Federal tax hikes could loom over state budget debate

While most coverage of the “fiscal cliff” tax debate centered on the nation’s wealthiest households, middle class consumers quickly are learning they will pay more this year as well.

So, as the state Legislature opens its 2013 session today staring at plenty of red ink, will frustration over federal tax hikes squelch any revenue proposals offered to solve Connecticut’s budget crisis?

“It’s in the back of my mind,” Rep. Patricia Widlitz, D-Guilford, co-chairwoman of the tax-writing Finance, Revenue and Bonding Committee, said this week. “We don’t exist in a fiscal bubble and we need to be cognizant of all of the pressures placed on taxpayers.”

“There’s no question about it, [taxpayers] have more questions,” said Harold Miller, a certified public accountant with Meyers, Harrison and Pia in New Haven. “When they hear ‘fiscal cliff’ — something with a cliff — it’s a scary thing.”

Andrew Lattimer, a CPA and tax partner in BlumShapiro’s West Hartford headquarters, agreed that taxpayers are more inquisitive — and therefore more aware — about the latest federal  tax changes.

“The biggest buzz I’ve heard,” Lattimer said, has come from nonprofit entities, whose donors want to know how their tax deductions could shrink in 2013. “People want to understand all of this.”

Ending the Payroll Tax ‘Holiday’

Perhaps the widest-reaching federal increase in the deal struck this month on Capitol Hill ends the federal payroll tax holiday.

For the last two years, all households earning up to $113,700 had to pay just 4.2 percent into the Social Security program, down from the regular 6.2 percent.

For a household earning $100,000 per year, restoring those two percentage points will cost an extra $2,000 in 2013.

But that wasn’t the only change that would affect more than the nation’s wealthiest households.

Limits on Itemized Deductions

Households claiming state and local tax payments and mortgage interest, charitable contributions or other deductible expenses once again face a limit on those deductions if their earnings top limits of $250,000 for individuals or $300,000 for couples.

Those deductions would be reduced by an amount equal to 3 percent of any earnings above the appropriate threshold.

For example, a couple with two children, annual earnings of $350,000, and $50,000 in itemized deductions would see those deductions reduced by $1,500 ($50,000 in over-limit earnings multiplied by 3 percent). This would, in turn, increase their tax by roughly one-third of that loss, or about $500.

Personal Exemption Phase-out

Filers can deduct a personal exemption for themselves, their spouse and their eligible dependents.

But with the new phase-out, the value of each exemption is reduced by 2 percent for each $2,500 a household earns over the threshold levels of $250,000 for singles or $300,000 for couples.

The same hypothetical family of four, referenced above, with a $350,000 annual income, would see its exemptions cut by 40 percent for a total reduction of $6,080.

Similarly, this household’s tax bill would rise by about one-third of that amount, or just over $2,000.

“The middle class family has been hit by these federal taxes,” said Rep. Sean Williams of Watertown, the ranking GOP representative on the finance panel. “To them, it doesn’t really matter which level of government did it. They feel the pain.”

But state government has its own fiscal pain to deal with, and views are mixed at the Capitol on how to proceed.

Fiscal analysts projected back in November that the next state budget, which begins July 1, has a built-in hole somewhere close to $1.2 billion.

Some of the spending cuts and revenue increases Gov. Dannel P. Malloy and the General Assembly ordered in special session in December to close a $365 million deficit in the current budget also will yield savings in 2013-14. It won’t be clear how much those changes will save of the nearly $1.2 billion problem until late January.

Malloy has pressed his fellow Democrats in the legislature’s majority to steer clear of taxes, given that they enacted a record-setting $1.5 billion two years ago to close a huge deficit left behind by the last administration and legislature.

Meanwhile officials are blocked legally from reducing some of the other big pots of money in the budget — state employee salaries and benefits and debt service — and slashing aid to towns is a political nightmare.

Relying on Cuts to Social Services

Not surprisingly, the governor and lawmakers relied heavily on cuts to health care and other social services to close this year’s gap.

Malloy said this week that unless the gap in the next state budget is eliminated predominantly with reductions, government likely would exceed the constitutional spending cap.

And while both of Malloy’s Republican predecessors routinely cooperated with Democrat-controlled legislatures to legally exceed the cap, the governor insisted he doesn’t want to go that route.

“For a number of years, everybody here has ignored the spending cap,” he said.

But how many more dollars can those health-care and social-service programs lose, particularly given the high demand in a sluggish economy?

“Not much,” said Sen. Toni Harp, co-chairwoman of the Appropriations Committee and a Democrat from New Haven, one of Connecticut’s poorest cities.

Harp also predicted that those who faced spending cuts in December, particularly Connecticut’s hospitals, have some supporters anxious to restore those reductions. “They are not going to be quiet” in the 2013 session, she said. “They are going to make a major push to regain some of that ground.”

Harp said it’s clear there wasn’t much interest in boosting state income taxes in Connecticut, even before the federal “fiscal cliff” deal was struck. But the New Haven lawmaker has said the state should be looking to trim some of the business tax exemptions it provides.

Putting the State Income Tax on the Table

And others have argued a state income tax hike, at the right level, shouldn’t be dismissed out of hand.

Better Choices for Connecticut, a coalition of labor, social service and other progressive advocacy groups, has been pushing since the last recession began for state officials to consider a more progressive income tax.

The coalition sent out letters this past summer to state legislative candidates, urging them not to rule out state tax hikes on the wealthy in 2013 if necessary to protect Connecticut’s poorest families and most vulnerable residents.

And Wade Gibson, a senior policy fellow with the New Haven-based Connecticut Voices for Children, said Connecticut, like President Obama has done, could ask the state’s wealthiest households to pay more.

“When you’re dealing with deficits, no matter which way you turn, you’re going to have people feeling some degree of pain,” said Gibson, whose group belongs to the Better Choices coalition. “But you want to make sure you at first protect those people who have the least to start with.”

The state income tax hike Malloy signed in 2011 doubled the number of marginal rates and lifted the top rate from 6.5 to 6.7 percent. But it also chopped 40 percent off of a middle-class credit to help offset municipal property taxes.

For the huge pocket of wealth centered on Wall Street, Connecticut’s competitors are New Jersey, westernmost Massachusetts,  New York City and its closest suburbs.

Massachusetts has a flat rate of 5.3 percent on most income. But it taxes capital gains and other major investment income at 12 percent. New Jersey and New York’s top state rates are both just under 9 percent, but residents of New York City can add up to 3.6 additional percentage points to their top rate.

“There still remains a great need for a state tax system that is more fair and balanced,” said Liz Dupont-Diehl, policy director for the Connecticut Association for Human Services and another member of the Better Choices group. “We still have to work toward a state where working families can sustain themselves and raise their children.”

But Williams said that taxpayers at all income levels are feeling the bite of federal taxes.

The “fiscal cliff” deal particularly targeted individuals earning more than $400,000 and couples topping $450,000. The top marginal federal income tax rate on that group rose from 35 to 39.6 percent, and the rate on capital gains earnings rose from 15 to 20 percent.

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