Impacts of the TCJA on Minnesota Individual Income Filers

With the signing of the Federal Tax Cut and Jobs Act (TCJA), attention now turns to St. Paul and state policymakers' response in the forthcoming legislative session.  The Minnesota Department of Revenue’s (DOR) preliminary estimate of state budget impacts stemming from its passage has grabbed the headlines, prompting questions about possible tax burden impacts, shifting, and potential “winners and losers” under this reform.

As we have done previously, our modeling examines how the TCJA would impact Minnesota taxpayers if the state conformed to it.  Our estimates are based on household profiles that DOR provided for our latest Multistate Individual Income Tax Comparison Study (tax year 2014).  These profiles let us model federal and state income taxes on an "average Minnesota taxpayer" for different filer types at various incomes under the TCJA.  The findings from our multistate study are the comparative baseline we use to determine the impact of the reform.

Our usual caveats once again apply:

  • We assume federal taxable income remains the starting point for Minnesota returns and that Minnesota conforms to the new calculations of federal taxable income.
  • We model first year effects (many individual income tax features are phased out in later years.)
  • Since the taxpayer information we have is specific to tax year 2014, our analysis assumes that changes effective for the 2018 tax year were instead effective for 2014.  This creates slightly larger differences between the baseline standard deduction and personal exemption amounts and the new standard deduction, and therefore slightly overstates the size of tax cuts.
  • Any particular taxpayer at these income levels can have a very different tax burden than the “average” taxpayer we model.  The most important factors in any variations include 1) the number of dependents claimed, 2) whether the filer itemizes deductions or claims the standard deduction, 3) the total amount of itemized deductions a filer claims if itemizing, and 4) the use of any “above the line” deductions (i.e. income subtracted in the calculation of federal adjusted gross income) that were eliminated in the TCJA.  Our modeling assumes married-joint filers have two children and head of household filers have one child.

And one new one based on the details of the final bill:

  • For married-joint filers at $150,000; $250,000; $500,000; and $1 million of household income we assume that any taxable income they have that is not assigned to wages, investments, or retirement is pass-through business income.  We further assume that this business income is eligible for the 20% deduction (i.e., it is not earned in the variety of ineligible occupations).  The TCJA imposes limits on the 20% deduction for our $500,000 and $1 million filers.  However, since we cannot determine from the taxpayer profile data how to model the limitation, we simply assume that half of such income for those filers is eligible for the deduction (an assumption offering the smallest possible error).

Impact on Minnesota Taxable Income for Different Filers*

* Note that per the DOR profile data, all households have a certain amount of nontaxable income that does not factor into these calculations.

The DOR analysis offers perspective on the sources and magnitude of state revenue increases resulting from applying Minnesota’s existing tax rates to the now-expanded tax base.  The following table offers a more detailed look at how Minnesota taxable income changes for various filer types at different income levels.

A couple of observations/explanations

  • The larger dollar increase and disproportionate percentage change in taxable income for our $50,000 married filer reflects the interaction of the larger standard deduction and the elimination of personal exemptions compared to the baseline for taxpayers taking the standard deduction under both the old law and the TCJA.  Put simply, personal exemptions are worth a lot more to lower income filers.
  • The decline in taxable income in the married joint $500k and $1 million filers is due to 1) the new 20% pass through deduction for qualified business income, and 2) the elimination of limitations of allowable itemized deductions (a.k.a. “Pease limitations”).  For federal tax purposes, the additional deductions these high income filers are allowed with the elimination of deduction limitations are offset by the higher taxable income resulting from the partial elimination of state and local tax deductibility.  However, since Minnesotans who itemize have already been adding state income taxes back when calculating Minnesota taxable income, the full value of this elimination of deduction limits now flows through to the state tax return.  Each of these two factors contributes to about half of the lower Minnesota taxable income these filers see under the TCJA.
  • The decline in Minnesota taxable income for our single and head of household filers represents “sweet spots” in the new tax structure.  For both of these filers, the additional standard deduction ($5,800 for the single filer; $8,900 for the head of household filer) is worth more than the value of the personal exemptions that the TCJA repealed.

Impact on Income Taxes Paid

As the table shows, all our average filer types realize net income tax relief – including our lowest income married joint filers – thanks to the expanded, partially refundable child credit included in the final bill.  However, the influence of higher state taxes on the amount of net tax relief varies significantly across filer types.  Increased state taxes offset only 7.3% of the federal tax relief provided to the $150k married-joint household but over 62% to the $50k married-joint household.  Meanwhile, higher income earners and single filers are able to take additional advantage from their declines in Minnesota taxable income.

How will such distributional consequences affect the state debate over responding to the TJCA?  Will tax fairness once again be the dominant rallying cry for public policy at it was several years ago?  Or will the prospect of some portion of a billion-plus in revenue for new spending and investments – more regressively raised but less felt and largely hidden from view – temper these calls?  These questions, and many more like them, promise to make the 2018 legislative session one to remember.