Session Breaks Bad, Better Call Saul

Minnesota’s 2016 legislative session finished with its now-trademark blend of chaos, drama, finger pointing, and a real-life “Chariots of Fire” reenactment – a staffer sprint to beat a clock before it struck 12.  In the end, even though there was strong agreement on top session priorities of transportation, bonding, and Real ID, the final gavels fell with no resolution on these topics.

With these events undoubtedly triggering some level of disbelief among capitol watchers, it seems appropriate to turn to the world of fiction for some perspective.  Fans of the television drama Breaking Bad and its prequel Better Call Saul know that ethically compromised attorney Jimmy McGill (a.k.a. Saul Goodman) has a special talent for negotiating impossible situations.  We clearly could use some of that skill set.  Fans also know Saul for his ultra-pragmatism – the ends don’t justify the means; the ends make the means completely irrelevant.  Observers could be forgiven for thinking this attitude has to some extent permeated the legislative process.  And his ability to manage volatile circumstances certainly has parallels in the rough and tumble world of policy making.  For these reasons, we frame our session summary using Saul Goodman’s sage quotes and advice.

An undeniably promising future as a tax chair

“What good is money that doesn’t spend?”

Who would have thought dealing with a $900 million surplus would prove to be as politically challenging as dealing with a multi-billion dollar deficit?  About six hours before adjournment, House and Senate conferees approved a 600-page supplemental budget to complement the tax bill that conferees had adopted a comparatively leisurely 18 hours earlier.

Table 1 summarizes the net impact on the general fund of both these bills.  As the bottom line suggests, lawmakers spent about half of the $900 million state surplus on new spending and tax relief – about a 60/40 split respectively.  The $777 million impact on the out-biennium appears affordable – at least given current economic expectations – as current forecasted revenues less spending for FY 2018-19 is $1.2 billion.¹

On the tax side, primary winners were college students and their parents, lower income households, farmers, and owners of rural business property.  A trifecta of provisions specifically targeted would-be and indebted college students, including a new $36.5 million student loan debt credit and two new incentives for contributing to 529 college plans.  One of the nation’s most generous and accessible state earned income tax credits would have become even more so with an expanded phase out and a bigger credit for childless filers.  Farmers would have seen major property tax relief with the state picking up some of their tab for school construction projects, which (conceptually) would have made it easier for rural districts to pass capital levies for school improvements.  And excluding the first $100,000 of property value from the state general property tax levy – with a corresponding levy cut to avoid tax shifting – was a partial win for the business community, addressing one of their biggest tax peeves.

On the spending side, the strategy appeared to be to support as many spending interests as possible by providing supplemental resources short of everyone’s ask but sufficient enough to keep most everyone satisfied until 2017.  Legislators boosted general aid payments to cities (LGA) and counties (County Program Aid) for the upcoming FY 18-19 biennium; but in the case of LGA, most of that would have been “prepaid” in the current FY 16-17 budget period.  The $35 million each for broadband expansion and equity programs may have been significantly less than what advocates were seeking and what Governor Dayton wanted to provide, but together they constitute 40% of all supplemental budget spending.  Although $75 million was appropriated for Jobs, Energy and Equity (which includes broadband) only $16 million of fiscal impact exists in the out-biennium, suggesting most of this new spending is, at least for now, one-time money.  E-12 Education received a $25 million injection to establish a pre-K grant program, $12 million for school support staff, and additional funding for other grants – many of which are also of a one-time nature.  The one budget area that seemed to get relatively short shrift is Higher Education, which received only a $5 million bump in the supplemental budget.

Many inevitably will take issue with the priorities, targets, and deservedness of the various tax relief and spending measures the legislature chose to adopt.  But from an overall budget perspective, the combination of relative restraint and emphasis on one-time money appears to be a rather fiscally responsible effort by the tax and supplemental budget conferees, especially in a non-budget year.  In the end, the governor signed the supplemental budget bill, but a happy ending never materialized for the transportation, bonding, and tax bills.

“Did you not plan for this contingency? I mean the Starship Enterprise had a self-destruct button.”

The fact that transportation and bonding bills never even made it out of the legislature was entirely predictable and arguably predestined.  The immune response the words “transit” and “gas tax” trigger among many Republicans is equaled by the hives that break out among many DFLers exposed to the idea that road and bridge infrastructure be considered a public good worthy of ongoing general fund support.  Last year’s impasse provided all the evidence that some contingent “Plan B” would be necessary this time around.

As the stalemate continued, legislators demonstrated several examples of Saul-like maneuvering to try to get results, even if the means weren’t exactly according to legislative Hoyle.  Both the House and Senate’s bonding bills went down to defeat in their respective houses, which according to 8^th grade civics classes and 1970’s Schoolhouse Rock videos should be the end of things.  To keep the bonding discussion alive, legislators put a disaster relief bill into conference committee to serve as the vehicle for a final bonding bill.  And when it became clear the transportation funding plan was dead, legislators tried bolting an emergency one-year stopgap transportation spending measure onto a barely-breathing bonding bill.

Nevertheless, the clock expired on these contingency plans.  Coincidentally, Captain Kirk used the Enterprise’s self-destruct mechanism to settle a long-standing dispute between two warring parties with mere seconds to spare.  In contrast, the legislature was too late to act and the session blew up.

The saga of the tax bill is a slightly different story but with the same ultimate ending.  The governor’s veto of the tax bill was a function of misfortune and miscommunication but with a whiff of political strategy wafting over the whole set of circumstances.

The relevant issues themselves were hardly the big buck, contentious topics one might expect to trigger a veto, but rather a bill drafting error and a curiously strident demand about a very minor tax expenditure.  Before the drafting error came to light, the Governor insisted that a prerequisite for calling a special session was the extension of the sales tax expenditure for ticket sales to Minnesota State High School League events.   After the drafting error came to light, which according to Administration officials triggers the need for legislative action to fix, the Governor stated he would have signed the tax bill as is if not for the drafting error – a tax bill that would not have included one of his essential demands for calling a special session.    While the governor’s commitment to resolving both issues shouldn’t be questioned, it’s difficult to look at this sequence of events and conclude special session leverage was not a consideration.

In any event, the tax bill joined transportation and bonding as session casualties.  The final contingency option is another special session.  As of this writing, it appears a lot of stakeholders want it, and the governor is very willing to consider it.  However, it is also clear session content will not be something as simple as declaring a mulligan on the last 15 minutes and re-teeing the final proposal.  Governor Dayton has made it clear a special session will have to address several new items with implications for both the size and scope of any bonding bill and the supplemental budget.  Requiring even greater levels of compromise by clearly recalcitrant House and Senate Republicans does not appear to be a recipe for hope.

“Some people are immune to good advice”

When the bipartisan, local government-dominated 2012 Property Tax Reform Working Group recommended the elimination of the state general tax, they certainly did not do so out of some intense desire to give tax breaks to major corporations and skyscraper owners.  Rather, it was motivated by principles of good tax policy and local governments’ self interest – both based on the recognition that the state’s considerable intrusion and footprint in the primary source of revenue for local government operations makes sound local government finance much more difficult.

Why does this tax exist in the first place?  Many argue it was created to address political objections that business was getting “too good of a deal” out of sorely needed class rate compression.  Others point out money was needed at the time to make the overall Ventura tax reform and budget package work and regardless of its political origins, the reality is that the business community signed off on the tax.  But what does not get recognized is that the way policymakers treat the tax is a departure from what its policy architects originally envisioned.

According to then-Revenue Commissioner Matt Smith in an email exchange with us, a key idea behind having the state general tax was to make future policy discussions on interstate business property tax competitiveness a state policy (and budget) issue rather than a local government issue.  The idea was if business property tax competitiveness were threatened (as the business community now argues vociferously), the governor and legislators could use the state general tax as a “relief valve” and dial down the levy accordingly.  But in practice, the state general tax has never served in anything resembling that capacity.  In fact, it has functioned in the opposite manner.  Since its inception, the state general tax has been on inflation-indexed autopilot using an arguably “inflated” inflation measure² explains why business is just as vocal about the indexing as it is about the tax itself.

Even if it never becomes politically feasible to adopt all of the 2012 working group’s recommendations, progress on good tax policy can be achieved by eliminating the automatic inflator and making the legislature biennially establish a levy which balances budget needs and competitiveness concerns.  Such a measure will likely prove to be tougher than enacting a value exclusion.  A reliable and predictably growing general fund revenue stream will generate a lot of spending interest antibodies to protect it.

“Interstate commerce?  It’s a b***h”

Legislators took Minnesota’s stance on taxation of remote sales to DEFCON 3 this year.  Emboldened by Associate Justice Anthony Kennedy’s comments on the U.S. Supreme Court’s 1992 Quill decision, state governments are clearly looking to instigate a challenge to the case.  South Dakota has taken the lead on the effort (perhaps not surprisingly, given that without an income tax it relies more heavily on sales tax revenues than most other states), enacting legislation designed to trigger a lawsuit.

Minnesota lawmakers have not been quite as aggressive as their South Dakota counterparts, but have still invested considerable time and energy into this topic.  The conference committee’s remote seller language:

• modifies and clarifies provisions related to marketplace providers;
• carves out an exemption to the definition of in-state retailers for any retailer with sales into the state of $10,000 or less over a 12-month period;
• expands the definition of “affiliated entities”;
• imposes collection and remittance requirements for marketplace providers and marketplace sellers; and
• imposes an effective date of no later than either a reversal of the Quill decision or July 1, 2019.

It’s clear a federal solution remains the preferred manner to address “marketplace fairness” but patience is plainly wearing thin.  The graph below, which we stumbled across in a financial blog, suggests why that may be among states (and for that matter many retailers).  It is just one very indirect data point pertaining to one year of financial results, but it conveys a rather loud message.

Lawmakers also tackled another longstanding concern tangentially related to interstate commerce:  the use of Minnesota domiciled professional service firms as a factor in determining residency.  In the 2015 session both the House and Senate had language in their respective omnibus tax bills prohibiting the location of someone’s attorney, CPA, financial adviser, or financial institution from being factored into residency determinations.  Legislators brought those ideas back this year with some additional definitional refinements and included them in the 2016 tax bill.

This long simmering issue has reached full boil in recent years as out-of-state competitors targeted Minnesota retirees and part-time residents with marketing campaigns that essentially distilled down to “Move your business to us. Why take the chance?”  Before the tax and conference committees, the Department of Revenue continued to emphasize its responsiveness to these concerns with their ongoing “clear language” efforts and informational products such as their recently issued Revenue Notice #16-01: Income Tax – Domicile Consideration – Location of Attorneys, Certified Public Accountants, and Bank Accounts”.  However, Minnesota’s financial services firms were not taking any solace in the fact that ongoing uncertainty and ambiguity could be communicated plainly and simply.  Tax conferees agreed, as one noted, information is nice, but a law is needed.

“If you're committed enough, you can make any story work.”

Over the last decade, the messaging on Minnesota’s public pension plans has been 1) there is nothing fundamentally wrong with the structure and design of the current system that a few benefit and contribution adjustments can’t fix; and 2) adopting those tweaks will put us securely on a path to full funding.  If the political press’ failure to discuss this issue in all the session post-mortem reporting is any indication, this story has been tremendously successful.

Valuation reports this year, however, revealed a $15 billion shortfall in assets needed today just to pay for the retirement benefits already earned, let alone pay for new benefits earned this year and every year going forward.  But that sum assumes the pension plans’ investments can generate returns of 8% per year, even though their actuaries have determined earning even 7% per year is only a 50/50 proposition over the next two decades.  Valuation reports also revealed state pension plans are now collectively “net sellers” – collectively $2 billion more money went out to pay benefits last year than came in through contributions.  Assuming this trend continues (as the demographics suggest) and less capital is retained to invest, it will become more and more difficult to invest our way out of the existing hole.

Not only did these numbers fail to generate more aggressive reform discussions, even the sustainability repair proposals the pension plans themselves recommended faced internal resistance.  And the source of the resistance was based on a commitment to a story of “fairness” that is so shortsighted in nature, so limited in scope, and so misguided in application, the idea ceases to have any meaning.

The contribution increases discussed this year would have been implemented a year from now (July 2017), giving school districts and state agencies time to plan for this additional expense.  But school district officials were adamant they could not afford the contribution increases and insisted the state had to commit to increase school aid to cover the cost.  MSRS, their stakeholders (and PERA and others) undoubtedly watched this development closely figuring what’s good for the goose’s budget would be good for the gander’s.  No commitment could be reached on new money now which derailed the contribution increases, but plan officials have made it very clear they will again be requesting them in the 2017 session.

When it became clear that contribution increases would not be enacted this year, retirees began barking about the unfairness of violating the spirit of “shared sacrifice”.  Remarkably, but perhaps not surprisingly, counter to the expressed recommendations of plans themselves, over 60 House members voted yes on a floor amendment to delay cost of living adjustment reductions.  And citing this “fairness” concern, the governor vetoed the omnibus pension bill – which is all the more interesting since his proposed budget had no money to help school districts or state agencies actually share in the sacrifice.

In summarizing what legislators attempted to accomplish this session with respect to pension repair, LCPR Chair Rep. Tim O’Driscoll employed an apt analogy which likened this year’s attempted corrective actions as embarking on just the first leg of a very long flight.  The problem is that we proposed to begin a grueling, multi-decade, around the world journey with a puddle jump from MSP to St. Cloud Regional with a 12-month layover.  And now even that flight out of MSP has been delayed for another year.

Thus, under the increasingly distorted story of what “fairness” means, even exceptionally modest attempts to improve the health of Minnesota’s public pensions have now been put on hold for another year.  In the process, fairness to current public employees whose retirement future is placed at greater risk, fairness to future taxpayers saddled with the costs of both their own (future) public employees and the growing legacy costs of the current employee base, and fairness to Minnesotans facing a future of higher taxes and/or diminished public services gets thrown under the bus.

While many may view the last couple of months as another session of unfulfilled potential, it may be unrealistic to expect more in a year when decisions regarding budget matters weren’t actually required and both houses are up for reelection.  The currency of compromise has been devalued over time, but more so in an election year since campaign literature can so easily market compromise to voters as an electoral liability.  Certainly, the election results this fall will eventually prove to be a more powerful influence on the state’s fiscal future than all the developments of this session combined.

Or as Saul says, “It’s the way of the world. You go with the winner.”