And Now, Son of Tax Reform

By George Russell

Taxpayers have scrambled for months to batten down for the new federal income tax era that finally began on Jan. 1. For those who thought the tax frenzy would finally die down -- surprise! They may soon discover that even as their federal tax rates fall, they will have to pay a bigger bite of their income than before to their state. This paradox is the direct result of federal tax reform, whose provisions will, unless modified by state governments, trigger billions of dollars in additional state taxes. What to do with the windfall is already causing consternation and debate in state legislatures across the country. Predicts Bob Griffin, speaker of the Missouri House of Representatives: "This will be the hottest issue we've dealt with in a number of years."

The federal reform is expected to have an impact on most of the 43 states (plus the District of Columbia) that levy some form of personal income tax. * The added state taxes will result from the common practice among state authorities of using federal tax rules -- including deduction guidelines -- as the basis for their own calculations, even while setting state tax rates independently of Washington. By eliminating deductions for, among other things, consumer interest payments and contributions to individual retirement accounts, federal tax reform will thus substantially increase the amount

of income exposed to both a federal and a state tax bite.

But while the reform sharply lowers federal tax rates, most states have not yet made comparable cuts in their own rates. Without such cuts, an estimated 32 state legislatures will now stand to scoop up bigger wads of money. To some wary taxpayer organizations, that result looks a lot like unwarranted additional taxation. The states with the largest projected revenue increases in percentage terms include Colorado (22%), Montana (20%) and Kentucky (14%).

In a number of states the reform will actually produce a decline in personal tax revenues. In some cases that will happen because state tax rates are based on the lower amount of U.S. income taxes that people will pay under tax reform, rather than on taxable income. States with the biggest potential tax declines include Rhode Island (-1%), North Dakota (-10%) and Nebraska (-9%).

Politicians in the states that will gain revenue are squirming over what to do with their potential embarrassment of riches. A few have taken action. In Ohio, Democratic Governor Richard Celeste has signed laws that will reduce the average state taxpayer's income taxes by 7% this year and an additional 1% in 1988. In New York, Democratic Governor Mario Cuomo promised as far back as last spring to return any windfall money to taxpayers. At a special session of the state legislature in December, he offered to cut the state capital gains rate from 13% to 9%. Following the Reagan Administration's lead, Cuomo also proposed to eliminate state income taxes for more than 500,000 truly needy New Yorkers. Republican legislators want an additional cut in the state's income tax rate. So far, the two sides remain at loggerheads.

The windfall issue will crop up often as other newly elected legislatures convene this month. Wisconsin's Republican Governor-elect Tommy Thompson has pledged to reduce state income taxes by 5% and reduce the state inheritance tax. In Missouri, Republican Governor John Ashcroft wants to enact a $100 ) million tax cut, which Democratic Leader Griffin opposes, even though it is, he admits, a "politically popular" idea.

In fact, keeping the money is what several states are tempted to do. In Louisiana, legislators met last month to consider how to deal with a budget deficit estimated this year at $125 million. Giving back a tax windfall of $60 million was not on their minds; giving the executive branch more power to cut budgets was. Minnesota's Democratic Governor Rudy Perpich campaigned on a promise of no tax hikes, but he now expects an $813 million budgetary shortfall. The $719 million that his state expects from tax reform over the next 2 1/2 years would come in handy. Taxpayer lobbies, though, are squawking.

Other Governors face the same dilemma. They must weigh the advantages of extra tax money against the political costs of public resentment.

FOOTNOTE: * States without any personal income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming.

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CREDIT: TIME Map by Joe Lertola

[TMFONT 1 d #666666 d {Source: State tax officials and U.S. Advisory Commission and Intergovernmental Relations}]CAPTION: Estimated % change from 1986 in a state personal income tax revenue resulting from federal tax reform

DESCRIPTION: Color illustration: Map of U.S. showing estimated percentage change from 1986 in personal income tax revenue resulting from federal tax reform.

With reporting by Melissa Ludtke/Boston and Harry Kelly/Chicago