The federal tax-overhaul package moving toward final passage in Congress could turn out to be a major fiscal windfall for state governments -- and a political Pandora's box for state candidates this fall.
Of the 43 states that have a state income tax, nearly all have "coupled" their tax laws to the federal income tax in such a way that tax revision will lead to an automatic increase in state personal income taxes.
That is because the federal overhaul plans eliminate many deductions, producing much higher levels of taxable income. Because federal tax rates would be slashed, many Americans would still end up paying less to the federal government. But on the state level, tax rates would not drop and in many states would still be applied to the now-higher federal taxable income figure.
Thanks to this "mirror image" aspect of state tax laws, the coming federal tax cut could bring in hundreds of millions of dollars in extra revenue for state treasuries -- a particularly welcome result in states that are hurting because of the energy bust and reductions in federal assistance.
But the windfall for states will come at the expense of individual taxpayers.
Although there are no firm estimates of the impact, a possible scenario in several states is that a family getting, for example, a $500 cut in federal taxes as a result of tax overhaul might face a simultaneous increase of about $200 in state taxes. In that case, 40 percent of the savings on Form 1040 could disappear when the family fills out its state tax form.
For candidates in this year's 36 gubernatorial races, these possibilities pose ticklish questions. On one hand, federal tax revision essentially gives state governments a "free" tax hike -- higher revenues without changing tax laws. On the other, state politicians could face voter wrath if they are perceived as stealing part of taxpayers' savings from federal tax overhaul.
Some governors, including Mario M. Cuomo (D) of New York and James J. Blanchard (D) of Michigan, have promised to return the "windfall" to taxpayers by lowering state rates. Others, including Richard D. Lamm (D) of Colorado, say that states should use the money to meet "critical unmet needs" in education, welfare and other areas where Washington's spending has been frozen or cut.
This dilemma has emerged as an issue in the hotly contested race for governor of Ohio, where former Republican governor James Rhodes is challenging Democratic incumbent Richard F. Celeste.
Celeste, noting that it is not easy to predict the precise impact of the federal change, has proposed holding any increased state revenues in an escrow account, with disposition of the money dependent on future economic developments.
Rhodes, in contrast, imported Senate Majority Leader Robert J. Dole (R-Kan.) for a news conference on the question earlier this month. Rhodes pledged that any "windfall" to the state would be immediately returned by cutting state tax rates.
"We never intended that there be a windfall to the states," Dole said. He said that any increase in state revenues should be "passed on to state taxpayers."
Whatever the congressional tax writers might have intended, various state and national studies agree that the federal tax-overhaul plan will lead automatically to tax increases in more than half the states.
At its core, the federal personal income tax revision involves a trade-off: Taxpayers have fewer deductions to shelter income against taxation, but in return the government imposes a lower tax rate.
Most states have what fiscal officers call a "deduction-coupling" income tax, which allows many of the same deductions the federal tax code permits. But few states have a "rate-coupling" system. Instead, most have their own tax rate structure. Thus, state rates do not automatically fall when federal tax rates are cut.
At the state level, federal tax overhaul means taxpayers will lose their deductions -- but will not get an offsetting reduction in rates.
Many state revenue officers cite a preliminary study of the impact of the House version of federal tax overhaul performed for the Advisory Commission on Intergovernmental Relations by the Policy Economics Group, a Washington-based consulting firm.
That report, a rough estimate subject to change, said that 12 states would see automatic tax increases of 5 percent or more. Another 14 would realize smaller automatic increases.
The study said seven states -- mainly those that assess their state income tax as a percentage of an individual's federal tax payment -- would lose money under the House bill.
The remaining states and the District of Columbia would see little or no impact.
The biggest gainer, according to the advisory commission report, would be Louisiana, followed by Utah, Montana and Missouri. The commission said Louisiana would get an "automatic" revenue hike of 21 percent. According to data from the Louisiana department of revenue, that would mean about $101 million more in state personal income tax payments next year.
States that would lose the most tax income are Rhode Island, Nebraska and Vermont, which base their tax on a fixed share of federal tax liability, and North Dakota, which ties its tax to federal tax liability and federal taxable income.
All estimates of the state "windfall" are preliminary. The impact on state revenues will depend on the shape of the final tax package that emerges from Congress and on economic conditions.
If Congress meets its schedule and produces a final tax plan by early fall, the "windfall" issue will likely heat up and become a major concern in state political races.
And when state legislatures convene next January, predicts Steven Gold of the National Conference of State Legislatures, "the response to federal tax reform will be one of the top fiscal issues facing legislators in 1987."
The legislatures' conference will discuss the question at its annual meeting next month, and some states are already studying what to do with their extra money. In Missouri, a legislative committee is touring the state, asking citizens what they want the state government to do with its tax-overhaul windfall.
But in many states, politicians and revenue officers are taking a wary stance, refusing to believe that anything coming out of Congress could produce a windfall for state treasuries.
"This is really not something you want to plan on," said Earl Morris, comptroller general of South Carolina. Even if tax overhaul leads to lower federal taxes at first, he said, "You just watch -- in two or three years they'll have the federal tax back up again."
Staff researcher Susan Kelleher contributed to this report.