Would a Full Exclusion of Social Security Income Keep Minnesotans Here?

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The tax bill currently in legislative limbo is the largest proposed tax relief in state history.  While that may not be a shock given the size of the surplus and current out-biennium projections, the centerpiece is a lot more surprising and justifiably curious.

Coming in at $1.6 billion over three years and rising from there, the House and Senate agreed to a full exclusion of Social Security (SS) income.  This provision fiscally dominates all the other tax relief measures in the agreement on both an absolute and relative basis.  In short, the legislature determined the biggest tax cut priority of the state – and by logical extension the most needed tax cut in support of a stronger, more attractive, and more competitive economy -- is a tax break predominantly benefiting upper-middle and high-income retirees.

The primary justification (other than 36  37 other states do it) was the need to keep more mobile and wealthier seniors here in light of the economic activity this demographic generates and the philanthropy, volunteerism, professional networks and relationships no less important to the state economy.  It’s worth taking a closer look at the ability of this incentive to tame any out-migration.

According to Senate Research, nearly two-thirds of all households benefiting from a full exclusion are married joint filers.  Within this filer group, 77% of the benefit would go those with incomes over $100,000.  Among these beneficiaries, the decision-making relevance of SS income compared to other income sources is relatively modest to begin with and, unsurprisingly, declines at higher income levels.  According to the latest Department of Revenue tax incidence study tax profiles (2018), taxable SS income as a share of total taxable income was 27% for the average senior $100k MFJ filer; 17% for the average $150k MFJ filer, and only 10% for senior $250k MFJ filers. 

We modeled what an exclusion would have looked like had it been adopted in 2018 which provides some perspective on the type of tax savings that could be expected and how the new Minnesota tax burden would then compare to other states.  Annual tax savings of $1,600 - $1,750 is not an insignificant amount money.  However, even after adopting a full exclusion Minnesota tax bills could still be expected to be around 25% higher than the average of all other states with an individual income tax and $2,200 -$11,250 more than retirement destination states without an income tax like Texas, Nevada, and Florida.  For our highest income earners, Minnesota’s rank among states wouldn’t change at all.

Data is for Tax Year 2018 which does not include the incremental enhancement to the SS exclusion passed in 2019
2021 MCFE Individual Income Tax Study (Tax Year 2018)
Senior taxpayer profiles courtesy of the Minnesota Department of Revenue
Calculations obtained from Internet TaxSim (Version 35), National Bureau of Economic Research

A full exclusion provides a carrot to keep seniors as residents.  The problem is these same seniors have a vegetable garden of other income streams still exposed to Minnesota’s higher state income tax rates (and, at the very highest levels, wealth exposed to estate taxation).  Any senior truly motivated by income taxation will still have plenty of reason, motivation, and places to relocate to reduce their income tax burden regardless of what Minnesota does with its Social Security taxation.

For some, the tax relief might provide enough economic benefit to offset other considerations in their location decisions.  But even if the marginal incentive of a full exemption does keep a few more seniors as residents, the cost/benefit of this policy deserves consideration.

According to Senate Research, there are 406,619 filers who would benefit from a full SS exclusion in tax year 2022 across all filing statuses.  If we apply an annual 2% gross rate of senior state out-migration of this population1, that translates into an “average retention price” to keep them here in FY 23 of $62,700 per senior filer ($509.6 million / 8,130 filers).  If we favorably assume that 25% of this 2% would now choose to remain in the state because of the exclusion, that translates into a general fund impact of $251,000 per retained filer.  The same analysis applied only to the subset of filers most likely/able to leave for tax motivated reasons (incomes over $100,000) is $385,000 per retained senior filer.

Why Now?

Minnesota taxation of this income goes back to federal conformity decisions in the early 1980s and 1990s.   Not surprisingly, it was not exactly popular then either.   However, over time it was phased-in and finessed with some compensating provisions targeting seniors.   We began to tax this income because, once upon a time, there was bipartisan belief that high general tax rates were bad for the economy, and that base broadening to lower rates was a good thing (the decision to start taxing SS benefits in 1985 was actually accompanied by a sizeable income tax cut).   That adherence to good tax policy principles lasted for a while.  The dot-com boom around the turn of this century featured a multi-year tax cutting frenzy in Minnesota.  Yet, no Social Security subtraction bill of any kind was introduced during that period. 

Over time, attitudes have changed and so have the underlying circumstances.  Our research indicates the first enhanced SS income subtraction bill was introduced in Minnesota in 2005.  The first full exclusion bill was introduced in the 2009-2010 session.    But these continued to be loner bills until 2015-2016, when interest in exempting SS income suddenly began to take off and the number of bill introductions and authors began to explode.  What changed to make this pursuit the largest and most important tax relief measure Minnesota lawmakers could enact this year?   Two charts likely tell the story.

Federal Reserve Bank of St. Louis, "The COVID Retirement Boom"

Minnesota Voting Turnout by Age Group

Source: Office of the Minnesota Secretary of State

Not only has the retiree population boomed (as projected) over the last 10 years, but it is glaringly apparent which age cohort continues to lead in voter turnout.  If a special session does resurrect the SS tax cut, it is even less likely there will be a thorough policy discussion about how it measures up to other possible choices for Minnesota's economic future -- as the November elections creep ever closer.

For the last 5 available years (2014-2019) IRS Statistics of Income Gross Migration Files indicates the average gross outmigration for 65 and over filers with $100 - $200k was about 1.4% of the total population cohort and 2.1% for the over $200k cohort.  Net migration for all these cohorts is less — some higher income seniors do move into Minnesota despite the tax differential.