Conservatives contend that Minnesota’s fourth tier income tax has led to a significant reduction in work, as well as flight to other states, among the high-income households affected by the tax. However, if we do the math, the impact of the fourth tier income tax increase upon the total tax liability and disposable income of high income households is actually modest and unlikely to be a significant work deterrent or flight impetus for a significant number of households. In fact, for many fourth tier filers, much of the tax increase is effectively borne by the federal government.
Minnesota enacted a new fourth income tax bracket—also referred to as “the fourth tier”—during the 2013 legislative session, which had the effect of increasing the tax rate on filers with incomes above the fourth tier threshold from 7.85 to 9.85 percent. In 2013, the Minnesota Department of Revenue (MDOR) estimated that the new fourth tier would affect 1.7 percent of all Minnesota income tax filers. Minnesota’s income tax brackets are adjusted annually for inflation; in tax year 2017, the fourth tier income tax rate will apply to taxable income above $261,510 for married joint filers, $130,760 for married separate filers, $207,540 for heads of households, and $155,650 for single filers.
The following analysis will focus on the income tax increase resulting from the fourth tier for married joint filers* with taxable incomes from $0 to $2 million. Taxable income is equal to gross income minus itemized deductions, such as mortgage and investment interest, charitable contributions, property taxes, and allowable medical expenses, to name a few. (Filers may opt for the standard deduction instead of itemized deductions, but most high income households subject to the fourth tier itemize.) For this reason, taxable income is often significantly less than gross income. For example, married joint filers with two dependents and a gross income of $300,000 typically have a Minnesota taxable income of about $246,000† and thus would be unaffected by the fourth tier tax rate.
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 households that are unaffected by the alternative minimum tax (AMT). (The effects of the AMT will be considered in the second part of this series.)
Approximately 98 percent of filers are unaffected by the fourth tier income tax, since their incomes are below the fourth tier threshold. For example, married joint filers with taxable income below $261,510 undergo no increase in their income tax liability as a result of the fourth tier, since none of their income is subject to the fourth tier rate. For filers with taxable incomes just above the threshold, the tax increase is small, since the fourth tier rate applies only to the portion of income in excess of the fourth tier threshold. For example, for filers with $265,000 taxable income, the state income tax increase resulting from the fourth tier is $69.80; for filers with $300,000 taxable income, the state tax increase due to the fourth tier is $769.80—hardly enough to encourage a reduction in work or flight to another state.
Furthermore, the increase in state income taxes resulting from the fourth tier will trigger a reduction in federal income taxes due to the deductibility of state income taxes from federal taxable income. Thus, for the married joint filers with $265,000 taxable income, the $69.80 increase in state income taxes resulting from the fourth tier will trigger a $23.03 ($69.90 times the marginal federal tax rate of 33 percent) reduction in federal taxes, for a net tax increase of $46.77. For the filers with $300,000 taxable income, the net tax increase resulting from the fourth tier would be $515.77. The chart below shows the state tax increase resulting from the fourth tier (the blue line), the offsetting reduction in federal taxes resulting from the state tax increase (the area shaded yellow), and the net income tax increase factoring in the reduction in federal taxes (the red line) for households with taxable income up to $2 million.
The reduction in federal taxes resulting from the fourth tier state income tax increase equals the amount of the state tax increase times the marginal federal income tax rate. For example, for married joint filers with a Minnesota taxable income from $261,510 to $454,420, the reduction in federal taxes resulting from the fourth tier tax increase equals the state tax increase times the marginal federal rate of 33 percent; for filers with Minnesota taxable income of $514,320 or more, the reduction in federal taxes resulting from the fourth tier tax increase equals the state tax increase times the marginal federal rate of 39.6 percent.
As a result of the deductibility of state income taxes from federal taxable income, a significant portion of the increased revenue generated by Minnesota’s fourth tier income tax is effectively borne by the federal government through a reduction in federal income taxes paid by high-income Minnesota households. For filers unaffected by the AMT, approximately one-third or more of the state income tax increase due to the fourth tier is shifted to the federal government; for these filers, the net (i.e., combined state and federal) income tax increase resulting from the fourth tier is approximately two-thirds or less of the state tax increase.
The net tax increase resulting from the state’s fourth tier income tax may look large to the average Minnesotan. However, in the context of the total income and total income tax liability of households affected by the fourth tier, the increase is rather modest, resulting in only a modest increase in the total effective tax rate. This topic will be explored more fully in part two of this series.
*Married joint filers comprise the single largest category of income tax filers in Minnesota.
†Based on MDOR estimates.