States' Sorry State Will Pinch Tax Breaks

Budget-crunched states may have to raise taxes, meaning the vaunted federal cuts could be offset.
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The checks are in the mail, but don't count your tax breaks before your state's plans are hatched.

This Friday, July 25, the Treasury will begin mailing checks to taxpayers who claimed the child tax credit for 2002. (The checks are an advance payment of the increased portion of the child tax credit for 2003.) Similarly, by now, most companies have adjusted the withholding amounts from your paycheck.

You're feeling richer already, I bet.

Sadly, though, that feeling is likely to be short-lived. Economists and tax analysts have long fretted that any benefit from federal tax breaks will be swallowed by the gaping maw of state budgetary woes. And now that states have finished their fiscal year as of June 30, the budgetary numbers certainly back that theory.

Unlike the federal government, states are required to balance their budgets (with the sole exception of Vermont). That means revenue

must

at least equal expenditures. And the fastest way to make that happen in times of dire straits? You guessed it: Raise taxes.

Now, state governments have done a remarkable job of avoiding raising income taxes. In fiscal 2003, 37 states were forced to reduce their already-enacted budgets by nearly $14.5 billion, according to the National Association of State Budget Officers (NASBO). That's the largest spending cut in the history of the association's 27-year-old fiscal survey.

In the early days of the recession, states initially attempted a "nip and tuck" approach to cutting their budgets. But in the year that ended June 30, 28 states used across-the-board cuts, 22 states spent the reserve funds they had built up in the heady days of the late 1990s, 17 states laid off employees, and 10 reorganized agencies and programs.

A variety of other measures were also employed by 29 states, such as refinancing state debt, hiring freezes, tobacco settlement securitization, deferred payments and fund transfers.

But now states are in a bind that would make even

MacGyver feel trapped. Even with the $10 billion Congress just grudgingly voted to disseminate to states, federal aid has been steadily shrinking -- states receive 20% of their budget from the federal government, down from 25% some 25 years ago.

The states are also facing increased costs foisted on them by federal dictum, such as rising cost of Medicaid and homeland security. A high rate of unemployment (last measured at 6.9%) means more spending (unemployment insurance) and a lower tax base (fewer people working and spending). And let's not forget the tax cut; 17 states have their income tax linked directly to federal forms. That means that if federal taxable income declines, so will state.

All of this adds up to big problems for 2004, including a projected combined shortfall of $80 billion, or about 15% of states' total budgets. "States are facing some very serious problems," says Keon Chi, a senior fellow at the Council of State Governments. "And now they are going to have to raise revenue by raising taxes."

Indeed, some 30 to 35 states have already begun raising taxes, although none have raised income tax. "States began by raising cigarette taxes and tacking on added fees for everything they could," says Greg Von Behren, a staff associate at NASBO. "But now they're running out of options and will have to look at broader taxes, like sales tax."

According to NASBO, 15 states have already proposed sales tax changes, for a net increase of $6.2 billion. (Woe to shoppers in California -- $4.4 billion of that amount will come from you.)

In earlier recessions, such as in 1981, 1986 and 1991, states raised income taxes in a pinch, lowering them again as soon as possible. But while states have remained steadfast in their attempt to find other solutions, they may not be able to for much longer. "Those recessions were very quick," Von Behren says. "This has been prolonged, and it's just not getting better. States are going to have fiscal problems through 2005."

Ten states will modify their personal income taxes, totaling $5 billion, according to NASBO.

The new federal tax law will save households with $75,000 to $100,000 of adjusted gross income about $1,700, according the Urban Institute-Brookings Institution Tax Policy Center. Households with adjusted gross income of $50,000 to $75,000 will save an average of $767 a year.

And you can use that money to pay for the higher state fees and taxes you're likely to face this year.