“Giving Back” What You Don’t Have

The tax cut plan released by Senate conservatives last week is still short on details, but here is some of what we do know: it will cut taxes by $900 million, presumably over the course of the upcoming FY 2018-19 biennium. The key elements of the proposal include a phase-out of taxes on Social Security income, major reductions in the state business property tax, more cuts to the highly progressive estate tax, and a reduction in the lowest income tax rate.

Exempting Social Security income from the state income tax—even if it is somehow targeted to households with incomes under $120,000, as promotional material released by Senate conservatives suggests—is likely to benefit higher income seniors. That’s because low- and middle-income seniors are already paying little or no tax on their Social Security income because the first $32,000 of this income is already exempt and only a portion of the income above $32,000 is taxed on a sliding income-sensitive scale. Based on 2012 data, sixty percent of Social Security recipients already pay no tax on their Social Security income; the forty percent that pay any tax on Social Security income tend to be of relatively high income. The chart below shows the distribution of taxable income reductions by income group resulting from the full exemption of Social Security benefits based on 2012 data.

 

It is not known yet if Senate conservatives will propose full exemption or an expanded partial exemption of Social Security benefits. In the case of the latter, the distribution of the reduction in taxable income will be less heavily skewed in favor of high income households than indicated above. On the other hand, the actual reduction in taxes resulting from a full Social Security exemption will be even more skewed in favor of high-income households than the above chart indicates because the marginal income tax rate of high-income households is greater than that of lower income households due to Minnesota’s progressive income tax rate structure and thus the amount of tax relief per dollar of taxable income will greater for high income households.

Research from non-partisan staff at the Minnesota House examined the policy implications of exempting Social Security benefits from the state income tax and concluded that it would produce some redistributional consequences of questionable fairness:

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. Individuals with otherwise identical amounts of income will pay different tax amounts.

Non-partisan House staff also found that exempting Social Security benefits raised serious questions of inter-generational equity:

Because Social Security recipients are primarily elderly, exempting benefits from taxation will shift the tax burden to younger taxpayers who mainly derive their income from earnings or work. The justification for favoring elderly taxpayers (who are otherwise similarly situated in terms of income to younger taxpayers) is unclear.

Regarding the “fiscal dividend” that the state would receive from enticing seniors to stay in Minnesota through a tax break, House staff concluded that:

… 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 cost of even a partial expansion of the Social Security benefit exemption will likely mushroom in future biennia, as the number of elderly Minnesotans (age 65 or older) is projected to increase from 806,000 in 2015 (14.7 percent of the state population) to 1,316,000 in 2035 (21.6 percent of the state population), based on State Demographer projections.

The second main feature of the conservative Senate tax plan is to reduce the state business property tax levy. A portion of this reduction—the exemption of the first $100,000 of taxable value—at least has the benefit of directing a sizeable share of the tax relief to the smaller businesses, as noted in a recent North Star article, but the elimination of the annual inflation adjustment to the state business property tax will direct the overwhelming bulk of tax relief to extremely high value businesses, with the top one percent of businesses by value getting 30.5 percent of the tax relief, while the bottom 75 percent of businesses by value get only 14 percent of the relief. In future biennia, the cost of eliminating the inflation adjustment is likely to grow rapidly and quickly surpass the amount of relief given through exempting the first $100,000 of value.

Another recent North Star article noted that the state business property tax is already isolated from most of the cost drivers that push government spending upward and is already among the slowest growing major state tax, with a 2017 tax rate that is approaching an all time low. In fact, state businesses property taxes per dollar of taxable value are 20 percent less than they were when the tax was first imposed in 2002. The slow growing state business property tax is among the reasons why total business property taxes in Minnesota have been growing much less rapidly than homeowner property taxes over the last fifteen years. The elimination of the inflation adjustment to the state business property tax will result in an even more favored treatment of this tax relative to other major state taxes.

The third proposal by Senate conservatives is to reduce the estate tax. Before the substantial estate tax reduction enacted in 2014 is even fully phased-in, Senate conservatives want to cut this tax yet again—presumably by increasing the exemption level to over $5 million of taxable estate value, according to Senate materials. Current exemption levels ($1.8 million for 2018) ensure that only a tiny sliver of the very wealthiest Minnesota households pay any estate tax at all; these extremely high income households will be the sole beneficiaries of increasing the estate tax exemption, making this feature of the Senate plan tremendously regressive.

Criticisms of Minnesota’s estate tax leveled by conservatives generally fall flat, as noted in a January 2017 North Star article. Minnesota’s estate tax has been successful in reducing tax regressivity and the intergenerational concentration of wealth, allowing the state to tax unrealized capital gains that would otherwise go untaxed, and requiring the wealthiest households that benefit most from a stable society to contribute a more appropriate share of their wealth to the maintenance of that society.

The cornerstone of the tax plan advanced by Senate conservatives is the reduction in the lowest (first tier) state income tax rate; based on recently introduced legislation, this rate would presumably drop from 5.35 percent to 4.9 percent. For households with incomes equal to or greater than the first tier rate threshold,* this would provide annual tax relief of $167 for married joint filers, $84 for married separate filers, $141 for heads of households, and $114 for single filers.

Other features of the Senate conservative tax plan—a property tax credit for owners of agricultural land, a tax credit for college students paying off student loan debt, changes is Section 179 business depreciation—may be sound tax policy, although it is difficult to say in the absence of details. However, beyond the components of the Senate tax proposal, a more important question is: can the state afford a $900 million tax cut?

The official surplus projected for the FY 2018-19 biennium is currently $1.65 billion, although much of this revenue consists of one-time monies carried forward from the previous biennium, not recurring permanent revenues. The official structural gap between general fund revenues projected to be generated in FY 2018-19 and expenditures to be made in FY 2018-19 is $922 million; this—in theory—is the amount available for permanent tax reductions and/or permanent spending increases.

However, as required by law, the official forecast—while factoring in the impact of inflation on state revenues—does not fully factor inflation into projected state expenditures. As a result, the official forecast understates the cost of providing state services at a constant level in future biennia. As noted in a February 28 North Star article, inflationary costs not included in the official forecast would be sufficient to wipe out the entire official structural surplus of $922 million, based on Minnesota Management & Budget estimates from the February 2017 forecast.

“Give it back” has been a mantra of tax-cutting conservatives in recent years. There is a very real possibility—even a probability—that this proposal is giving back tax revenue that the state general fund will not have, thus returning state finances to the era of recurring deficits from which we emerged only a few short years ago.

 

*For tax year 2017, the first tier 5.35 percent rate applies to the first $37,110 of taxable income for married joint filers, the first $18,560 for married separate filers, the first $31,261 for heads of households, and the first $25,391 for single filers.