required otherwise, he wrote.

Miller last briefed the Senate Finance Committee about the need for action late last month, according to a Senate source.

Representative Richard Neal, a senior Democrat on the Ways and Means Committee who represents parts of Massachusetts, said fixing the AMT was an absolute must.

"It has to be done. It reaches too many people if it's not," Neal said. "I think it is again being used as (a) bargaining (chip)."

Republicans say they are holding out for a bigger deal.

"That is not going to solve the fiscal cliff," said Republican Representative Pat Tiberi, who leads the revenue sub-panel of the tax-writing House Ways and Means Committee.

"It is a very important part of the tax code but once you start picking winners and losers in the tax code, how do you get ... the big deal done?"

(Additional reporting by Richard Cowan; Editing by Howard Goller and Mohammad Zargham)

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