Link to special CCH Tax Briefings on key topics from 2003:
 

• Year-End Tax Legislation Update (Dec. 10)
• Corporate Income Tax and 'Bonus' Depreciation
  (Dec. 4)
• Military Family Tax Relief Act (Nov. 11)
• Jobs and Growth Tax Relief Reconciliation Act of 2003 (May 28)

CCH can assist you with stories, including interviews with CCH subject experts. Also, the CCH Whole Ball of Tax 2004 is available in print. Please contact:
 
Leslie Bonacum
(847) 267-7153
mediahelp@cch.com
 
Neil Allen
(847) 267-2179
allenn@cch.com

States Struggle to Increase Revenues, Not Tax Rates

(RIVERWOODS, ILL., January 2004) – Taxpayers can file their federal Form 1040s this year with little fear that the tax benefits bestowed through recent federal tax cuts will be taken back by state tax authorities, according to CCH INCORPORATED (CCH), a leading provider of tax law information and software. But while the vast majority of states are not raising individual income tax rates, they also are not rushing to match the cuts contained in recent federal laws. The result is an ever-greater disconnect between state and federal income taxes and a variety of efforts by the states to plug budget holes through other tax measures.

While the federal government can hand out tax cuts that create or deepen deficits when the economy is in decline, state governments are bound usually by their constitutions, to pretty much balance their budgets, according to John Logan, an attorney and state tax analyst with CCH.

"States can’t print their own money, and since investors have little interest in buying the bonds of a bankrupt state, state legislatures and governors have to come up with some way of matching income with expenditures," Logan said.

The bursting of the stock market bubble of the late 1990s, a recession and a slow, mostly "jobless" recovery have all taken a toll on state finances.

Over the last few years, state governments have resorted to a variety of temporary solutions while hoping that sales tax and individual income tax receipts – their major sources of revenue – will once again rise with a recovering economy.

"Decoupling" Preserves Revenue

One tactic states use is to hold on to revenue that would otherwise be lost if the state followed federal tax trends too closely. While most state income tax systems are based to some extent on the federal system, states can use a variety of methods to decouple from the federal model when it suits their purposes. Beginning with cuts made in 2001 at the federal level, states have increasingly decoupled their systems to keep their revenues from plunging further.

Many states have recast their estate and inheritance tax laws, because otherwise the revenues from these sources would shrink to zero in the coming years. Under legislation passed in May 2001, states will get a smaller and smaller slice of the federal estate tax, and the federal tax itself will be phased out, year by year. To make up for this, many states have decoupled from current federal law, tying their estate taxes to the law as it existed at the beginning of 2001 or enacting new taxes that operate independently of federal law.

In 2002 and again in 2003, federal law offered businesses the opportunity to take "bonus" depreciation on qualifying equipment they placed into service between certain dates.

Of the 47 jurisdictions with a corporate income tax, only 12 states completely follow the federal rule on bonus depreciation; the remaining 35 states and the District of Columbia either don’t conform at all or modify it in some way.

Cuts made in 2003 to the federal taxation of capital gains and dividends don’t directly translate into state tax cuts, and no states have changed their laws to match the federal cuts on these categories of income.

"Some years ago, the trend was for federal and state taxes to be more similar. Now, the trend is for different rules to apply to individual and corporate income at the federal and state levels. One consequence, of course, is that taxes become more difficult for the average person to understand," Logan said.

One-time Remedies and Sin Taxes

A number of one-time remedies have already been tried. States that set aside rainy-day funds in the 1990s have spent them. Money from the cigarette settlement has been anticipated and spent. Temporary sales and income tax increases due to expire in 2003 have been kept in place.

Tax amnesties have been declared in many states to bring back taxes out of hiding in exchange for forgiveness of penalties. Arizona, Colorado, Florida, Illinois, Kansas, Kentucky, Maine, Massachusetts, Michigan, Missouri, Nevada, New Hampshire, New Mexico, New York, North Dakota, Ohio, Oklahoma, South Carolina and Virginia have all concluded wide-ranging amnesty programs within the last two years. Some have been extremely successful, such as the program in Illinois, which brought in over $500 million.

"The problem with amnesties is that they can’t be repeated too frequently," Logan noted. "If they’re successful, they bring in most of the money that the states are likely to collect. If they’re declared too frequently, taxpayers may figure, ‘why bother to pay on time?’"

Imposition of "sin" taxes is a route to increased revenues that brings little opposition from the general public. Arkansas, Connecticut, Delaware, the District of Columbia, Georgia, Hawaii, Idaho, Kansas, Montana, Nevada, New Jersey, New Mexico, Rhode Island, South Dakota, Vermont and Wyoming all increased their cigarette taxes in 2003. Pennsylvania increased its tax effective January 7, 2004 and Hawaii has an additional increase already slated for July 1 of this year.

"Add-backs" and Shelters

Corporations are an increasingly tempting target for state legislatures and tax administrators. Corporations that operate and are taxed in many states often structure transactions so that certain items, such as interest and royalty income, are assigned to states that tax them lightly or not at all. Following the lead of New Jersey, an increasing number of states are looking into legislation that will add back a portion of this income to their jurisdictions so they can increase their take of corporate taxes.

Also attracting attention are various tax "shelters" used by corporations, pass-through entities and wealthy individuals. As the IRS identifies such shelters as abusive for federal tax purposes, state administrators can be expected to follow through with collection at the state level.

"These tactics are attractive because they are targeted at corporations and individuals who have lots of resources and who are seen as not paying their fair share," Logan said. "This is much more palatable than measures that affect corporations and individuals across the board."

Taxing E-commerce on the Horizon

Shimmering on the horizon are measures that would allow states to collect use taxes that they currently lose when their residents purchase goods through mail-order catalogs or over the Internet. That loss has been estimated at over $13 billion for 2001 alone, nearly $440 billion for the period 2001 through 2011.

A number of states have joined in a Streamlined Sales Tax Project to harmonize their sales and use tax laws with an eye to one day recovering these losses. They want to ensure, for example, that residents of Kansas City, Kan., are charged the correct city, county and state use taxes on all their Internet purchases, no matter where the companies that they purchase from are located. Thirty-eight states are participating in the project, and 20 have actually adopted conforming laws, so that they agree on certain basic definitions of what is taxable and what isn’t – which can turn on questions such as whether orange juice is a "fruit" or "beverage."

The project will simplify matters for the states and, importantly, for businesses, and it is hoped that more e-commerce merchants will collect use tax voluntarily.

The problem with the project, as far as the states’ immediate budget woes are concerned, however, is that it will not produce any results for a number of years. What’s more, without congressional action, the states must depend on voluntary collection by businesses.

"For the states to be assured that they will benefit from e-commerce transactions as they do from brick-and-mortar stores, Congress must grant the states the power to collect use taxes remotely," Logan noted. "That’s not a slam-dunk, and certainly not in an election year."

Biting the Bullet

The big question for 2004 is whether states will be able to squeak by on a combination of increased revenues from the nascent recovery and the patchwork of measures that have tided them over thus far. If not, they may have to do what has so far proven to be unpalatable and raise taxes generally.

In 2003, only Pennsylvania enacted an across-the-board income tax increase, at the very end of the year. New York and New York City raised the top tax bracket, and such an increase was proposed, but not enacted, in California.

"Raising the top rate is attractive to many legislators because it affects relatively few people, but can raise a significant amount of money," Logan observed.

Legislatures may find it difficult to act even on such a simple measure, however. This is an election year, and elected officials will be wary of voting for any sort of tax increase. In addition, many states will have a shortened legislative session, making it more difficult to negotiate and pass bills.

"In many states, people will be keeping their fingers crossed that the recovery fills the treasury a lot quicker than it has so far," Logan said. "Otherwise, look for some special sessions and tough issues later this year."

About CCH INCORPORATED

CCH INCORPORATED, headquartered in Riverwoods, Ill., was founded in 1913 and has served more than four generations of business professionals and their clients. The company produces more than 700 electronic and print products for the tax, accounting, legal, securities and small business markets. CCH is a Wolters Kluwer company. The CCH Federal and State Tax group, CCH Tax Compliance and Aspen Publishers Tax and Accounting group comprise the new Wolters Kluwer Tax and Accounting unit. The unit’s web site can be accessed at tax.cchgroup.com.

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