Beware the Trojan Tax Cut

As Homer tells it, a besieged Troy eagerly welcomed the present of a large wooden horse as a herald of good times to come. This “gift,” however, actually led to the ruin of the proud city. Minnesotans should take this cautionary tale to heart before they embrace the large tax cut schemes being promoted by conservatives, which—like the Trojan Horse—are being delivered with promises of prosperity, but which are likely to be ruinous in the long term.

Specifically, some of the tax cuts currently being considered by the legislature have a price tag that will soar in future biennia. These cuts appear modest in the short term, but will rapidly escalate in future years to the point where the revenue loss will create a strain on the state general fund and possibly harbinger a return to the era of budget deficits from which we emerged only a few short years ago.

The tax cut that will produce the most rapidly expanding state revenue loss is the proposed freeze of the state business property tax. According to projections from the Minnesota Department of Revenue (MDOR), proposals to freeze the state business property tax will reduce state revenues by just under $10 million in the fiscal year (FY) 2018-19 biennium.* However, in the subsequent biennium (FY 2020-21), the cost is projected to increase eightfold—to $80 million.

The $80 million FY 2020-21 revenue loss resulting from the state business property tax freeze is only the tip of the iceberg. The revenue loss resulting from this freeze is projected to more than double in the next biennium and will continue to escalate thereafter, ultimately reaching a projected $405 million in FY 2026-27—over forty times greater than in FY 2018-19. Over the course of the next ten years, the state business property tax is projected to reduce state revenues by approximately $1 billion.

The need to enact such a rapidly escalating tax break for businesses is suspect, given that the current state property levy is already capped at the rate of inflation. As a result, statewide business property taxes have increased much less rapidly than that of homeowners and most other classes of property over the last fifteen years. In addition, most of the direct relief resulting from the state business property tax freeze will accrue to large, high value business properties; after taking into account the final incidence of the tax changes resulting from the freeze, most of the relief is likely to be exported out of state. Finally, the most recent 50-state business tax report from the Council on State Taxation found that Minnesota was already below the national average in total effective business tax rates, total state and local business taxes per private sector employee, and the business share of total state and local taxes.

The impact of repealing the annual inflation adjustment to the state cigarette tax (referred to as “indexing”) is small in comparison to the state business property tax freeze, but—like the property tax freeze—the revenue loss will escalate rapidly in future years. According to projections from legislative fiscal staff, the revenue loss from the cigarette tax indexing repeal will be $1.8 million in FY 2018, $7.2 million in FY 2019, $12.7 million in FY 2020, and $18.0 million in FY 2021. This growth pattern is likely to continue in subsequent years. By freezing the cigarette tax, the real (inflation-adjusted) impact of the tax will decline over time, not only reducing state revenue, but also reducing the disincentive to quit or not start smoking in the first place among price sensitive groups, especially teens.

The revenue loss from other proposed tax cuts—while not escalating at the exponential rate of the state business property tax or cigarette tax freeze—will nonetheless increase rapidly in future years. For example:

  • Driven in large part by rapid growth in the number of retirees, the revenue loss from the expanded Social Security subtraction is projected to grow from $105.5 million in FY 2018 to $124.0 million in FY 2021—an annual average growth rate approaching six percent. Conservatives are pushing an expanded tax preference for Social Security income (which already enjoys preferential tax treatment relative to other forms of income), despite findings from non-partisan House staff that, “Favoring one type of income, Social Security benefits, will result in unequal treatment of individuals who are otherwise similarly situated but derive their income from other sources.”†
  • Revenue loss resulting from conforming to the federal estate tax exemption—a move that will benefit a tiny fraction of the state’s wealthiest households who already enjoy a state and local effective tax rate below the statewide average—is expected to increase at an annual average rate of about five percent through FY 2021,‡ and there is no reason to expect this rate to slow in subsequent years. Conservatives insist that further reductions to the estate tax—which already was cut substantially in 2014—will lead to a dramatic reduction in the number of high-income households leaving Minnesota, despite the fact that a research review conducted by non-partisan MDOR staff found no statistically significant impact of the estate tax on out-migration.

There are good reasons to be wary of excessively large tax cuts, especially ones that will result in a rapidly escalating drain on state revenue. Conservative tax cuts currently being proposed are premised upon rosy projections of a state budget surplus, which—contrary to the recommendations of the non-partisan Minnesota Council of Economic Advisors—ignores most of the effects of inflation on state spending and does not account for the huge financial hit the state may take due to changes in federal policy (including the  possible implementation of the American Health Care Act). State finances are additionally menaced by the possibility of a national recession, which increases as the current recovery—already one of the longest in U.S. history—continues to age. The low rate of GDP growth, which is well below the long-term U.S. average, makes the economy especially susceptible to negative shocks.

To compound matters, the state budget surplus—which serves as a cushion against unforeseen fiscal traumas—was already reduced earlier this legislative session, even though it had never reached the level recommended by the non-partisan experts at MMB.

All of these factors combine to cast serious doubt upon the wisdom of excessively large tax cuts, especially ones with rapidly ballooning costs in future years. To paraphrase a sage of ancient Troy, beware of conservatives bearing tax cuts.

 

*MDOR has projected the revenue loss resulting from the freeze of the total state property tax, including both the business and seasonal/recreational portions of that tax. The portion of the revenue loss attributable to the freeze of the state business property tax alone is equal to 95 percent of the total revenue loss.

 Non-partisan House staff also concluded that:

The justification for favoring elderly taxpayers (who are otherwise similarly situated in terms of income to younger taxpayers) is unclear. Current law already provides modest preferences to seniors in the form of a higher standard deduction amount and (temporarily) a lower threshold for claiming medical expense deductions, as well as the partial exemption of Social Security benefits and Minnesota’s elderly exclusion. Advocates often advance justifications that the elderly have higher costs of living, particularly higher medical expenses. However, they also are more likely to have mortgage-free homes and to receive untaxed government benefits.

 They were also skeptical of claims that enhanced Social Security tax breaks would yield the fiscal benefits promised by proponents:

 … it is not clear that retention of potential elderly out-migrants would actually yield such a fiscal dividend. As a group, the elderly consume disproportionate amounts of governmental services (both publicly funded health care and social services). Working to retain them by lowering their taxes in order to realize a fiscal dividend may be a losing proposition, even if one thought (contrary to reliable empirical evidence) that tax incentives are effective in deterring out-migration.

The average annual five percent growth rate is based on projected growth from FY 2019 to FY 2021. FY 2018 was excluded from this analysis because growth in the revenue loss resulting from federal estate tax conformity from FY 2018 to 2019 (29.0 percent) is due to a partial year impact in FY 2018. Including data from FY 2018 would yield an annual average growth rate in the revenue loss due to federal estate tax conformity of 12.5 percent.