Reuters Money

It’s hardly a secret that state budgets are tight. Still, when budgetarily-beleaguered Illinois raised its individual income tax rate to 5 percent from 3 percent, it raised eyebrows — and questions about what other states might follow.

The Tax Foundation, in a recent research report, notes that fewer states raised taxes in 2010 than had been expected to do so, but that with the temporary federal stimulus aid ending mid-year and many states in budgetary trouble, “2011 may be a year of dramatic tax increases.”

“So far, the big news has been Illinois,” says Joseph Henchman, the Tax Foundation’s director of state projects and author of the report. “It is at one extreme in state budgets, but other states are piling up debt right now, and not solving their problems.”

Among the states facing budgetary problems are California, New York, Pennsylvania, Wisconsin, Ohio, Washington and Maryland, Henchman says. Whether these states will follow Illinois, or get creative on raising funds in other ways, remains to be seen. New York’s newly-elected governor, Andrew Cuomo, a Democrat, for example, has pledged no new taxes.

“I’m not sure you’re going to see a lot of rate increases given the political pressures, so states are going to have to find other more creative ways [to find cash],” says Stuart Rosow, a tax partner at Proskauer. “It may also depend how desperate the state is. I think the bellwether will be California.”

States typically do anything they can to bring in cash — fees, sales taxes, sin taxes, etcetera — before raising income taxes. In 2009, according to the Tax Foundation, 18 states raised cigarette taxes; another seven followed in 2010. New York’s cigarette tax, the highest in the country, is now $4.35 a pack.

Last year, Rhode Island legalized fireworks, boosting sales-tax revenues by some half-million dollars, and a flood of states got in on Powerball and Mega Millions to raise funds. This year, Washington state considered, and then ditched, a plan to require people to pay to park on state beaches, while New York has proposed a 2.75 percent surcharge on purses at horse races around the state.

Long-term, even if these type of tweaks, fees and targeted taxes go through, they’re unlikely to be enough to solve the budgetary problems long term. Meanwhile, current state income tax rates are all over the map: Florida, for example, has no income tax, while Hawaii and Oregon (following a rate increase on high earners last year) top the list with rates of 11 percent.

“States are trying to do all sorts of things to raise money,” says Bill Smith, managing director in the national tax office of CBIZ MHM. That means that even if cash-crunched states refrain from raising income taxes (or corporate taxes), there’s likely to be greater enforcement and more states tussling over “nexus” — that is, when there is an obligation of a person or company to pay taxes in that state — as states fight to gain a bigger piece of the overall pie.

For individuals and businesses, who could potentially be taxed by multiple states, these state tax fights could wind up increasing their overall tax burden, depending on the rates of the states involved —  or require them to pay back taxes to one state after the statute of limitations for a refund from another has already expired. The statute of limitations on such refunds, Smith notes, is three years.