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What's
the State of Your State?
The division of power between state and federal governments has never been a clean
one. State powers have ebbed and flowed over the course of history in response
to political climates and public opinion.
One power
that state and federal governments have long shared is the ability to levy
taxes. That’s why you may file two tax returns: one to your state government
and one to the federal government.
Lately, state and federal tax policies have begun to conflict as efforts in
Washington to cut taxes have been resisted at the state level. Consider these
examples, which may already have begun to affect your financial situation.
Taxes and Tax Cuts
Although President Bush managed to get a tax cut through Congress in 2001 that
reduced federal income taxes, several cash-strapped states have indicated they
may raise their state income taxes. This could potentially offset benefits
taxpayers receive from the federal tax cut.
In 2002, at least 46 states were facing a combined budget shortfall of $58
billion for the coming fiscal year.1 Unlike the
federal government, most states are required to balance their budgets every year
or every two years.
Reasons
for state budget deficits range from rapid spending growth in the 1990s to
plunging tax revenues in the 2000s. So far, only a few states have introduced
new taxes, primarily on cigarettes. Most have spent reserves or borrowed against
tobacco settlement payments to balance their budgets.2
Unless the economy begins
to generate higher tax revenues for state governments, it’s likely that most
will resort to tax increases and spending cuts to cover the shortfall. One study
found that closing the $58 billion budget shortfall could cut gross domestic
product by 0.6 percent.3
Retirement Contributions
Another aspect of the 2001 tax law was increased contribution limits to
tax-favored retirement savings plans such as IRAs and 401(k) plans. Although
contributions to these programs are deductible from state and federal taxable
income, some states have yet to adopt the higher contribution limits (some
states don’t have laws requiring automatic conformity with federal law).
 What
that means to you depends on where you live. If you contribute the new higher
amount, some states may simply tax the difference at regular income tax rates.
Other states may assess a penalty against the contributor or even revoke the
plan’s tax-favored status, which could jeopardize tax breaks for individuals
who contributed to it.
Although only a handful of states are still out of sync with federal law, the
number stood at more than 20 in January 2002.4
Once a legislature passes a law to conform, plan providers must amend their
plans to allow the higher contribution limits. This could pinch the amount of
time retirement savers have to take advantage of the higher caps.
One bright spot is that all states are expected to conform eventually and allow
retirement plan contributions to be recorded retroactively on tax returns.5
In the meantime, taxpayers are left with confusion and uncertainty.
Estate Taxes
Even though provisions in the 2001 tax law designed to repeal the federal estate
tax are so far only temporary, at least 16 states and the District of Columbia
are severing the link between their state estate tax and the federal levy.6
Because most states assess their estate taxes as a percentage of the federal
estate tax, the federally scheduled phaseout will potentially cut revenue to
state coffers. More states are expected to keep their estate taxes intact.7
One danger is that heirs who manage to avoid federal estate taxes altogether may
not realize that an estate owes a state estate tax, which could result in
penalties and interest until the tax is paid.
The growing disparity between state and federal tax laws makes it tough for
people to comply. Taxpayers who attempt to do it without professional advice may
find they are in over their heads.
1–3) The Wall Street Journal, October 7, 2002
4, 5) mPowerCafe.com, April 4, 2002
6) The federal estate tax is scheduled to be repealed in 2010. However, unless
new legislation is passed, the repeal of the estate tax is subject to the
December 31, 2010, sunset provision of the 2001 tax act. This means that in
2011, federal estate tax law will revert to the pre-2002 law and federal estate
taxes will be reinstated.
7) The Wall Street Journal, August 1, 2002
©
2002 Emerald Publications
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