Unfinished Business?

The Rabbit Hole of Senior Tax Relief

"Would you tell me, please, which way I ought to go from here?”
“That depends a good deal on where you want to get to,” said the Cat.
“I don’t much care where,” said Alice.
“Then it doesn’t matter which way you go,” said the Cat.
“So long as seniors get tax relief,” Alice added.

“Going down the rabbit hole” is defined as “entering into a situation that is particularly complex, especially one that becomes increasingly so as it develops or unfolds.”  This superbly captures the substance and the politics of a centerpiece of this year’s tax debate -- the proposal to fully exempt Social Security income from state taxation -- and the complicated equity problems that result when choosing to provide income tax relief based on how people get their income.

As we have frequently discussed, a full exemption of Social Security income really doesn’t have a principled policy leg to stand on.  That fact is politically irrelevant.  Possession may be nine-tenths of the law, but politics and perception is 99% of Social Security tax policy.   Which is why this year’s result -- a significantly expanded exemption, but now based on household adjusted gross income to make its taxation more understandable and transparent, is the best outcome that could have been put together given the political environment.  However, this solution does not address the cascade of “what abouts” and fairness problems arising among seniors whose income composition and profile differ in any number of ways.

This session the legislature addressed one “fair treatment” complaint triggered by  excluding Social Security income – government retirees whose pensions are not coordinated Social Security and do not receive Social Security benefits.   That still leaves out seniors reliant on smaller taxable private pensions and/or those who must continue to work part time to supplement smaller amounts of Social Security income.  The latter appears to be a growing demographic.   According to the U.S. Department of Labor, the number of people ages 65 and older working or seeking work has increased by 144 percent in the past 20 years.   

The definitive guide to Senior Taxation in Wonderland can be found in a post entitled “Bad Policy Breeds Bad Policy” by former House Research tax guru Joel Michael on his state and local finance and tax blog, SALT Speak.   (As an aside, his blog is an absolute must read for anyone interested in gaining a better understanding of the topics, issues and complexities surrounding government taxation and finance.  Agree or disagree with his analysis and takes, you are guaranteed to be a lot smarter for the visit.)  In his post, he notes that Minnesota now has four different overlapping but uncoordinated special income tax preferences for seniors.  He offers an alternative approach to address senior relief in a way true to treating income equals equally.

Disassembling and reassembling senior tax policy is a highly unlikely undertaking in the next legislative session.  That’s especially true since many legislators have declared the full exclusion unfinished business and a priority agenda item for the future.  Lawmakers will likely hear a lot from wealthy senior households about this.  Not just because these households are being shut out of Social Security tax relief, but also because it’s likely to be seen as the cherry on top of a 2023 tax increase sundae comprised of a bigger phase out of their standard and itemized deductions and a new net investment income tax.   Whether this issue continues to have legs with the average (and for that matter, well above average) senior household will be a function of both their awareness of the changes and, more significantly, candidate willingness to educate them on it.

Options for Local Options

This year’s tax conference committee discussion and report addressed several controversial elements, one of which was the fate of nearly three dozen municipal local option sales tax proposals.  While the Senate included these requests in their omnibus bill, the House saw these provisions as an affront to state equalization objectives and interests and refused to hold a committee hearing on them.  The final tax bill authorized all new local sales tax proposals for the required local referenda vote, but also established a two-year moratorium on such provisions.  

In the interim a new Local Taxes Advisory Task Force, has been established to take a closer look at the role of local sales taxes as a funding mechanism for city and county governments going forward.    Consisting of a representative from the League of Minnesota Cities, the Association of Minnesota Counties, plus four members of the public appointed by Revenue Commissioner Marquart, the task force is charged with identifying objective evaluation criteria and processes for local general sales tax proposals, as well as for other special local sales taxes like food, beverage, and lodging.   The explicit exclusion of any legislator participation on the task force is interesting and a departure from similar tax task forces in the past, perhaps in recognition of strong political opinions and predispositions on this issue. 

This task force is not limited to an investigation on improving rigor and consistency regarding the “regional significance” hurdle that current law requires.   The language requires a reconsideration of the requirement itself, opening up the possibility of policy alternatives to the “project-by-project” approach now in place.  The language also requires the task force, in developing its recommendations, to consider interactions with general purpose aids and local property tax capacities.  In short, the work product has the potential to be a proposed restructuring of local finance policy – an immense task for a small group whose report is due before the start of the 2024 session.

As this session demonstrated, commitment to state equalization efforts remains strong but so is the hunger for local revenue diversification.  The ability to export tax burden is often cited as a primary motivation behind the interest.  However, the significantly lower visibility and salience of sales taxation compared to the unpopular property tax, the ability to link the use of sales tax dollars to a specific purpose or tangible outcome thus increasing public acceptance, and the ability to pay for the effort without competition from within the regular budgeting process are other factors influencing its popularity.   The success rates of local option levy referenda are a testament to this.  Whether local option taxes to fund general government operations would feature similar public support is an open question.

Uneven revenue raising ability from sales taxation across the state is understandably a chief concern among those opposed to granting greater local authority.  But e-commerce and its taxation has now introduced an interesting twist to this issue.   A recent national study examining the effect of e-commerce on the geographic distribution of local sales revenues found that as e-commerce increases, a destination basis for remote sales taxes results in higher growth in local sales tax collections in smaller, generally more rural jurisdictions.  Hand collecting revenue data from state revenue departments over the 2015-2021 time period, researchers found long term sales tax growth rates were 6.6 percentage points higher in small jurisdictions than the growth rate prior to the pandemic, accounting for influences like tax base growth, tourism effects, federal stimulus, and mobility.  In contrast, long term sales tax revenue growth rates in larger jurisdictions were 1.6 percentage points lower than the growth rate prior to the pandemic. 

The researchers conclude, “increases in on-line shopping disproportionately benefit smaller jurisdictions,” and that e-commerce “can act as an equalizer of sales tax revenue by eroding the fiscal benefits of large retail agglomerations.”   Moreover, with regards to equity concerns, the authors observe, “if rural residents are lower income and those jurisdictions have lower taxes, a switch from physical to remote goods may lower the regressivity of the sales tax.”

A 2021 report from the Center for Rural and Policy Development in Mankato largely echoes these findings here in the state.  This investigation found significant declines in the number of retail establishments in all areas of the state since the mid-2000s with the most severe declines occurring in the most rural areas of Minnesota which have lost nearly 25% of such establishments.   Yet Minnesota results "align with ongoing research across the nation showing that commercial and retail sectors have felt significant impacts from the growth of online sales but those impacts haven't translated into negative impacts for governments in terms of revenues."   Evidence also appears to support the national findings of benefits of e-commerce taxation accruing disproportionately to Greater Minnesota with this authority.   In examining communities with the longest histories on having local option sales taxes, researchers found the seven-county metro area trails all other regions of the state in the percentage increase change in local option sales tax revenue since implementation.    

Still, an investigation into changes in local sales tax authority will need to take tax exporting realities into consideration.  That starts with a better understanding than exists today of how local sales tax bases differ across the state and what can be done to address state equalization concerns.   One approach would be to incorporate local sales tax capacity into the LGA formula as part of the “need-capacity” gap calculation.   For suburban communities who do not receive general purpose aids but have the potential to export large amounts of tax to non-residents because of their retail base, some kind of power equalization formula element may be necessary whereby the state retains some of the local taxes collected for redistribution to lower tax base cities.  All of this would add complication to an aid formula that was just modified this session. 

Even with the 14% increase in LGA and 30% increase in County Program Aid enacted this session, it is doubtful the pressure to expand local option sales tax authority in any form will be ameliorated.   General public antipathy toward property taxation is too strong, now exacerbated by leveraged and declining commercial property values sloshing onto homeowners. At the same time there would likely be considerable pushback to additional equalization measures as a condition of expanding local option sales authority.  Political accountability and the disadvantages of the current law approach are other important considerations.  It’s a complicated issue, and task forces and moratoriums notwithstanding, it’s an issue that is not going away.

Teacher Pensions:  Equity Pursuit Results in New Inequity

Thanks to its $176 million share of one-time money for pension support, additional employer and employee contributions, a last-minute increase in pension adjustment aid in the tax bill, and a fresh 30-year amortization period, the Teachers Retirement Association was successful in making the complicated math work to knock a year off from when its members can retire with full benefits from 66 to 65 (effective July 1, 2025).  It doesn’t create equity with teachers hired before 1989 who operate under the “Rule of 90” but it’s a small step in that direction.

Meanwhile, lawmakers did pass an early retirement provision for St. Paul Teachers enabling teachers in that system to retire with full benefits at age 62 with 30 years of service.   It’s an interesting achievement since the plan is facing the same cost increases from enacted discount rate reductions as state plans, and the plan has only 69 cents in assets for every dollar of benefits already earned – second worst of any plan in the state -- based on the latest valuation report.

How does the math work to support a major benefit increase in that condition?  Part of the answer is that SPTRFA members and the district will be contributing more in the future to make it happen. The employee contribution of 9% percent of total salary on July 1, 2025 will be 1 percentage point higher than employees contribute to TRA, while the employer contribution rate will be 4.59 percentage points more than what other districts contribute to TRA.   Employer and employee contributions alone for pension support will then constitute 22.59% of salary.

But the answer also lies in the amount of state support the district receives. Based on the most recent valuation report, 19.9% of SPTRFA contributions come from state pension aids versus only around 4% for TRA.  The district will also receive its proportional share of one-time direct pension aid from the pension budget bill ($15.7 million, doubling the amount of direct state aid it now receives annually) plus its share of the nearly $100 million in new “pension adjustment revenue” included at the last minute in the tax bill.  Put it all together and the money coming in now and in the future is deemed sufficient to not only pay for pension benefits employees will earn over the next year and pay off the plan’s unfunded liabilities in the established time period (2048), but also make an early retirement benefit mathematically and actuarially feasible, at least on paper.

Why the difference in state support compared to TRA?   It's because the state is still paying for the funding sins of decades past. For almost two decades after transitioning the plan to being coordinated with Social Security, the state essentially stiffed the district on making necessary supplemental contributions that other transitioned state coordinated plans were receiving.¹  

Since 1994, four pieces of legislation have increased St. Paul Teachers annual direct aid appropriation to its current level of $15.7 million per year to address the underfunding that resulted.  If there is a cautionary tale regarding the sustainability of enacting a major benefit increase in a significantly underfunded condition, it might be seen in the results obtained from almost three decades of this remedial effort.  In 1994, when direct aid payments began, SPTRFA’s funded ratio was 68.3%.  In FY 2022 with employee and employer contribution rates 63% and 107% higher respectively, it was 68.7%.

Be that as it may, TRA members, already less than satisfied with the session’s outcomes, can certainly be expected to flag this new inequity and question their legislators about the disparate treatment in state support for their pension plan. Legislators probably should not expect the phone calls and emails to abate anytime soon.

Footnote

¹ As reported in Minnesota Teacher Fund Consolidation Study, December 13, 2013.  Prepared as mandated by the legislature by the Duluth Teachers Retirement Fund Association, St. Paul Teachers Retirement Fund Association, and Teachers Retirement Association of Minnesota.