Federal Tax Rebates an Issue For Some States

When Congress approved President Bush’s income tax rebate plan, lawmakers in nine states were faced with the prospect of being cast as the grinch who stole Christmas. That’s because laws in their states would have taken a bite out of the federal refund to taxpayers.

But the lawmakers quickly realized that the political headache caused by the rebates also presented political opportunities.

The legislatures in Iowa, Oregon and Utah have already acted to make the rebates exempt from state taxes, shoring up taxpayer-friendly images in the process. Oregon Gov. John Kitzhaber has yet to sign his state’s measure but is expected to do so soon.

Missouri and Oklahoma are expected to follow suit. Still holding the line, however, are lawmakers in Alabama, Louisiana, Montana and North Dakota — they have yet to exempt the rebates and don’t appear ready to do so anytime soon.

Alabama Gov. Don Siegelman said shielding the rebates from state taxes would take more than $20 million from the state’s public school children.

His cash-strapped state has already cut hundreds of millions of dollars in K-12 education spending. Given its fiscal struggles, Alabama would be hard-pressed to give up its unexpected windfall from the federal rebates.

The reason the federal tax refunds are an issue in these nine states is a wrinkle in their tax codes that makes federal income tax payments deductible for state income tax purposes. This would now have the ironic effect of raising the state income tax slightly because the federal rebate will result in smaller deductions. To many people, this looks like a state tax on the federal rebate.

The federal rebates, which amount to as much as $600 for married couples who file a joint return, are not an issue in 32 other states whose state income tax codes are configured differently. According to the Federation of Tax Administrators, nine states have no state income tax. They are Alaska, Florida, Nevada, New Hampshire*, South Dakota, Tennessee*, Texas, Washington and Wyoming.

*New Hampshire and Tennessee tax dividend and interest income.