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Onerous New State Tax Rules

Oregon shed its fierce anti-tax reputation last month by doing something rarely seen — it voted for higher taxes. Facing a budget deficit of more than $700 million, Oregonians passed two proposals that tied them with Hawaii for the highest personal income tax rate in the nation and gave them the highest capital gains tax and corporate minimum tax.

Oregon’s plight was not unique, although most states have not left the solution to a vote. High unemployment and cautious consumer spending have hurt state tax revenues. Through the third quarter of 2009, states’ year-over-year tax revenue, adjusted for inflation, was down an estimated 12.5 percent. This compares with 1.4 percent growth a year ago. Ultimately, states have two unpopular tools to fix the resulting unbalanced budgets: cut spending and increase taxes. Most states have done a bit of both, although with about a third of revenues coming from the income tax, many states have focused their efforts on squeezing more out of their residents, especially those in the upper brackets.

In some cases, the changes have been straightforward increases in tax rates. For example, New Jersey increased rates for its three highest brackets for 2009. Now, those earning more than $400,000 in the Garden State will pay an 8 percent income tax, up from 6.97 percent in 2008. Those who earn more than $500,000 will pay 10.25 percent, and those earning more than $1,000,000 will pay 10.75 percent in income tax. However, the Legislature intends the increases to be a one-year patch and expects to drop the rates back in 2010. (I will let you take that with as much salt as you choose.)

New York, which already had comparatively high tax rates, created two new tax brackets with higher rates. The brackets depend on filing status, but a joint taxpayer with an adjusted income of more than $300,000 faces a 7.85 percent rate, which increases to 8.97 percent if one earns more than $500,000. In 2008, New York taxpayers paid only 6.85 percent on income over $150,000. Like New Jersey, these rate increases are supposedly temporary and have a 2012 expiration date.

Rounding out the tri-state area, Connecticut also increased its income tax rates, but residents of the Constitution State will hit a 6.5 percent tax bracket only after earning $1,000,000.

Everyone knows of California’s budget woes. Strapped for cash, California resorted to issuing IOUs to cover its funding gaps in 2009, and CNBC ranked the state ninth on its “Government Debt Issuers Most Likely to Default” list. California increased rates on all tax brackets by 0.25 percent, not on just the highest brackets. Furthermore, California’s brackets were adjusted downward in 2009 to account for deflation. The highest bracket for joint filers now starts at $92,698, instead of $94,110, and has a rate of 9.55 percent.

California also accelerated payment of estimated taxes to bring revenues in more quickly. Those whose income tax liabilities are not covered by withholding from their paychecks must make payments to the state to cover their estimated liabilities. Previously, one would pay California estimated taxes in equal quarterly installments. In 2009, California required that the first- and second-quarter payments each equal 30 percent of the taxpayer’s estimated liability. The remaining 40 percent was split into equal payments due in the third and fourth quarters. For 2010 and beyond, California requires 30 percent of the liability in the first quarter, 40 percent in the second quarter, nothing in the third quarter and the final 30 percent in the fourth quarter. Unless the taxpayer earns 70 percent of her income in the first half of the year, California is effectively taking a loan from her. The state gets its cut before the income may even be earned.

Some states have also made less conspicuous changes to the tax laws that effectively increase revenue without increasing the actual rates. For example, Vermont allowed taxpayers to exclude from their incomes the lesser of 40 percent of their net long-term capital gains or 40 percent of their federal taxable income. This will still hold for gains occurring in the first half of 2009; however, for the second half and after, the exclusion is the smaller of the entire net long-term capital gains for that period or $2,500. For example, if you incurred a $50,000 long-term capital gain in March 2009, you could exclude $20,000. But, if you incurred that gain in October, your exclusion is capped at $2,500. Vermont can now tax you on an additional $17,500 of income.

In fairness, Vermont slightly decreased its income tax rates in 2009. The rate for the highest bracket dropped all of 0.10 percent to 9.40 percent. The taxpayer in the above example will still pay more on the capital gain now than under the old rates and rules.

Another method states use to increase taxable income is to limit or eliminate deductions. Itemized deductions for New Yorkers with adjusted gross incomes over $1,000,000 are now limited to 50 percent of the federal itemized deduction for charitable contributions. All other itemized deductions are reduced to zero. New Jersey, which is known for its high property tax rates, will now limit its deduction for property taxes, and taxpayers with income of more than $250,000 will no longer be able to deduct them at all.

Some states have also enacted new taxes to cover their budget shortfalls. For example, New York has instituted the Metropolitan Commuter Transportation Mobility Tax (MCTMT). This tax affects employers and self-employed individuals in the five boroughs of New York and outlying counties, including Westchester, where Palisades Hudson’s Scarsdale office is located. The tax rate is a low 0.34 percent but, as those required to pay it can attest, the MCTMT adds up quickly. Revenues are earmarked to support the struggling Metropolitan Transportation Authority, which has already had to raise fares and cut service as a result of its lack of funding.

So far, the states’ tax adjustments appear to be working. Tax changes increased state revenue by an estimated $4.1 billion in the third quarter of 2009 compared with 2008. California’s changes increased personal income tax and sales tax by an estimated $1.1 billion, and New York’s by $1 billion. Oregon and other states’ new tax increases will likely help bridge their budget gaps, at least for now.

In the long run, taxpayers are mobile. They can choose to uproot in favor of lower taxes. States must be careful how far they push taxpayers. On the other hand, cutting essential services, such as education, is not likely to please citizens, either. The pursuit of a balanced budget is, indeed, a balancing act.

If you enjoyed this article, be sure to check out Palisades Hudson’s book, Looking Ahead: Life, Family, Wealth and Business After 55, now available in paperback and as an e-book.

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