What Tax Cut?
States are using higher taxes and fees to take back what Uncle Sam is giving away
You might want to relish that tax cut George Bush gave you last year--the one he argued in the State of the Union address last week should be made permanent.
That's because for all the dollars the feds are letting you keep, the states are scrambling to grab some of them right back with tax increases and a plethora of user fees and other levies designed to fill their bare coffers. States are in a fiscal bind partly because they raised their budgets in the 1990s to meet rising social needs, then saw revenue plummet. Most tie their income tax to the federal Internal Revenue Service filings. The combination of declining taxpayer income, new federal breaks, and often ill-advised state tax cuts caused a slash in revenue.
Facing yawning budget gaps--totaling about $200 billion over the past three years--state legislatures are trying to ease the revenue squeeze by disconnecting their tax rules from the federal system. That can mean denying on state individual and business returns the federal favors that Washington is bestowing on stock dividends, inherited estates, capital gains, and deductions.
Overall, 18 states imposed major tax increases last year that are expected to raise $6.2 billion for fiscal 2004, according to the Nelson A. Rockefeller Institute of Government in Albany, N.Y. That's on top of boosts of nearly $6 billion that 15 states enacted in 2002. This is the heaviest round of increases since hikes during the recession of the early 1990s. In 2001, only six states hiked taxes; during the three years before that, it was mostly tax cuts.
Printing press. All states except Vermont have laws that generally call for a balanced budget, but there's another big difference between state capitals and Washington. "Unlike the federal government, the states cannot print money," says Nicholas Jenny, a senior policy analyst at the Rockefeller Institute. So states have been raising taxes, limiting deductions, borrowing money, cutting spending, and engaging in tactics such as speeding up collections and tapping "rainy day" funds.
Indiana has often gone along with federal changes. "Every time we make a modification from federal rules, we have to add another line to our tax form," notes Tom Conley, the state's administrator of tax policy. But federal enactment last year of a 50 percent bonus on depreciation allowances for business equipment is too hard to swallow. The state legislature previously did not go along with a 30 percent federal bonus--which could have cost Indiana $180 million a year--and is now preparing to block the new amount. Many states had blocked the earlier depreciation bonus, and only about 15 are allowing the new, bigger write-off. Arizona Gov. Janet Napolitano unveiled a "no tax increase" state budget this month, but businesses will nevertheless have to adjust their state returns to count as taxable income the bonus depreciation they claim on their federal returns.
New York accountant Mark Plostock, who lectures on state and local taxes, notes that despite new low federal tax rates for dividends and capital gains, his state--home to Wall Street--still treats dividends and capital gains as fully taxed regular income. "Many people only hear sound bites about federal reductions," he says. Few states allow lower capital-gains rates--and even those are often limited--and the feds are mostly alone in favoring dividends.
Many states are galled by the hit they will take because of the federal decision to phase out the estate tax by 2010 and end after this year a tax credit that diverts a share of estate tax to states. At least 18 states are divorcing their estate-tax setups from the federal levy in order to make up the loss. In West Virginia, which faces a $120 million budget shortfall, Gov. Bob Wise has proposed a replacement state levy that could bring in $60 million over the next five years.
New York, Oregon, Connecticut, and Arkansas went against the federal grain last year by increasing personal income tax rates. New York legislators, overriding a veto by Gov. George Pataki, boosted the state's top rate from 6.85 percent to 7.7 percent, which is expected to raise $1.4 billion this year. Arkansas hopes to raise $56 million a year with a 3 percent three-year surcharge.
No smoking. Also on the upswing are sales taxes, fees, corporate levies, and assorted taxes for such things as hotel rooms, entertainment, and motor fuel. A 1 percentage-point hike in their sales taxes is expected to raise $165 million in fiscal 2004 for Idaho, $29 million for Vermont, and $1.3 billion for Ohio. Smokers are also paying more. Georgia, for example, has more than tripled its cigarette tax to 37 cents a pack, and New Jersey upped its tax from $1.50 a pack to $2.05. Even Delaware, known as corporate headquarters-friendly, was forced to increase its business franchise tax. According to a survey by the National Conference of State Legislatures, the total of fee boosts last year was three times the increase in 2002, which itself was more than double the amount in 2001.
While most of the federal tax cuts are scheduled to expire unless extended, many state boosts are also supposed to be temporary and last only two or three years. That means new strains could be coming. While state revenues are showing signs of picking up as the economy improves, and there are proposals in some states to roll back tax hikes, budget deficits still loom. Iris Lav, deputy director of Washington's Center on Budget and Policy Priorities, says that after increased borrowing and implementing stopgap measures, states may find it difficult to "go cold turkey" without those supports. Gov. Dirk Kempthorne of Idaho, whose temporary sales tax boost expires next year, is warning residents now to expect fiscal belt tightening. Ohio's Office of Budget and Management says a proposal to end that state's sales tax increase six months early could set the state back $800 million. Marty Stephens, speaker of the Utah House and president of the state legislatures group, sees "some rays of sunshine on the horizon" but acknowledges that "when government puts on a temporary tax, it sometimes becomes permanent."
Raiding your pocket
A growing number of states are raising billions of dollars through tax hikes.
The number of states that increased taxes...
2000 2
2001 6
2002 15
2003 18
...and the amounts they raised (in billions)
2000 $0.26
2001 $1.83
2002 $5.96
2003 $6.17
Source: Nelson A. Rockefeller Institute of Government
USN&WR
This story appears in the February 2, 2004 print edition of U.S. News & World Report.