The High Cost of Fully Exempting Social Security Benefits

Fully exempting Social Security from the state income tax will result in a rapidly escalating state revenue loss and will have consequences that violate several principles of good tax policy. These and other aspects of plans to exempt all Social Security benefits were explored in a March 2016 House Research background paper.

Using information from this background paper, supported by data from the Minnesota Department of Revenue (MDOR), a recent North Star article demonstrated that the principle beneficiaries of fully exempting Social Security from the state income tax will be relatively high income households. In fact, approximately three-quarters of the tax reduction resulting from the full exemption of Social Security will go to the third of Minnesota households with the highest income. This is because the Social Security benefits of low-income households and much of the benefits of middle-income households are already tax exempt—and thus these households will get relatively little or no benefit from expanding the exemption to include all Social Security income.

The House Research background paper also reveals striking growth over time in the revenue loss resulting from the full exemption of Social Security from the state income tax. Based on previous MDOR revenue estimates, the full exemption of Social Security would have reduced state revenue by $166 million in 2002. By 2012, the estimated revenue loss would have increased to $230 million. By 2018, MDOR estimates that the revenue loss from the full exemption of Social Security will be $461 million—double what it would have been just six years earlier.

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Based upon the most recent population projections from the Minnesota State Demographer, the number of Minnesotans over age 65 will grow from 810,000 in 2015 to 1,324,000 by 2036—an increase of 58 percent. Because of the burgeoning number of retirees, the Social Security Actuary estimates that benefits as a share of gross domestic product will increase by 20 percent over this period. For these and other reasons, the non-partisan experts at the House Research Department anticipate that the “supra-normal growth in the revenue effects [of fully exempting Social Security] will continue for some time.”

The anticipated $461 million revenue loss anticipated in tax year 2018 is likely to quickly escalate to a biennial revenue loss in excess of $1 billion dollars in the relatively near future—and even more in subsequent years. The ability of the state general fund to absorb this much revenue loss without producing a deficit is questionable. While the 2016 February forecast projected a $1.2 billion surplus in the FY 2018-19 biennium, there is an increased chance that this surplus will not be as large as anticipated, given that recent state revenue collections have fallen short of February forecast expectations.

More importantly, the projected $1.2 billion surplus takes into account the impact of inflation on state revenues, but—contrary to the recommendations of the non-partisan Minnesota Council of Economic Advisors—ignores the impact of inflation on the vast majority of state expenditures. Informal estimates from Minnesota Management & Budget published in the 2016 February forecast indicate that inflation will increase FY 2018-19 expenditures by $1.7 billion above the official projection, resulting in a $0.5 billion deficit, assuming no changes to current state law. This raises very serious concerns about the ability of the state budget to absorb the large revenue loss resulting from the full exemption of Social Security income.

The House Research background paper examines various other implications of fully exempting Social Security from the state income tax. In addition to producing a likely increase in overall tax regressivity in Minnesota, the full exemption would produce some redistributional tax effects of questionable fairness. For example,

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. Individuals who did not participate in the Social Security system (e.g., because they are retired federal employees or public safety employees, such as police officers and firefighters) are likely to perceive this unfairness most acutely.

House Research also raises additional issues regarding the inter-generational equity of fully exempting Social Security from taxation:

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. 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.

As a general rule, economists favor expanding tax bases and lowering tax rates. The full exemption of Social Security benefits from the state income tax goes in the opposite direction by narrowing the state tax base, with the effect of redistributing state taxes to other forms of income or onto other taxes, such as sales or property—all with dubious consequences in terms of the overall fairness of Minnesota’s tax system.

Proponents of fully exempting Social Security from the state income tax have argued that it would encourage more elderly Minnesotans to stay in the state and that this would produce a “fiscal dividend” through increased state and local tax collections. The House Research critique of this argument is twofold. First, they observe that “The best empirical research finds little or no evidence that the elderly migrate to states with more favorable tax climates (e.g., no income taxes or expansive exemptions for retirement income such as pensions and Social Security).” Secondly, they find 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.

All other things being equal, policymakers prefer revenue sources that are stable—that is to say, that do not result in large swings in revenue that are difficult to predict and that could result in an unanticipated deficit. Because Social Security is a relatively stable source of income compared to alternative sources—such as wages, capital gains, stocks, dividends, and other income categories that can fluctuate significantly depending on vicissitudes in the state and national economies—House Research concludes that the likely effect of fully exempting Social Security will be a slight reduction in the stability of Minnesota’s revenue system.

Finally, the House Research background paper explores the regional distribution of tax reductions resulting from the full exemption of Social Security. Conventional wisdom is that the distribution of tax relief resulting from the full exemption will favor Greater Minnesota, since a majority of Social Security recipients reside there. However, a disproportionate share of Social Security recipients in Greater Minnesota are of lower- and middle-income and thus—for reasons noted in the preceding North Star article—already pay little or no tax on Social Security income. For this reason, the benefit of tax relief resulting from the full exemption of Social Security will actually favor the seven-county metro area, based upon an MDOR analysis of 2012 data; the estimated annual revenue reduction per Social Security recipient in Greater Minnesota ($314) is nearly $100 less than in the metro area ($411).

At best, the full exemption of Social Security will crowd out other potential uses of the state budget reserve, such as investment in early childhood education or transportation or other forms of tax relief. At worst, it will produce an unsustainable revenue loss that will return Minnesota to the era of recurring revenue shortfalls, budget cuts, and accounting gimmicks from which we recently escaped—all for the sake of a policy that will increase revenue volatility, reduce tax fairness, and result in inter-generational tax inequities.