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Money and the Fed Effect

States are taking steps to protect their pocketbooks as Washington tax cuts take a toll on state revenue.

The $1.35 trillion tax cut President George W. Bush signed into law in June will have a direct and long-lasting impact on state revenue--and most of it will be in the loss column.

The most widespread effect will be from the repeal of the estate tax. Since the 1920s, the states have linked their own estate taxes to a tax credit in the federal code. But the federal tax cut phases out this credit by 2005, effectively eliminating the estate tax in 40 states and slashing it in the other 10. The total state losses could mount up to between $50 billion and $100 billion over a 10-year period, according to estimates by the National Governors' Association.

States will feel the pain of those revenue losses long before the feds do. "That is not the sort of federal partnership the governors association appreciates," Michigan Governor John Engler told a meeting of the U.S. Conference of Mayors in June.

Other federal tax changes threatened to put three states in a deeper fiscal hole. For years, North Dakota, Rhode Island and Vermont piggybacked directly off the federal income tax. In Rhode Island, for example, taxpayers paid the state 25 percent of whatever they owed the feds. Now, Rhode Islanders' federal income taxes will drop. By formula, state income taxes slump proportionally. This would cost state coffers $38 million this year, rising to $115 million by 2010.

To stem those kinds of losses, lawmakers in Rhode Island--and in similarly afflicted North Dakota--overhauled their income taxes to bring them into closer alignment with the tax-bracket and rate systems used by the majority of states that tax personal income. The change is not meant to create any new revenue for the states--only to make them less susceptible to Washington tax policy.

Vermont took a different tack. Taxpayers there will simply calculate their state income taxes as though the federal tax cut never happened.

The revenue impact on states is not all negative. In nine states-- Alabama, Iowa, Louisiana, Missouri, Montana, North Dakota, Oklahoma, Oregon and Utah--taxpayers deduct their federal taxes from their state returns. So lower federal taxes means a lower state deduction and thus higher state taxes.

At the same time, this year's one-time federal tax rebate is taxable in eight of those nine states. That presents a political problem. "People have funny attitudes about refunds," says Veranda Smith, a government affairs associate with the Federation of Tax Administrators. "They want to make sure it's not taxed."

Such sentiments have been duly noted. Iowa passed a one-time exception making the rebate check tax-free. Missouri, Oklahoma and Alabama are all expected to follow suit this fall.

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