States eye income tax rises as rich pay less

California Governor Arnold Schwarzenegger signs the 2009-10 state budget at the State Capitol in Sacramento, California February 20, 2009.

NEW YORK (Reuters) - U.S. states, already battered by the financial crisis, risk suffering a further hit to their coffers when individuals file their income tax returns in April.

Falling income tax receipts from wealthy individuals could further gouge their already battered budgets, according to state officials and financial analysts.

Raising income taxes, as California did just last week, may fail to raise more tax dollars as the incomes of some wealthy people are falling too precipitously.

Yet most U.S. states by law must balance their budgets. The risk that their credit ratings will be cut if they borrow or sell assets, from hospitals to water systems, to close deficits may force states into difficult spending cuts.

Congress hoped to stave off job-killing spending cuts by the states by including $150 billion in its new economic stimulus plan for them. But states face a total of $311 billion of deficits in the next two years and can only use about $8 billion of the new federal aid to fill in budget holes.

Rich individuals who pay state income taxes cut their estimated payments in January, which means their final bills due in April likely will be smaller than expected. These taxpayers, typically the self-employed, who are paid bonuses or reap capital gains, may even be owed refunds.

California, New York, Connecticut, New Jersey, Massachusetts, Virginia, and Maryland, which all rely heavily on income taxes paid by well-to-do residents, saw these tax revenues plunge 15 percent to 30 percent. The main culprit was the fall in the stock market, officials said.

The federal government faces the same problem. The top 5 percent of U.S. taxpayers paid nearly 44 percent of all income taxes in 2005, according to the Congressional Budget Office.

The drop in Maryland's revenues is particularly troubling because it increased millionaires' income tax rates in 2008, noted David Roose, director of Maryland's Bureau of Revenue Estimates. The levy rose to 6.25 percent from 4.75 percent.

Democratic President Barack Obama deficit-cutting plan includes letting Republican President George W. Bush's tax cuts expire in 2011, which will push the top rate above 39 percent. But by then the economy could have rebounded. In contrast, some states, including New York, might raise millionaires taxes now.

Advocates of such a move note that on an historical basis the highest U.S. tax rate at 35 percent is just about one-third of the 94 percent rate paid by wealthy individuals in the last two years of World War Two.

Foes of wringing more income tax dollars out of wealthy people say this will prolong the recession.

For example, Kenneth Adams, chairman of The Business Council, says New York should cut spending more deeply instead of adding two percentage points to push the top rate to 10.3 percent, as some Democratic lawmakers proposed.

"The massive increase in the personal income tax...would devastate New York's economy and undermine our chances for recovery from this deep recession," he said.

Joel Slemrod, a University of Michigan economics professor, said state tax increases or budget reductions could thwart the national economic stimulus plan.

"I think either way, cutting spending or raising taxes, is the opposite of what we want to stimulate the economy."

A recent JPMorgan Chase report demonstrated just how much the U.S. economy relies on spending by states and cities. Together, they spent $1.85 trillion in the third quarter of last year, two thirds more than the federal government.

Though Slemrod said states might now need to raise everyone's taxes to close deficits, he sees some leeway to raise millionaires' income taxes. "In the long-term, I think there is room for increasing taxation on high-income people," he said.

Another criticism of boosting income tax rates for the rich was cited by New York City Mayor Michael Bloomberg, who says the Democratic speaker's plan to raise the city's top rate one percentage point to 4.65 percent will just drive them to move.

The third-term seeking independent mayor instead favors higher sales taxes. The city needs its wealthiest taxpayers, he says, as one percent of residents with incomes of at least $500,000 a year pay nearly half of the city's income taxes.

Still, a Princeton University study showed a tiny fraction -- less than 0.2 percent -- of its millionaires moved after their income tax rates were increased to 8.97 percent in 2004.

Democratic Governor Jon Corzine last September noted the ranks of "half-millionaires," who earn at least $500,000 a year, shot up 70 percent in the last four years though their income taxes also went up.

(Additional reporting by Lisa Lambert in Washington)

(Reporting by Joan Gralla)