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President-elect Obama plans middle-class and business tax cuts to stimulate the economy, but the impact of those cuts could be softened by state governments trying to hike taxes and fees to close the worst budget gaps they’ve seen in decades.

Most states face a budget shortfall this year. New York and California each face gaps of approximately 25 percent of their total budgets.

That means possible taxes on gasoline – passed in Minnesota and Nevada last year and proposed in California – as well as fee hikes on everything from boats to cars, libraries, and parks. New Hampshire and New York raised cigarette taxes and Indiana has raised sales taxes.

The situation also means forgoing proposed or planned tax cuts. Florida canceled a sales tax holiday and California has suspended net operating loss deductions.

“States are telling us their revenue situations are a disaster,” says Arturo Pérez, analyst for the National Conference of State Legislatures in Denver. “They are looking at every possible way to make up for billions in lost revenue.”

These comprise both spending cuts and tax hikes. Iowa is cutting back on schools, Kentucky is cutting library hours, and Minnesota, where the Republican governor has said he will not raise taxes during a recession, is proposing to cut $5 billion from state services.

Illinois is contemplating an 8 cent gasoline tax to raise $7 billion and one proposal in California is for a 13 cent per gallon tax, which would help raise $9.5 billion.

At a conference of US state legislators December, Standard and Poor economist David Wyss told legislators to first consider hiking gasoline and sales taxes.

Still, tax hikes remain an unpopular solution. Despite the severity of the 2001 recession – the worst in 50 years at that time – there were few tax increases, according to Donald Boyd, fiscal analyst for the Rockefeller Institute for Study of the States. But this time around, the recession is worse, he says.

All told, 40 US states are reporting an estimated $150 billion in budget shortfalls.

California’s crisis

In California, where state finance director Mike Genest declared that this is “probably the most challenging budget situation the state has ever faced,” legislative Republicans have blocked several of Gov. Arnold Schwarzenegger’s tax hike proposals.

As the legislature convenes this week, it will examine the governor’s proposal for $14.3 billion in tax increases in addition to $17.4 billion in spending cuts over the next 18 months.

The state is attempting to close a projected $41.5 billion shortfall.

Mr. Schwarzenegger has already signed an executive order forcing 235,000 state workers to take two furlough days a month starting Feb. 1 and required a 10 percent cut for state agencies, which could lead to thousands of layoffs.

There is also talk of reinstating a notorious car registration fee that Schwarzenegger ended with great fanfare five years ago by staging the dropping of a giant wrecking ball on a rusting old car, and declaring, “Hasta la vista, baby!”

“Republicans cannot support the governor’s proposal to impose a $14 billion in higher taxes on Californians,” Assembly Minority leader Mike Villines told the San Francisco Chronicle last week.

Democrats hold majorities in both houses of the California legislature and have moved closer to Schwarzenegger’s position than Republicans. Nevertheless, the governor vetoed Tuesday a Democratic budget plan that fell short of meeting his demands on spending cuts.

California is one of only three states that requires a two-thirds legislative majority to pass a budget, which is why the state is often extremely late in doing so. When Schwarzenegger signed the most recent budget in September, it was 85 days after the fiscal year began, a record in state tardiness.

Worse before it gets better

Most states are reining in their budget projections for 2010 and anticipating still more cuts.

In New York, another state awash in red ink, Gov. David Patterson proposed 137 new or increased taxes and fees, including an obesity tax, and $9 billion worth of spending cuts in the coming fiscal year.

Reaction to a proposed 18 percent obesity tax ranged from high praise to ridicule: New York Times columnist Nicholas Kristof calling it a “miracle tax diet” to rival the health benefits of not smoking, while the tabloid New York Post labelled it “Tax Hell.”

Meanwhile, Florida, trying to close a $2.3 billion gap in its $66 billion budget, this week is considering raising cigarette taxes. Increasing the tax by between $1 to $1.34 a pack will pull in $700 million annually for the state treasury.

By spring, legislators may also reconsider many of the exemptions they have given that now apply to dozens of goods and services, from accountants to ostrich farmers and charter boat fishing captains.

Like most states, Florida’s fiscal situation is expected to continue to deteriorate. Florida leads the nation in job losses and is among the worst hit by mortgage foreclosures. It has had to cut measures that were supposed to slow those problems – such as a small-business loan program and expanded tax credits for firms that create Florida jobs.

As on the national level, economists expect the fiscal situation for states is likely to get worse before it gets better.

Obama’s stimulus package may stave off further state tax increases, says Mr. Boyd, the fiscal analyst, since outright fiscal relief makes raising taxes harder to justify. Obama’s cuts may be close to 40 percent of a possible $775 billion bill.

But the potential for more tax hikes won’t go away, adds Boyd. And after constituencies see what spending cuts do, they might be more amenable to them.

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