(MONEY Magazine) – As midwinter gusts blow in a new year, here's some news that's sure to toast taxpayers' mittens: State legislators and governors cut taxes by $3.3 billion in fiscal 1996 and approved another $4 billion in cuts for 1997, according to the National Conference of State Legislatures in Denver. Indeed, ever since Republicans gained a net 13 governorships and nearly 500 state legislative seats two years ago (they now control 32 state mansions and make up 46.7% of the nation's 7,424 legislators), state taxes have decreased in two consecutive years for the first time since 1979-80. Consider:

--Ten states have significantly reduced income tax burdens during the past three fiscal years, led by multiyear rate cuts totaling 13% to 30% in Arizona, New Jersey and New York.

--Sixteen states have provided some form of property tax relief since 1994. For example, Wisconsin is in the third year of increasing state spending on public schools, from $2.2 billion to $3.5 billion, which has enabled local school districts to reduce property taxes 11.5%. In 1995, South Carolina exempted $100,000 of a primary home's assessed value from school taxes; the state is making up the loss to the schools from its own revenues. As a result, homeowners are saving $200 million a year in property taxes. And Arizona repealed its statewide property tax in 1996, cutting its taxpayers' bills by $151 million.

--American voters continue to express their hostility to hikes in taxes of all kinds. In November, Florida and Nevada voters approved ballot measures that will make it more difficult for those states to raise taxes. At the same time, voters in California, Oklahoma and 18 of Illinois' 102 counties said yes to significant limits on local taxes, including property taxes.

But if your hands are warmed by the antitax flames crackling across the country, don't count on the glow reaching your toes. The $4 billion in state tax cuts in 1997 will shave just above 1% of the total that you and other taxpayers will have to pony up to state capitals. That means the average U.S. household can still expect to pay almost $5,000 a year in state and local taxes, or about $1 of every $13 it earns, according to the Tax Foundation in Washington, D.C. (To see how your state's tax burden compares with others for a hypothetical family earning as much as typical MONEY subscribers, see the table on pages 72 and 73.)

Despite the rate rollbacks, the states' tax take grew 4% in 1996, because economic growth swelled sales and income tax revenues. In fact, at the end of 1996, states had more than $21 billion in rainy-day surpluses. "When states have had surges of revenue in the past, they've gone out and spent it, but not this time," says Raymond Sheppach, executive director of the National Governors' Association in Washington, D.C. State officials are holding back chiefly because they remember how badly their tax collections suffered during the 1990-91 recession. Between 1990 and 1992, the states had to raise taxes more than $25 billion to balance their budgets. Also, officials are wary of further cuts in federal aid, which could force them to increase state spending, particularly on social welfare programs.

This tax holding pattern means that to get your state and local tax bill below the average $5,000 for 1996 and in the future, you'll probably have to engineer your own tax cut. How? By taking advantage of every possible tax break your state offers. Below, we outline eight moves that can slice at least $1,000 from your state tax bill for 1996. Then we explain seven strategies to help you cash in on often overlooked exemptions and loopholes in 1997 and future years.

First, here are our tips for '96. In preparing your 1996 return, take special care with the following:

--Social Security benefits. If you're retired, you shouldn't pay taxes on your Social Security income in the District of Columbia and 28 states--Alabama, Arizona, Arkansas, California, Delaware, Georgia, Hawaii, Idaho, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Michigan, Mississippi, New Jersey, New York, North Carolina, Ohio, Oklahoma, Oregon, Pennsylvania, South Carolina, Virginia and Wisconsin. Estimated savings for a typical retiree who receives the maximum benefit ($14,976 in 1996) and is taxed in California's 9.3% top bracket: $1,184 a year.

--Your spouse's income. The federal marriage penalty forces many couples who file taxes jointly to pay at a higher rate than they would if they filed as individuals. But the District of Columbia and 15 states--Alabama, Arizona, Arkansas, Delaware, Hawaii, Iowa, Kentucky, Maryland, Massachusetts, Mississippi, Montana, Pennsylvania, Virginia, West Virginia and Wisconsin--lighten this burden by letting you and your spouse file separate state returns even if you file jointly at the federal level. In general, you should consider filing separately when one of you earns sufficiently less than the other to qualify for a lower bracket if he files on his own. For instance, under Iowa's system of progressive income tax rates, a husband and wife who earn $80,000 and $25,000, respectively, would pay a top rate of 9.98% as joint filers but separate top rates of 9.98% and 7.55% by filing separately. Savings: about $1,000 a year.

--Pension income. If you're retired, you can deduct or take a credit for all or part of your pension in the District of Columbia and 22 states--Alabama, Arkansas, Colorado, Delaware, Georgia, Hawaii, Illinois, Iowa, Kentucky, Louisiana, Maryland, Michigan, Mississippi, Montana, New Jersey, New Mexico, New York, North Carolina, Oregon, Pennsylvania, South Carolina and Utah. Suppose you're retired with a $25,000 annual pension in Pennsylvania, which excludes all pensions from its 2.8% flat-rate income tax. You'd save $700 a year.

--Your child's investment income. Children under 14 with investment income above $1,300 are taxed at their parents' top marginal rate by the feds. With the exceptions of California and Hawaii, all states that have income taxes, plus the District of Columbia, tax tykes in their own brackets as long as they file separate state and federal returns. Let's say you made $75,000 in taxable income last year in New Mexico, while your 12-year-old daughter earned $4,975 in dividends from her stockholdings in 3M. If you file a separate return for her, she'll pay 1.49% of her gain in tax, instead of 7.9% at your rate, saving your household a tidy $393.

--Your federal tax liability. It's fully or partially deductible on your state tax return in nine states--Alabama, Iowa, Louisiana, Missouri, Montana, North Dakota, Oklahoma, Oregon and Utah. Estimated savings for the hypothetical MONEY household in Oregon, which imposes a top tax rate of 9% and allows a $3,000 federal income tax deduction: $270 a year.

--Your property taxes. All states except Mississippi and Pennsylvania give an income tax deduction or credit for some part of your local property taxes. In 1996, for example, New Jersey began phasing in a property tax deduction that will reach $10,000 in 1998. Last year's maximum deduction of $2,500 in property taxes saved the hypothetical MONEY household in New Jersey with a top tax rate of 6.37% $159.

--Capital gains. Varying amounts of investment income are exempt from taxes in three states--60% in Wisconsin, 50% in Massachusetts and 44% in South Carolina. Estimated savings for a hypothetical MONEY subscriber in Wisconsin: $70.

--Health-care expenses. Four states--Alabama, Arizona, New Jersey and North Dakota--let you write off a larger share of your health-care expenses than the federal government permits. (Uncle Sam allows you to deduct only costs that exceed 7.5% of your adjusted gross income.) For example, in Arizona, health-care costs became fully deductible in 1996, saving the hypothetical MONEY household, which spent $1,407 on medical expenses, $59 in state taxes.

Okay, so much for 1996. Now it's time to determine which tax-saving strategies you can use in 1997. Start by making sure you're not overpaying the property tax on your home: Douglas and Mercy Hayes, profiled on page 71, appealed their assessment and cut their tax tab $2,049, or 23%. Indeed, half of the homeowners who appeal their property tax assessments win reductions (see "Avoid These Eight Mistakes" in MONEY's December 1996 issue). And if you're in at least the 28% bracket--estimates for '97 are taxable income of $24,650 or more if you're single, $41,200 or above if you're married filing jointly--you'll cut your state taxes if your portfolio includes tax-free municipal bonds issued in your state or U.S. Treasury securities. For example, the Riezmans, profiled on page 69, saved $500 last year by investing in Missouri municipal bonds.

Here are five not-so-obvious ways to shear your future state tax bills:

--Sock away tax-free money for your children's education. Prepaid-tuition plans, which let you make payments now toward future college costs, are available in 13 states--Alabama, Alaska, Colorado, Florida, Massachusetts, Michigan, Mississippi, Ohio, Pennsylvania, Tennessee, Texas, Virginia and Wisconsin. And because of a recent federal law that makes the programs tax- exempt for state governments, many more are likely to be created in the next two years. With a typical plan, you make monthly or yearly payments into the program to buy certificates or credits toward future tuition costs at public--and in some cases private--colleges in your state. Essentially, your money is guaranteed to earn interest that keeps pace with tuition increases (recently an average of 5% a year nationally), and you cash in your investment when you need money for school bills. State taxes on your gains, generally deferred until you redeem your credits, are usually paid by your child, who typically will be in a lower tax bracket than you. One downside: If your child attends a college not covered by the program, you'll have to make up the difference in tuition costs.

--Shop for sales tax breaks. Special local tax surcharges often make it worthwhile to travel to a low-tax town to buy an expensive item--say, a big-screen TV. For instance, Cleveland tacks an extra percentage point on Ohio's sales tax, boosting the rate in the city to 7%. But smart Clevelanders can drive 35 miles to shop in nearby Lorain and Elyria, where the tax is 5.75%. You might also take advantage of sales tax breaks your state has enacted to promote business in depressed areas. For example, consumers in New Jersey pay only 3%--half the state's regular rate--in 29 special enterprise zones, including Elizabeth, home to Ikea and Toys R Us superstores.

Be careful about crossing a state line to take advantage of such tax bargains, however. States have become much more aggressive about enforcing use taxes, which you are supposed to pay on goods that you buy across the border. Similarly, shoppers' free ride on the Internet, where credit-card purchases often escape sales taxes, won't last forever. Sally Adams, an analyst at CCH Inc., a tax information service in Riverwoods, Ill., says that state governments are expected to take such actions as asking online service providers to forward information about computer users' location to merchants, who will then charge the appropriate sales taxes.

--Save your tax money by ditching cigarettes. While states have held the line on income taxes, they have been quite willing to bump up excise taxes on products that the public regards as unhealthy. Cigarettes are a favorite target. Four states hiked taxes on smokes last year, and more than half of all states now collect 30[cents] or more per pack on cigarettes. Get this: A pack-a-day smoker in Washington State, which has the nation's highest cigarette tax (82.5[cents] a pack), would save more than $300 a year in taxes by saying no to nicotine.

--Check to make sure you're not missing out on property tax exemptions. Attention, homeowners: The District of Columbia and 20 states (Alabama, Arizona, California, Florida, Georgia, Hawaii, Idaho, Illinois, Indiana, Iowa, Louisiana, Minnesota, Mississippi, Montana, New Mexico, Ohio, Oklahoma, South Carolina, Texas and Wisconsin) have so-called homestead exemptions or credits, which allow you to shield part of your home's assessed value from property taxes. Hawaii, for example, lets homeowners exempt the first $40,000 of assessed value, which last year saved the hypothetical MONEY subscriber in Honolulu $144.

Further, special local tax breaks--for example, for people who are military veterans, are over 65, have physical disabilities, have recently made home improvements or head low-income households--are available across the country. "You have to talk to your assessor to see what you're eligible for, or you could wind up paying hundreds of dollars a year in unnecessary taxes," says James Dunne, director of tax research for the New York State Office of Real Property Services.

--Earn interest on your property tax payments. If you're a homeowner, you may pay your property taxes along with your mortgage payments in 12 monthly installments a year. And your bank probably hangs on to those payments, without crediting you with any interest, until your property taxes are due. (Only 14 states--California, Connecticut, Iowa, Maine, Maryland, Massachusetts, Minnesota, New Hampshire, New York, Oregon, Rhode Island, Utah, Vermont and Wisconsin--require banks to pay interest on mortgage escrow accounts.) "This is the biggest slush fund in America," says Frank Adler, author of How to Reduce Your Property Tax (HarperCollins, $15). He urges homeowners to demand interest on these accounts from their banks--and if that doesn't work, he recommends telling your bank you want to pay your property taxes on your own. "The smaller your bank, the more likely you are to get what you want, but you should always ask," says Patricia Boerger, a representative of the American Bankers Association.

Tax time, after all, is no time to be shy. Says Adler: "One thing is clear: Nobody's coming from the government to tell you the best ways to cut your taxes. You have to get out there and find them on your own."

Reporter associate: Judy Feldman