A “Once a Generation” Challenge Awaits State Tax Committees

The Minnesota Department of Revenue has released a preliminary estimate of the state budget impacts stemming from the passage of the Federal Tax and Jobs Act – specifically the impacts arising out of changes to the definition of federal taxable income, which is the starting point for determining Minnesota taxable income.  As we have discussed before, the general theme of broader bases offset by lower rates results in federal income tax relief for most Minnesotans, but applying the now-expanded tax base to unchanged Minnesota tax rates would result in higher state corporate and individual income collections.  The DOR revenue estimate offers perspective on the sources and magnitude of the changes.

As the summary table shows, absent any state policy responses, projected revenue collections would increase by about $850 million in the current budget cycle (FY 2018-19) and by $1.5 billion in the FY 2020-21 budget cycle.  A few observations from a closer look at the details:

  • Most of the media attention has focused on the partial loss of state and local tax deductibility, but eliminating personal exemptions will have the biggest impact on state income tax filers.  Over the current and upcoming budget cycles, conforming to the more generous federal standard deduction will cost the state $3.2 billion, but that will be more than offset by the $4.1 billion increase in state income taxes from repealing personal and dependent exemptions.  The net $929 million increase is over 50% larger than increased taxes stemming from the repeal and modification of itemized deductions, of which only a portion is the partial loss of state and local tax deductibility.
  • Pass through income is going to be a lightning rod for debate.  Tax experts have almost universally derided the new federal 20% deduction of certain pass through income for many reasons including 1) the lack of any coherent reasoning for who should get this benefit and why as well as 2) its considerable inducement to artificial tax planning.  Tax scholar Daniel Shaviro has even called it, “the worst provision ever even to be seriously proposed in the history of the federal income tax.”  It also turns out to be very expensive for the state – costing $963 million over FY 18-21.  Even the conservative Tax Foundation of Washington D.C. has argued states like Minnesota should decouple from this provision.  Yet Minnesota’s business community has long made some tax relief for pass through entities a major reform theme and priority.
  • A lot of legislative time and mental energy will inevitably be sucked up by conformity issues surrounding various business and investment provisions.  The Department’s preliminary estimate identifies 22 “other business and investment provisions” (excluding the high profile bonus depreciation and Section 179 expensing) plus three international business income provisions.  On an individual basis, the budget impact of these provisions is relatively modest even if the sum is less so.  However, their individual budget impacts belie the seriousness, importance and relevance these provisions will have to specific Minnesota businesses.
  • Federal tax reform has the potential to make property taxes look more affordable in the eyes of the state.  “Property tax interactions” reflect the impact on the state’s income tested refund programs.  Repealing personal exemptions is projected to reduce property tax refund payments in the upcoming FY 2020-21 budget cycle, eating up over $160 million of the federal tax relief being provided to homeowners and renters.

The Department of Revenue notes these estimates “should be a starting point” for policy discussions rather than a policy proposal.  Adding to the complexity is that balancing the state budget is only one dimension to consider in crafting policy going forward.  State competitiveness, a rapidly shifting federal/state spending relationship,equitable treatment of business entities, and the state’s historical emphasis on tax fairness are just some of the other high profile issues guaranteed to influence the state’s response.

Look for our modeling of individual income tax burdens under the final bill in the near future.