Federal tax increases could trigger higher state tax liabilities.
WASHINGTON - As lawmakers seek an elusive deal to avert the federal government's fiscal cliff, some taxpayers in Minnesota and other states could face another bump at the bottom of the cliff: a bigger state tax bill.
Minnesota is one of at least two dozen states where scheduled federal tax increases could trigger higher state tax liabilities as well -- an effect that would produce more state tax revenue even as Washington cuts back on grants and other forms of federal spending.
But researchers from the Pew Charitable Trusts, which issued the findings in a report on Thursday, warn that any additional state revenues would likely be short-lived as the recessionary effects of higher taxes and lower spending take their toll on businesses, consumers and taxpayers.
"If the country were to go over the fiscal cliff, the Congressional Budget Office has projected a general economic slowdown, and that would overwhelm the effects of any of the separate [tax] components we analyzed," said Anne Stauffer, project coordinator for the Pew Center on the States. "These changes would have automatic effects, and states are going to have to decide how to respond."
Much of the debate over the tax-law changes looming in January has centered on Congress, but the new report details how the linkage between federal and state tax rules could grip many taxpayers in a double-bind.
For example, certain federal tax breaks such as the earned-income tax credit and the child and dependent care credit are linked to existing Minnesota write-offs as well. If Congress reaches no agreement by Dec. 31, the result could be increased taxable income on federal and state returns.
"A lot of people think 'fiscal cliff,' and they're thinking the Bush tax cuts for the rich," said Joseph Henchman, vice president for state projects at the Tax Foundation. "But there are a lot of other components beyond just that."
The hit to Minnesota taxpayers is not lost on the state's congressional delegation.
"The last thing Minnesota families need in these tough economic times is an increased tax burden at both the state and federal level," said Minnesota Republican Michele Bachmann, a former IRS attorney.
Sen. Amy Klobuchar, a Democrat starting her second term, called the Pew report "another example of why it's so important for Democrats and Republicans to work together on a bipartisan solution."
Said Minnesota Republican Erik Paulsen, a member of the tax-writing Ways and Means Committee: "Our nation is heading towards a fiscal cliff that will have enormous implications on all levels of our economy and government."
State budget questions
While President Obama meets with congressional leaders at the White House Friday, state budget officials are coming to grips with the implications of across-the-board federal spending cuts and tax increases.
Minnesota's state economist, Tom Stinson, said his staff faces increasing uncertainty as it prepares revenue forecasts for the coming year. One big concern is a possible increase in the federal tax rate on capital gains, which could prompt investors to cash out their investments before the end of 2012. While that would produce an immediate windfall for state and federal treasuries, he said, "it takes money out of the future."
The same is true for added state revenues from changes in certain personal and business exemptions. All those tax rules affect the larger economic climate, Stinson said, which could depress future state revenues.
"If we go over the fiscal cliff, it's not going to be a linear thing," he said. "It's going to disrupt confidence -- consumer confidence as well as business confidence."
Paul Wilson, research director at the Minnesota Department of Revenue, downplayed any direct impact on state revenues, saying that most of the tax code changes tied to the fiscal cliff have no automatic effect on the state's income tax, or have been counted in state revenue forecasts.
The Pew report suggests that the general drag on Minnesota's economy might be worse than the direct effects of spending cuts and higher taxes. Federal spending on procurement, contracts and salaries, for example, is only 1.8 percent of Minnesota's gross domestic product, making the state less vulnerable to government spending cuts than states such as Alaska, Hawaii and Virginia, which benefit from large defense outlays.
Moreover, federal grants in education, housing, nutrition and other areas of domestic spending subject to the fiscal cliff's automatic cuts make up only 5 percent of Minnesota's state government revenues; that's lower than the national average of 6.6 percent.
The Pew report's calculations are based on a worst-case scenario: Obama and congressional Republicans remain deadlocked over raising taxes on the wealthy, and automatic tax hikes and spending cuts, negotiated as part of the 2011 debt crisis, kick into place for everyone.
Federal tax hikes
The Tax Foundation calculates that the complete expiration of the Bush tax cuts would result in an average increase of $2,883 in 2013 for federal taxpayers in Minnesota.
Obama's plan to raise taxes only on those making more than $250,000 would narrow the impact significantly. According to the IRS, Minnesotans filed 78,933 tax returns in 2010 reporting adjustable gross income $200,000 or more, putting those taxpayers close to or above the Obama threshold in 2013.
About the same number could be hit by a once-obscure tax provision called the Alternative Minimum Tax (AMT).
It was originally created to keep the wealthy from using loopholes to escape taxes altogether, but now touches millions of households farther down the income ladder.
Raising this year's AMT threshold before Jan. 1 is considered a top bipartisan priority in Congress, even as some lawmakers consider delaying a grand bargain on the rest of the budget.
Going forward, state analysts say the biggest stakes in the fiscal cliff debate come down to taxes. They reason that, given the nation's $16 trillion debt, spending cuts are inevitable, with or without a budget deal.
Said Stinson: "It's the tax part of the fiscal cliff that's going to have the biggest impact."
Kevin Diaz is a correspondent in the Star Tribune Washington Bureau.