Ever since its passage during the 2013 legislative session, Minnesota conservatives have been critical of the fourth tier income tax, which increased the state tax rate on income above the fourth tier threshold from 7.85 percent to 9.85 percent. However, as noted in part one of this series, a significant portion—up to nearly 40 percent for some very high income households—of the state tax increase resulting from the fourth tier is effectively borne by the federal government due to the deductibility of the state income tax liability from federal taxable income.
The mechanics of Minnesota’s fourth tier income tax were described in part one of this series. For the sake of simplification, the following analysis will ignore differences between federal and Minnesota taxable income, except for the deduction of state income taxes from federal taxable income. In addition, this analysis will ignore complexities arising from the marriage penalty and will focus on married joint filers—the single largest category of income tax filers. The first portion of the following analysis will focus on households that are unaffected by the alternative minimum tax (AMT). The impact of the AMT—which is difficult to simulate—will be considered at the conclusion of this article.
As was noted in part one, the net tax increase resulting from the state’s fourth tier income tax may seem large to the typical Minnesotan. For example, the net tax increase due to the fourth tier for married joint filers unaffected by the AMT with a 2017 taxable income of $2 million is $21,000. However, this amounts to a 2.5 percent increase in the combined federal and state income tax liability for such a household, from $830,965 to $851,966. The blue line in the following chart represents the combined state and federal income tax liability under current law; the red line represents the income tax liability if there were no fourth tier Minnesota income tax, holding everything else constant.
On the scale of this chart, the tax difference with and without the fourth tier is virtually imperceptible until the level of taxable income approaches $1 million. Even for married joint filers with taxable income well in excess of $2 million, the net income tax increase resulting from the fourth tier never exceeds 2.7 percent.
The level of taxable income remaining after paying income taxes is also only modestly reduced by Minnesota’s fourth tier income tax. The blue line in the following chart represents taxable income minus combined state and local income taxes under current law for married joint filers unaffected by the AMT; the red line represents the same, except that the fourth tier income tax is removed and all other things held constant.
The above chart does not truly measure after-tax income, since it is based on taxable income—not gross income—and ignores all federal, state, and local taxes with the exception of income taxes. Nonetheless, it provides a way of approximating the impact of the fourth tier on disposable income, and this chart suggests that that impact is small. The difference between the current law line and the “no 4th tier” line is nearly imperceptible at taxable income levels below $1 million. At $2 million taxable income, the fourth tier has the effect of reducing the level of taxable income minus income taxes from $1,169,035 to $1,148,034. This reduction represents slightly over one percent of total taxable income.
The net tax increase resulting from the fourth tier represents less than one percent of gross income for the vast majority of fourth tier filers unaffected by the AMT and can never be more than 1.2 percent—even for households with no deductions.
For households subject to the AMT, determining the tax increase resulting from the fourth tier as a percent of gross income is complicated due to interactions between the AMT and the regular income tax and differences between gross income, regular taxable income, and alternative minimum taxable income. For example, filers affected by the fourth tier and subject to the federal AMT will be able to deduct less than 100 percent (and often none) of their fourth tier tax increase from their federal taxable income. In addition, the impact of the fourth tier should not be evaluated in isolation from a corresponding increase in Minnesota’s AMT tax rate from 6.4 percent to 6.75 percent. (It is possible that some AMT filers in Minnesota would be unaffected by the fourth tier, but would be impacted by the AMT tax rate increase.)
However, we can say with certainty that for households affected by the AMT, the tax increase resulting from the marginal two percent fourth tier tax rate increase (i.e., the difference between the third and fourth tier rates) will be significantly less than two percent of gross income because (1) the marginal fourth tier tax rate only applies to regular taxable income above the fourth tier threshold ($261,510 for married joint filers in 2017) and (2) the gross income of households subject to the AMT is generally much greater than taxable income.
Tax increases of this magnitude are unlikely to encourage a mass exodus of high income households from Minnesota or contribute to a significant reduction in work effort. This conclusion is supported by MDOR data—summarized in a May 9 North Star article—which showed a significant increase in the number of very high-income taxpayers and the income taxes paid by them in the year following enactment of the fourth tier. In addition, state income tax collections have generally met levels projected in 2013 when the fourth tier was enacted—an unlikely outcome if high income households were fleeing the state in significant numbers or working significantly less in response to the fourth tier income tax.
These conclusions are further supported by a literature review conducted by MDOR, which found that, “Most rigorous and peer-reviewed studies of tax migration fail to find any statistically significant effects of tax variables.” MDOR further noted that this conclusion holds for both estate taxes and income taxes.
The above analysis of the practical impact of the fourth tier on high income households reveals a fairly small impact on the total taxes paid by these households that is hardly sufficient to lead to significant tax flight or work reduction—a conclusion supported by data from other sources. As with all tax policy decisions, the minor deleterious effects of the fourth tier income tax need to be weighed against the benefits achieved through adequately funded public investments and a balanced state budget.