States fear removal of dividend tax could worsen deficits
Already facing huge budget deficits, some state and local governments fear President Bush’s plan to eliminate taxes on corporate dividends could end up costing them money they can’t afford to lose. Because most states tie their income tax codes to the federal tax code, an end to federal dividend taxes could also result in a loss of state tax revenue.
States could get hurt in another way, too: Bush’s proposal could make stocks a more attractive investment than the bonds issued by states and municipalities for building schools, roads and other projects. To attract investors, local governments might have to offer higher interest rates on their bonds, and that would make it more expensive for them to borrow money.
The loss of state tax revenue could top $4 billion for the 2003 tax year, the Federation of Tax Administrators, a national organization of state revenue departments, said Wednesday.
It is difficult to forecast the effect on the bond market. But “in the long term, it may be an even larger impact because your borrowing costs are increased forever,” said Harley Duncan, executive director of the Washington-based federation. The end result is that the president’s stimulus plan could cost states far more than the $3.5 billion that they would receive in aid under Bush’s proposal.
The National Conference of State Legislatures and the National Governor’s Association have raised concerns about the plan. “It’s a potential destimulant in what is supposed to be a stimulus proposal, and it potentially exacerbates the states’ fiscal conditions in a negative way,” said Michael Bird, an NCSL legal counsel in Washington.
White House spokesman Ari Fleischer said Wednesday that repealing the federal dividend tax is not one of the measures in Bush’s package meant to stir immediate growth. Instead, it is “a chance to do something fundamentally good for long-term growth,” Fleischer said.
The NCSL puts states’ collective budget shortfall at more than $70 billion for the next fiscal year. A study by the Center on Budget and Policy Priorities says that shortfall could be as large as $85 billion.
It is possible that state government groups are overstating the potential harm of the president’s plan.
When the federal government allowed businesses to take a 30 percent extra tax write-off as part of last year’s economic stimulus plan, government groups predicted it would cost states $14 billion over three years because it would reduce state tax revenue.
But 30 of the 41 states that collect income taxes decided not to pass along the federal tax break to state taxpayers. The result: The projected loss to states has been lowered to $4 billion over three years, Bird said.
To separate themselves from the latest proposed federal tax break, about 20 states would have to specifically change their state laws.
In Missouri, where federal tax breaks automatically are passed on, Democratic Gov. Bob Holden said that the repeal of the federal dividend tax could cost the state $95 million during the next fiscal year. “When federal taxes are cut, the states suffer,” said Holden, who is struggling to make up a projected $1 billion budget shortfall. “The problem is that the federal government can run a deficit, but Missouri government must have a balanced budget. We are left with the choice of cutting programs that help citizens.”
As for the potential effect on bonds, California state Treasurer Phil Angelides said repealing the federal dividend tax would undoubtedly drive investors away from bonds “at a time we have enormous infrastructure needs.”
Governments may simply forgo construction of such things as schools, stadiums or roads because the debt service on bonds will become too burdensome, Bird said.
Concerns about the bond market may be exaggerated, said Steve Cochrane, senior economist at Economy.com, a suburban Philadelphia economic forecasting firm. That’s because tax-free government bonds generate guaranteed income for investors. There is no guarantee stocks will return dividends – tax-free or not.
“I don’t think stocks are going to be extremely competitive with the bond market,” he said. The federal stimulus plan “will shave demand on the margin for municipal bonds, but not do it very significantly.”