Federal tax and spending reform proposals present a challenging and volatile environment for state budget development. But Minnesota lawmakers can be guaranteed of two things.
The old Sunday school song goes “the foolish man builds his house upon the sand,” but sometimes the “man” has really no choice in the matter. Such is the case for state lawmakers tasked with constructing a biennial state budget while facing a potential wave of federal reform efforts in individual and corporate income taxation, ACA repeal, infrastructure spending, and K-12 education – just to name a few areas. Adding to the challenge, there appear to be some differences of opinion on these matters between the Trump administration and the Republican-controlled Congress. So the “hurricane watch” is not just a matter of intensity; it’s also a function of where the storm may be coming from.
Both the House and Trump individual income tax plans are based on similar themes of dramatic simplification, rate reduction, and expanded bases. Both reduce the number of income tax brackets from 7 to 3 (with identical rates of 12%, 25%, and 33%), although the Trump plan implements the top bracket for single filers at a much lower rate and eliminates the “head of household” filing status. Both increase standard deductions, both eliminate personal exemptions, and both eliminate the Alternative Minimum Tax. Perhaps the most notable difference regards the treatment of itemized deductions. The Trump plan caps them – albeit at high levels (e.g. $200,000 for married-joint filers) – while the House plan eliminates them entirely except for mortgage interest and charitable contributions.
If some version of this structural reform comes to pass, many tax policy experts predict potentially sizeable income tax revenue gains for states that conform with the federal code for a simple reason: states’ existing tax rates would now apply to broader tax bases. History suggests the revenue gains could be substantial. In the aftermath of the 1986 federal tax reform premised on base broadening, state income tax revenue grew by an estimated 20% or more in 19 states.1
To examine how such reform might play out here, we modeled the effects the House and Trump plans would have on state income tax burdens for income tax filers at selected incomes and filing statuses. We based our modeling on the representative taxpayers the Department of Revenue created for us to use in our latest Multistate Individual Income Tax Comparison Study. The findings from that study establish our comparative baseline, and we modeled tax returns for these filers under both reform proposals. It’s important to recognize while our modeling assumes the tax plans create no changes in taxpayer behaviors, it’s very likely that taxpayer behaviors would change under such significant federal reform, with corresponding changes in tax burdens. In addition, changing the number of dependents filers claim could have big effects on the comparative differences. Nevertheless, Table 1 offers some perspective into how burdens may change and what the resulting implications might be for state income tax revenue collections.
As the table shows, we project state income tax collections from conforming to the House plan would increase for all the married and single filers we modeled, ranging from a modest 1.4% for our single filer to 16.0% for our married filer with $50,000 in income. Similar, albeit less variable, results exist in conforming to the Trump plan, although its significantly more generous standard deduction for married filers compared to the House proposal results in a $120 state income tax cut for the $50,000 married filer rather than a $201 increase.
In most cases, higher state income taxes would be more than offset by lower federal income taxes lowering the total combined income tax burden. The big exception lies with our wealthiest example – the $500,000 married joint filer. Under the House tax plan, federal income taxes would increase as well as state taxes because the loss of state income tax deductibility overwhelms any benefits the adjustments to the federal rates and brackets provide. Currently, high-income filers in states like Minnesota that rely heavily on progressive state income tax systems benefit greatly from state income tax deductibility as the federal government effectively subsidizes higher state-level marginal tax rates. With competitiveness concerns and incentives to relocate already a prominent fixture of Minnesota’s individual income tax debates, this type of federal reform would take these discussions to a completely new level.
The history of tax reform is littered with ideas that make economists and tax wonks swoon but fail to get any public or political traction. Such seems to be the case with the Republican “destination-based cash flow tax” (DBCFT) – which would abolish the federal corporate income tax and replace it with a border adjusted, more progressive form of a value-added-like tax on goods sold in this country. Although it’s garnered a lot of interest and received some positive reviews from across the political spectrum, it would be truly significant reform creating major winners and losers in the business community and would demand a lot of leadership and political capital to make it happen. President Trump has declared the tax “too complicated,” and has demonstrated an interest in taking a mercantilist approach by addressing competitiveness concerns through tariffs. Any near-term reform effort will likely turn to less ambitious but familiar ideas along the lines of individual income tax changes – lower corporate rates paired with base expansion through elimination of or caps on various tax expenditures.
The Trump proposal cuts the corporate income tax rate from 35% to 15% while creating a new 15% rate for pass-through business income. As part of its DBCFT, House Republicans envision a 20% tax rate, 100% expensing on all tangible and intangible capital assets, and the elimination of various tax expenditures. It would seem likely those ideas would try to find their way into a federal corporate income tax reform proposal.
Revenue impacts aside, a federal rate reduction of this magnitude would almost assuredly trigger an immediate call to dramatically reduce Minnesota’s corporate income tax rate over competitiveness concerns. Although Minnesota’s 9.8% rate is second highest in the nation, the current top federal rate of 35% has a much larger relative influence with respect to competitiveness issues. Under federal reform state taxes would suddenly represent 50% or more of all corporate income tax exposure on Minnesota-sourced revenues.
The other potential budgetary curve ball lies in federal policy changes regarding the repatriation of foreign earnings. Both the president’s and the House’s tax plans have called for a deemed repatriation of corporate profits (Trump at 10%, the House at a rate of 8.75% percent for cash and cash-equivalent profits and 3.5% on other profits.) Both rates are likely low enough to have the policy feel and implications of a voluntary repatriation holiday like that which occurred in 2004. Back then, the state’s economic forecast projected higher near-term corporate income tax collections offset by a loss of revenues in future years. While the ongoing compulsory nature of deemed repatriation may mitigate some of the “espresso effect” on corporate income tax collections, it seems likely any movement on foreign earnings repatriation would give a boost to projected revenues.
For two-thirds of the federal safety net’s Big Three – Social Security and Medicare – it’s not clear whether congressional Republicans and the president are on the same page. But for the third program, Medicaid, a shared sense of policy direction exists with potentially major ramifications for the state budget.
Our national health insurance program for the poor (“Medical Assistance” in Minnesota) is funded jointly by the federal government and the states. Currently, the federal government pays states at least 50% of Medicaid program expenditures based on certain criteria. As states increase the generosity and scope of their Medicaid programs, the federal government pays its portion of the increased costs. Both the president and the congressional majority have expressed concerns about the incentives this creates and have stated an interest in converting Medicaid into a block grant program.
This seemingly straightforward idea masks a really challenging question: how would you determine each state’s grant? One option would be to use existing Medicaid spending as a base and issue the block grants on a per capita or per enrollee basis. But an analysis by the Urban Institute showed that current spending per low income person varies by a factor of 5:1 across the states and spending per enrollee varies by a factor of at least 2:1.2 Block grants based on current spending would lock in these disparities, turning state policy decisions into federal ones.
As an alternative, the block grants might be determined using some need based calculations independent of state Medicaid decisions like per capita income, which is already used to determine the federal government’s share of each state’s spending. But an analysis by researchers at the American Enterprise Institute concluded such an approach would “result in a seismic redistribution of federal spending."3 According to the analysis, under a personal income-adjusted block grant program Minnesota would stand to lose $1.07 billion per year in federal Medicaid support.
The potential general fund budget considerations regarding Medicaid reform don’t stop there. What would be the financial implications of all the new administrative responsibilities now delegated to Minnesota? Since demand for Medicaid is countercyclical and increases in difficult economic times, would we need to strengthen our existing budget reserve even further on the expectation that federal contributions would not increase during recessions? And if the federal government’s block grant appropriations fail to keep up with demand, what are the contingency plans (and the general fund implications) for more uninsured and underinsured residents?
These three areas are just the tip of the iceberg. On the revenue side, any state gains that may materialize from federal individual and corporate income tax reform could be offset by other reforms which make retaining other state collections much more challenging. For example, expressed interest in abolishing the federal estate tax would make it even more difficult for the handful of states like Minnesota that have this tax to keep it. On the spending side, all other discretionary spending areas – transportation, higher education, K-12 education, non-Medicaid human service programs, etc. – will be exposed because of the likely transformation in the federal-state relationship specifically and in the concept of fiscal federalism generally.
Amidst all this uncertainty, state lawmakers can be guaranteed of two things. First, whatever revenue gains federal tax reform might generate for states will be counterbalanced by significantly greater responsibility in financing public goods and services. This will come with greater pressure to ensure state tax systems do not get out of line with the rest of the country because of the much larger role state tax systems will have with respect to tax competitiveness.
Second, competition for resources within state budgets is only going to intensify. Politically unpopular and dangerous topics that tend to keep government redesign ideas in filing cabinets will have to be discussed. Some of the most sacrosanct ideas about organizing, managing and delivering government services are going to have to be rethought. We will once again have to embrace the idea of the states as laboratories of democracy, and Minnesota is going to need all the mad scientists we can find.