Session Wrap

A look at the tax and fiscal aftermath of the 2021 Special Session and why a “miscellaneous” provision deep in the tax bill may eventually turn out to be the most influential long-term tax policy action arising out of this strange year.

As this year’s special session dragged on and lawmakers crept toward the precipice of a government shutdown, leadership assured everyone that budget agreements would be reached in time.  Lawmakers delivered on that assurance, but in the process proved money doesn’t necessarily buy timely conclusions to legislative sessions.

For the fourth consecutive biennial budget session, lawmakers ran through the constitutional stop sign.  The legislature might not consider the May deadline a functional anachronism, but it’s certainly been treated as one.  All the special extenuating circumstances surrounding COVID and public safety reform certainly didn’t help, but this is now a regular feature of state lawmaking, at least during times of divided government.  When the Minnesota Supreme Court ruled in 2017 that a shutdown means the state would actually shut down, June 30 became the “real” budget deadline date – the one that actually has teeth.

Moreover, some legislators have suggested the deadline has become a practical anachronism as well due to state government’s modern size and complexity.  They observe the scope of the general fund budget is much larger and infinitely more complex than when the state constitution was ratified.  Indeed, for most of the state’s history, local rather than state government budgets were predominant and preeminent.  It’s even arguably different now than it was as recently as 1971 when the legislature created a commission to study the constitution and make recommendations to maintain its utility.  In that year, property tax collections were still over 35% larger than state individual income and state sales tax collections combined – an indication of local government’s continuing relative primacy.  Today, these two state revenue workhorses support twice as much government per year as property taxation, but lawmakers still have the same roughly 75 days to pull together a general fund budget.

Be that as it may, the work is done – at least for the time being.  Here’s a look at the tax and fiscal aftermath of the 2021 Special Session and why in future years it may turn out – looking back in retrospect – that the most influential long-term tax policy action arising out of this strange year came from a provision filed under “miscellaneous.”

The Big Picture on Spending

Table 1 presents how the new general fund budget shakes out.  The $52.3 billion for FY 22-23 is a $1.73 billion (3.4%) increase over February forecasted spending under current law for FY 22-23 and a $3.9 billion (8.1%) increase over what was enacted 2 years ago.  Since changes in the general fund budget relative to the February forecast present a state budget picture using a baseline of current law spending, it has the potential to mask the budget impacts current law actually has on the budget growth over time.  As always, nowhere is this more relevant than in the Health and Human Services area.  As the table shows, while the actions of lawmakers this year boosted general fund HHS spending by an additional $433 million[1], actual biennium-on-biennium growth is in the range of just under $2 billion.

Federal Government Funds: Eligible Uses Could Change

The biggest fiscal question hanging over this year’s budget deliberations was if, how, and to what extent $2.83 billion in federal fiscal recovery cash could be used to support general fund spending or offset existing general fund expenses.  That question took on much greater relevancy in mid-May when long-anticipated Treasury guidance indicated the state had a lot more flexibility in using the money for general government services than had been anticipated.  At the same time caution was warranted not just because of the unpredictability of COVID recovery and its ongoing spending demands, but because of the potential for triggering federal recoupment of funds through various tax actions.  The parties may have profoundly different perspectives on matters of state taxing and spending, but they are certainly unified on one core fiscal idea: don’t give money back to the federal government.

In the end, the enacted State Government Finance bill appropriates federal fiscal recovery funds in four ways:

  • $500 million goes to a new “COVID Flexible Response Account.”  This is the carved-out sum appropriated to MMB to pay for the Governor’s chosen COVID response priorities such as summer education programs.  Like last year’s COVID 19 Minnesota Fund, certain proposed expenditures are subject to the COVID Response Commission’s review and recommendation process,[2] although the threshold for triggering a review is increased from $1 million to $2.5 million.
  • $663.1 million goes to general fund revenue replacement in FY 22-23
  • $550 million goes to general fund revenue replacement in FY 24-25
  • $1.15 billion is reserved for the 2022 legislative session or a special session before then.  This sum may only be spent as appropriated by the legislature in law (The agreed upon $250 million for pandemic bonus pay later this year would come out of this pool).

As these figures indicate, lawmakers chose to leave a considerable amount of federal support on the bottom line – roughly $1.65 billion to be exact – for future decision-making.  In addition, the $663.1 million which was appropriated for the current biennium essentially equals the $669 million biennial price tag of federal conformity (almost all of that being PPP loan forgiveness) and the unemployment subtraction -- both approved uses of recovery funds.  Money is fungible, so it’s fair to say nearly every cent of revenue replacement from Fiscal Recovery Funds appropriated for the current FY22-23 biennium (so far) is going to PPP loan forgiveness and unemployment tax relief.

Leaving money on the table for future appropriations enhances budgetary flexibility and financial stability (and may have made closure this year a little easier with fewer resources to fight over).  It also improves the odds of getting out of the 2022 session on time while generating a lot of goodwill with voters in an election year. However, the strategy is not without some risk with respect to the most flexible use of federal dollars: providing general government services.

Treasury guidance on the use of recovery funds for general government purposes dictates that if the state’s revenue collections have “recovered” as determined by a formula provided by Treasury, then the money can no longer be used for this purpose.  The next recovery checkpoint is December 31, 2021.    Given the state’s recent revenue collection trends, it seems entirely possible (and we think highly probable) that the door will close on general government uses of ARPA funds as early as the end of this year.

Minnesota would then still be able to spend recovery funds on three other uses: pandemic response (which is a rather accommodating category in its own right), more premium pay, and water/sewer/broadband infrastructure.  The state finance bill addressed this contingency by stating if the transfer of ARPA funds to the general fund for the provision of government services is not allowed, then MMB is authorized to replace a comparable amount of enacted general fund appropriations in that biennium (appropriations that represent permissible uses of ARPA funds.)  But as COVID's health and economic impacts presumably diminish going forward, we would expect reimbursable COVID expenses will be getting harder to come by and justify.  That's especially true when $5 billion in additional ARPA funds are being distributed throughout state and local government to address COVID's health and economic fallout.  How can $550 million of forecasted general spending two years from now be linked to COVID recovery actions and be eligible for federal fund use/reimbursement under Treasury’s guidance?  We don’t doubt lawmakers and MMB would work hard to find a way to make that happen.

The Tax Bill – Fighting for COVID’s Table Scraps

Early in the session initial concerns surrounding the tax bill centered on the possibility that various forms of tax cuts/relief could have the unintended effect of triggering recoupment of federal dollars.  That concern faded as MMB reported collections well over forecast, culminating in the May update declaring fiscal year-to-date receipts were already $2.17 billion above what was projected in the February forecast.  It appears Minnesota will have plenty of “organic growth” – in the words of Treasury – to offset any clawback concerns.  Moreover, most of the revenue reductions in the tax bill arise out of  conformity to federal PPP loan forgiveness and unemployment insurance exclusion, neither of which count as revenue reductions in eyes of Treasury.  Of the $745.6 million in biennial revenue reductions from tax policy changes, 86% come from just these two provisions.

These two provisions were commonly described as “tax cuts” in the media, although “tax relief” is a better label given the temporary, mostly one-time nature of these reductions.  An even more accurate description would be “tax abeyance,” since in non-emergency conditions both types of income would – and if adhering to good tax principles should -- be taxed.  According to the Department of Revenue, the approximately 487,000 returns claiming the unemployment subtraction will have an average reduction in tax of $482 in tax year 2020.  For the PPP loans, Revenue estimates 24,800 returns will have an average benefit of $9,300 for loans in tax year 2020, and 28,000 returns will have an average benefit of $5,100 for tax year 2021.

The price tag of the PPP and unemployment provisions had major ramifications for the rest of the tax bill by consuming so much of the global target for taxes.  With regards to the state’s rather lengthy federal conformity decision-making agenda, lawmakers decoupled from several provisions and adjusted effective tax years for most of the rest (by typically limiting conformity to tax year 2020 and earlier).  A lot of this partial or temporary conformity can probably be expected to be revisited next year in the 2022 session.  Similarly, the mish-mash of small individual and corporate income tax credits and exclusions that survived in the omnibus bill were often reduced by limiting effective tax years, capping allocations, or making other tweaks.  A couple of provisions with slightly more noticeable budget impacts in this biennium or the next are:

  • $20 million of local homeless prevention aid to counties per year (beginning in FY 24);
  • A $50,000 increase in the market value exclusion for the state general levy (with a $10.6 million per year reduction in the levy in FY23 to avoid shifting, increasing to $20 million per year in the out-biennium);
  • A new housing tax credit for contributions made to an affordable housing account (about $10 million per biennium, effective tax year 2023); and
  • $30 million to counties to pay for property tax refunds owed by local governments to utility and pipeline companies due to state overassessment.  Although this is one-time aid, there are more potential refunds in the pipeline (no pun intended).  They are smaller but generally impact more counties.   For that reason, the tax bill also included a provision requiring the commissioner of revenue to perform a review of the process by which utility and pipeline properties are valued.

A few other non-fiscal impact provisions are worth flagging.  At the top of the list is the pass-through entity tax.  Minnesota has now joined 15 other states in providing higher income resident relief from the 2017 Tax Cuts and Jobs Act’s $10,000 cap on the state and local tax (SALT) deduction without lowering state tax revenue.  The state budget reserve amount has been updated to $2.38 billion, and a new “revenue shift fix” has been tacked on to the pre-session allocation of any surplus revenues arising out of the November forecast.   This one reduces the percentage of accelerated June sales tax liabilities until the percentage is reduced to zero.  It is sixth in the pecking order behind items like budget reserve replenishment and paying back school shifts.  With regards to property taxation, summary budget information on local units of government and percent changes in their proposed levies for the following year will accompanying taxpayer notices of proposed property taxes beginning in tax year 2023.

Wrestling with Tax Expenditures

Overlooked in the narrative of tax relief and buried deep in the text of the omnibus tax bill’s “miscellaneous” article is a provision offering possibly the biggest lasting and beneficial impact on the state’s tax system.  The provision launches a serious effort to bring tax expenditures into the biennial budget process thanks to the leadership of House Tax Chair Marquart, who has been a champion for this cause for some time, and the support of Senate Tax Chair Nelson.

The centerpiece of the legislation is the establishment of a new tax expenditure review commission.  It will be comprised of four senators (two appointed each by Senate majority and minority leader) four House members (two appointed each by House Speaker and minority leaders) and the commissioner of Revenue (or designee).  Supported administratively by the Legislative Budget Office and the Department of Revenue, the commission for the first three years will conduct an initial review and identify evaluation measures.  After this period, tax expenditures will be reviewed on a regular rotating basis, which among other things would include:

  • measurable impacts and efficiency of the expenditure;
  • comparison of effectiveness to a direct expenditure;
  • potential modifications to improve efficiency and effectiveness;
  • potential revenue-neutral rate reduction from repeal;
  • cumulative fiscal impacts of other state and federal taxes providing benefits for similar activities; and
  • a recommendation of whether the expenditure should be continued, repealed, or modified.

The commission will be required to submit a report to the legislature by December 15 of each year, and tax committees are required to hold a public hearing with testimony in the year following the submission of the report.

Minnesota’s biennial tax expenditure budget report, long regarded as a model for other states, will also be enhanced.  Beginning in 2024, the report will include incidence analysis of significant sales and income tax expenditures[3], estimates of revenue neutral rate reductions from repeal, and purpose statements for each expenditure communicating the rationale for its policy existence.  The enhanced report will be published in November of every even numbered year to align it with the biennial budget session.

Having a good definition of what constitutes a tax expenditure is important, and definitional debates have often been a thorn in the side of making progress on this topic.  The bill also amends the definition of tax expenditure to exclude provisions that mitigate tax pyramiding on intermediate business-to-business inputs.  (It should also exclude comparable corporate tax provisions like the dividend received deduction).

Finally, the legislation requires any bill that creates a new tax expenditure or continues an expiring tax expenditure must include an expiration date for the tax expenditure that is no more than eight years from the day the provision takes effect.

As we have stated before, tax expenditures are not by definition bad policy.  They can support important public policy goals.  But they can also:

  • cause tax rates to be higher than they need to be;
  • introduce significant amounts of administrative complexity and cost into the tax system;
  • create perverse incentives; and
  • violate important tax principles like treating equals equally.

Contrary to popular belief, tax expenditures do not shrink the size of government.  Taxpayers who do not benefit pay higher rates for the same size of government.  If forgone revenue would have been used for a rate cut, the size of government has gone up not down.

The smart money is probably on lowering expectations from this initiative.  As State Tax Notes columnist Billy Hamilton recently observed about these provisions, “The political inertia of doing nothing is amazingly powerful, regardless of which party controls the legislature and governor’s office.”[4]  But even if political inertia wins, it won’t be because we don’t have a much better and needed understanding of what we are doing with our tax system, why we are doing it, and what the implications are for the both the state and taxpayers themselves.


[1] Includes a $100 million transfer from the budget reserve.

[2] The make-up the commission would require a majority of the House and the Senate commission members to prohibit an expenditure, which under the current commission composition, makes any such prohibitions unlikely. 

[3] “Significant” is defined as all tax expenditures excluding those incorporated into state law by reference to a federal definition of income, results in a revenue reduction of less than $10,000,000 per biennium, or is a business tax credit (because Revenue’s incidence database isn’t sufficiently granular for corporate or pass-through business taxes.)

[4] “The Stubborn Stickiness of Tax Expenditures,” State Tax Notes, December 10, 2020