Linked Income Levies to Rise : Revision of Federal Taxes Sets Up Bonanza for States

In an unintended but major consequence of the sweeping overhaul of federal taxes, state treasuries across the nation can expect windfall gains of billions of dollars in added revenues--and a host of tricky fiscal decisions.

Most states automatically couple their income taxes to the federal definition of taxable income. Others, including California, usually legislate the necessary adjustments, and the California Assembly already has passed a bill, now pending in the state Senate, that would bring the state into line with the federal changes.

Because federal taxable income will rise next year with the elimination of many tax deductions, these states are in line for increased income tax revenue of as much as 20% unless they scramble to reduce their tax rates. In California, for example, Gov. George Deukmejian is on record as opposed to any tax increase.

Adjustments ‘Forced’

From California to New York, predicted Gerald Miller, executive director of the National Assn. of State Budget Officers, most states “will be forced politically and practically into opening up their tax laws and adjusting to the new situation.”

And apart from the threat of sudden state income tax increases, many states are confronting increased costs as a result of the federal tax bill.

The massive bill, which cleared a House-Senate conference committee Saturday and faces almost certain approval by both houses of Congress, eliminates the federal deduction for state and local sales taxes, which are the main source of revenue in many jurisdictions. Consequently, state governments are expected to feel pressure from taxpayers to reduce sales tax rates and to raise more revenues from income and property taxes, which remain deductible on the federal tax form.

Bond Restrictions

State and local governments also will have to gauge the additional costs posed by the tax plan’s stringent new restrictions on the issuance of tax-exempt bonds. Interest on bonds to finance such private projects as sports arenas and industrial parks no longer will be tax exempt, and bonds for public purposes such as airports, wharves, water plants and student loans will be limited.

Moreover, governments will probably have to pay higher interest rates on new bond issues that continue to carry tax-exempt status. That is because the tax bill, by reducing personal tax rates, could make tax-exempt bonds less attractive to buyers because they will provide a smaller tax break. Although interest rates on tax-free municipal bonds fell on Wall Street this week, they remained unusually high contrasted with rates on taxable bonds.

The National Governors’ Assn. estimates that nationwide, the number of tax-exempt bond issues will fall by as much as 50% under the tough new rules and that states and local governments will have to pay as much as 1.5 percentage points more on each new issue than they would have without the tax bill.

Juggling Revenue Sources

The precise impact of these changes remains unclear. But what is certain is that no state will be untouched by it and many will find themselves juggling revenue sources.

Increase in Taxes

“To the extent that the new law broadens the base, most states will be collecting more--some, much more--if they don’t lower their rates or increase their exemptions,” said Gillian Spooner of the Touche Ross & Co. accounting firm. “Many individuals could end up with an aggregate increase in the taxes they pay, even if they pay lower federal taxes.”

Accordingly, Spooner said, “we can expect many states to respond in a couple of years, and there will likely be great pressure on them to respond. But in the near term, they will get a windfall.”

They will, that is, unless state politicians take the opportunity to provide their citizens with an income tax “cut”--actually, a reduction in tax rates to offset the coming increase in taxable income. Action is already under way in some states, including New York, where Gov. Mario M. Cuomo has pledged to cut taxes.

Windfalls for Seven

According to a preliminary study of the tax overhaul bill by Miller, seven states can expect income-tax revenue windfalls of about 20% if they do not reduce their income tax rates in the next year or so. These are Louisiana, Missouri, Oklahoma, Utah, Colorado, Montana and Kansas.

Big Gainers

Other big gainers are New York, up about 10%, or slightly more than $1.5 billion, and California, up about 8%, or $1 billion.

On the other hand, Miller said, four states couple their income taxes to a percentage of federal taxes paid. Since the tax overhaul bill would cut personal taxes by $120 billion over five years, those states--Nebraska, North Dakota, Rhode Island and Vermont--will lose revenue if they do not raise rates.

A different and perhaps even tougher predicament faces the seven states--Nevada, Texas, Florida, South Dakota, Wyoming, Washington and Alaska--that have no income tax.

Sales, Property Taxes

Because they rely on sales and property taxes and other forms of revenue, they will get no windfall from the new federal tax plan, and their residents will not be able to reduce their federal taxes by using the sales tax deduction.

Nevada and Washington derive more than 60% of all revenues from sales taxes, and their taxpayers claim hefty sales tax deductions on their federal returns. Only four states--Delaware, New Hampshire, Montana and Oregon--levy no sales tax, but municipalities there have traditionally used it as a means of generating revenue.

Spooner said the public, upset by the loss of their federal tax deduction for sales tax payments, will put mounting political pressure on state and municipal governments to reduce their reliance on sales taxes.

“States have always used the sales tax as a steady income source,” she said, “and they will have to look very carefully at that source in the future.”