State taxes going up because of deflation STATE TAXES State rates will be going up with adjustment for the sour economy

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California taxpayers just got hit with another increase in state income taxes, and it didn't require a vote from a single legislator.

The culprit: deflation.

In 1982, California voters approved a proposition that indexed state income tax rates to inflation. So each year, the California Franchise Tax Board adjusts tax brackets and certain deductions and credits for inflation. The annual adjustment is tied to the California Consumer Price Index, and it usually goes up. Indexing is designed to prevent people from paying higher taxes as their incomes rise proportionately with inflation. But when inflation turns negative, indexing works in reverse. Tax brackets and credits are adjusted downward. If your income remains the same, the result is a tax increase.

The Franchise Tax Board has just released adjustments for 2009, and for the first time since 1983 they are down, reflecting a 1.5 percent drop in the California Consumer Price Index between June 2008 and June 2009.

As a result, everyone's state taxes will go up by a modest amount this year. The amount will vary depending on taxpayers' income, whether they itemize deductions and how many personal exemptions and other credits they claim.

A single person with no dependents and $51,000 in adjusted gross income would pay an extra $41. A married couple with two dependents and $90,000 in income would pay $71 more, according to the Franchise Tax Board. (This assumes both parties take the standard deduction.)

Once a taxpayer reaches the top tax bracket, the added tax doesn't change much no matter how much money they make. A married couple with two dependents and $1 million in income would pay only $79 more as a result of deflation.

This tax hike comes on top of two increases the state Legislature approved for 2009 - a 0.25 percentage point increase in tax rates and a sharp decline in the tax credit for dependents. Those increases will cost taxpayers much more than the deflation factor, says Gina Rodriquez, Sacramento editor with Spidell Publishing, which works with tax professionals.

This is only one of many taxes and benefits that are being upended by deflation.

In California, property tax assessments are adjusted each year based on the change in the state Consumer Price Index for the 12 months ending the previous October. Through June, the index is down 0.7 percent.

Proposition 13 limited the annual increase to 2 percent but didn't say exactly what would happen if there was deflation. The California Board of Equalization expects to announce next week whether property taxes will go down next year if the CPI is negative.

Some seniors are complaining because they probably won't get an increase in Social Security benefits next year because of deflation. Benefits are indexed each year to inflation, but by law can never go down.

Federal taxes also are indexed to inflation. Adjustments for 2009 were announced in October and were based on the change in U.S. CPI for the 12 months that ended Aug. 31, 2008. Inflation during that period was positive, so adjustments were up. It's not clear what will happen in 2010 if inflation for the 12 months ending in August is negative.

"It's likely it would be down about 1.7 percent," says Mark Luscombe, principal tax analyst with publishing company CCH. Technically, the IRS could adjust brackets down, "but there is speculation the IRS might have enough wiggle room to leave it the same," thus preventing a tax increase.

"The IRS is aware of the issue, but we are not speculating at this time," says IRS spokesman Jesse Weller.

In California, inflation-indexing started in the late 1970s. "The Legislature in 1979 had fully indexed the income tax for 1980 and 1981. An attempt to continue full indexing was vetoed by Gov. (Jerry) Brown on fiscal grounds," David Doerr writes in "California's Tax Machine."

In 1982, California voters approved Proposition 7, which made inflation indexing permanent. The next year, inflation turned negative, but that didn't happen again until this year.

The Howard Jarvis Taxpayers Association, which fought for Proposition 7, does not object to the tax increase resulting from deflation. "Hey, fair is fair," says association President Jon Coupal. "If there is true deflationary pressure, then we're OK with those rates being adjusted accordingly."

The tax increase will bring in much-needed revenue for the state, but not as much as it had factored into this year's budget. "We thought (deflation) would be 2.2 percent," says H.D. Palmer, a spokesman for the state Department of Finance. Because deflation was only 1.5 percent, "There is actually going to be a marginal hit to the state's bottom line."

The state has not broken out how much tax revenue it expects from the deflation factor.

Justin Garosi, an economist with the Legislative Analyst's Office, estimates that if deflation had been 1.5 percent in 2006, (the last year for which tax data is available) it would have raised about $295 million (factoring in an adjustment for the change in the dependent credit). By comparison, a quarter-point increase in rates in 2006 would have brought in about $2 billion.

The new tax rate schedules were released to professionals last week and will be posted this week at www.ftb.ca.gov.