Governor's Budget Released - Familiar Session Plot Line to Commence

Governor Walz released his budget Tuesday marking the first major salvo in the FY 22-23 biennial budget battle.  He described it as a both a fiscal and moral document but like all budget proposals it serves as a political document as well.  Although presented as a COVID recovery budget, it is a highly ambitious expression of familiar DFL tax ideas and spending proposals.  And, unsurprisingly, Republican reactions to this budget might also prompt memories of legislative sessions past.   

As we have previously noted, according to the November forecast, 95 cents of every dollar of new FY 22-23 biennial general fund revenue is now forecasted to be consumed by current law health and human service spending. That presents a major budget challenge, for lawmakers especially given the needs in other areas of government in these times.   The Governor’s proposed action plan is to raise $1.66 billion of revenue and tap $1 billion of the state’s budget reserve to fund $1.3 billion in new spending.   (For the current biennium he is proposing an additional $175 million in spending from the current surplus to address economic, health and educational fallout from the pandemic.)   

On the spending side, the Governor is placing a major emphasis on addressing educational disparities/achievement gaps/equity issues all exacerbated by COVID.   In addition to a $301 million increase in general formula aid (1% for FY 2022 and 2.5% for FY 2023), and $86 million to address special ed and English learner cross subsidies, the Governor is proposing about two dozen new initiatives (or expansions of existing initiatives) yielding an E-12 education budget increase of $663.5 million.   In the other big slice of the general fund pie chart  -- health and human services -- the Governor’s budget features about $100 million in budget reductions and includes nearly $60 million in savings identified through the Governor’s Blue Ribbon Commission.  However, spending increases elsewhere in the DHS budget results in a $166.9 million increase in biennial spending over current law forecast.  (Combined with current law spending, that would consume over 100% of the currently forecasted increase in FY 22-23 general fund revenues, all else being equal.)

Arguing that those who have likely benefited in recent times need to step up and pay their "fair share," the Governor is proposing an array of tax increases, mostly targeting the wealthy and business.  They include:

• Creation of a fifth-tier bracket for incomes over $1 million (affecting top .7% of tax filers, proposed rate not available) -- Projected revenue: $402.7 million
   
• Capital gains tax (imposing an additional 4% tax on long-term capital gains and qualifying dividends income in excess of $1,000,000 -- in addition to existing income and capital gains taxes.)  Projected revenue: $486.1 million
   
• Repatriation of foreign earnings -- Projected revenue: $336.2 million
   
• Corporate franchise tax rate increase to 11.25% -- Projected revenue: $423.8 million
   
• Modified sales tax exemption for new and existing qualified data center software purchases by decreasing period of exemption from 20 to 5 years and limiting refund to 50% of sales taxes paid after June 30th, 2021 -- Projected revenue: $30.7 million

The budget also includes another familiar staple of tax bills past - a $1 cigarette tax increase.   Notably the budget does not include an allowance of deductions for business expenses paid with forgiven PPP loans which comes with a $437.8 million price tag for the FY22-23 biennium.  The budget proposal also features a $101 million increase in the state’s Working Family Credit and an expansion of the first tier of the state income tax providing tax relief to an estimated one million Minnesota families.   $470 million is left on the bottom line for the FY24-25 out-biennium.

As might be expected, the Republican reaction to the proposal was less than enthusiastic.   Senator Gazelka said the Republicans have drawn “a line in the sand” with regards to any tax increases.  He argued the state should be focusing on the fundamentals like balancing the budget with the state's reserve and getting kids back in school, rather than pursuing new policies.  In short, in these rather extraordinary times, it’s shaping up to be a “ordinary” Minnesota legislative session in a time of divided government.   We will have more to offer in our next issue of Fiscal Focus.

A few comments

Federal Government to the Rescue? -- A lot can happen between now and the all-important release of the February forecast.    At the top of the list is yet another round of federal COVID relief that this time would provide general purpose state aid to replace lost revenues.   These revenues would seem to be needed for the Governor being able to make meaningful progress in his ambitious agenda.   Even if it does materialize, Republicans have made it a top priority to have the legislature be much more involved in the distribution and use of funds. 

The Forthcoming Tax Incidence Study is Going To Get a Lot of Scrutiny  --  The topic of tax fairness has been on a bit of a hiatus for a while but is now returning to center stage. The Governor has made it clear he believes that the disparate impacts of the pandemic require those whose economic fortunes have improved during these times need to pay their “fair share” to get Minnesota through this difficult period.  However, the Governor is proposing permanent rate increases rather than temporary rate increases or surcharges.  This indicates an interest not just to get through a tough period but to raise large amounts of permanent revenue under the tax fairness banner. 

Two years ago a Star Tribune headline read, “Lowest-Income Minnesotans Hit Hardest by Gov. Tim Walz's Tax Plan,” a finding based on the Department’s tax incidence analysis of the Governor’s revenue raising proposals.   With a renewed Daytonesque focus on the wealthy, the Governor is clearly not intending to let that happen again this time around.

We don’t know what this year’s study results will show in the post-TCJA world.  However, we will be interested to see if, once again, the study finds that all the taxes state and local governments collect directly from citizens are collectively progressive.  In other words, Minnesota’s highly progressive individual income tax (with help from the property tax refund program and a small assist from the estate tax) has more than offsets the combined regressivity of every other form of individual taxation in the state — including especially regressive taxes like tobacco and gasoline taxes.   This has made business taxes the source of overall state tax system regressivity.

A Cost/Benefit Analysis of Recent "Talking Points" -- In the Republican response to the Governor’s budget proposal, leadership derided the Governor’s proposed tax relief through the expansion of the income tax first tier. It was noted the average tax cut of $36 dollars a year translates into a cup of coffee a month and is, “a perfect example of why his budget is not real… a talking point not a tax cut.”  

This proposal deserves to be compared with a couple of other recent tax cuts introduced by Republican legislators with equivalent interest and enthusiasm and subsequently enacted in 2019:

• Reduction of the second tier income tax rate from 7.05% to 6.8%.  Based on the modeling underlying our income tax comparison study, for married-joint filers with $100,000 of household income (near the median for couples) and two kids we estimate the rate cut yielded $73 of income tax relief– which equals $6, or two cups of coffee per month at a cost to the state of about $300 million for the forthcoming biennium.
   
• Maximum Social Security subtraction increased.  Again, based on our tax comparison study modeling, median married-joint senior filer income of $75,000 realized reduced income tax burdens by $32, or $2.67 a month at a cost of $10 million to the state treasury.

These bills get pursued because even though the relief is likely to not even be noticable to taxpayers, the political benefits are substantial.  They are also a very "real" part of the budget because of their often large impact on state revenues providing tiny amounts of relief to large numbers of taxpayers.  Expanding the first tier to give a million households an average of an extra $3 a month per year is projected to cost the state $92.5 million for the coming biennium -- enough to support the Governor’s proposed FY 22-23 spending changes in jobs, economic development, commerce, and environment combined.

Be Careful What You Wish For – With a renewed focus on taxing high income earners, there will be a justified renewed concern about state competitiveness, talent attraction, and the risk of capital and high earners drifting away over time.   But progressives’ own agenda may also be at risk.  Author and scholar Monica Prasad of Northwestern University has built a distinguished academic career around investigating the sociology of taxation. In exploring why decreases in social spending took root in some countries but not others, she has concluded tax codes and tax progressivity have a major effect. Countries with stronger progressive tax codes and more punitive business taxation triggered much stronger and more aggressive conservative responses against social welfare policies and related spending. The net effect in these countries is that progressive agendas actually lost ground over time.